Gaia (GAIA): A Strange Value Investment in a Strange Streaming Service

Gaia (GAIA): A Strange Value Investment in a Strange Streaming Service

Gaia operates a streaming service like Netflix, but for yoga, meditation, and weird conspiracy videos. They have many great titles, like “The Baltic Sea Anomaly; A Crashed UFO Or Natural Rock Formation?” or “Cannabis Spirituality: Using Plant Medicine as a Sacred Tool”. The company is run by its founder, Jirka Rysavy, who owns over 32% of the company’s stock. Rysavy is an experienced entrepreneur who founded Corporate Express, which became a Fortune 500 company before merging into Staples. Gaia is growing extremely fast, but has been losing money along the way. I believe the net losses are a result of investments for growth that will dramatically decrease over the next few years.

At first glance, Gaia is exactly the kind of business that value investors would avoid. The company is selling for $160 million, and produced just $42 million of streaming revenues in 2018. This gives the stock a price to sales ratio of 3.8. The company’s losses have been growing, with a net loss of $33.8 million in 2018 and $23.3 million in 2017. At this point, most value investors would have lost interest and moved on to the next idea. However, there are some very interesting aspects of this business that deserve a closer look.

Gaia has a low amount of operating expenses, while most of their net loss comes from investments for growth. This provides the business the potential to earn very high returns on capital as the investment in growth spending slows. In the 2018 Q4 earnings call, management expressed that their plan was to reduce subscriber acquisition spend throughout 2019 as they attempt to head toward profitability.

What really excites me about Gaia is the low cost of content. This can be seen within the company’s gross margin. As the company grows, the gross margin continues to rise as well, from 80.7% in 2015 to the 87.2% Gaia had in the 4th quarter of 2018. Netflix, for comparison, has a gross margin of 36.9%. In addition, the gross margin doesn’t tell the whole story for Netflix, as their amortization of streaming content leads to cash flow being much worse than net income. The opposite is true for Gaia, as they reports better cash flow than net income. However, cash flow is still negative for Gaia for the time being. This low cost of content is achieved even considering that the vast majority of Gaia’s titles are either created by or exclusively for Gaia. About 90% of Gaia’s content is exclusively available for Gaia subscribers. For companies like Netflix or Gaia, the sole product is content. With such low costs of content, there is potential for abnormal profits eventually.

The net loss for Gaia can be attributed to the ‘Selling and Operating’ line on the Income Statement, as this is currently 156% of revenue. In 2018, this value was $68.3 million. Management discloses in the earnings calls the breakdown of what they consider operating expenses compared to subscriber acquisition costs. $52 million was spent on subscriber acquisition costs in 2018, leaving about $16.3 million of expenses within ‘Selling and Operating’ that management considers a part of normal operations. $46.3 million of this subscriber acquisition cost was spent on advertising, while the remainder was mostly spent translating current titles into new languages as they expand abroad. In a subscription based business, advertising should not be needed to retain customers. If the business experiences low customer loyalty and high turnover, then advertising would be needed to attract enough customers to offset the lost customers. However, as long as customer retention isn’t poor, then the vast majority of this advertising expense should be considered growth capex.

 

	2018	% of Revenue
Revenue	$43,843	100%
Cost of Revenues	$5,705	13%
Gross Profit	$38,138	87%
Corporate, general, and administration	$5,909	13%
Profit before Selling and Operating	$32,229	74%
Selling and Operating	$68,321	156%
pre-tax profit (loss)	-$36,092	-82%

 

Customer turnover is not disclosed currently, and this is a key part of the bear thesis on the company. I don’t believe there is enough information to be sure one way or the other on customer turnover. However, Gaia has experienced pretty intense growth recently. They grew subscribers by 80% in 2017 and 51% in 2018. If they had large numbers of old customers leaving them, then they must have been adding an even larger number of new customers over the past few years. This makes me a little more comfortable about customer turnover. Additionally, Gaia is rated 4.8 stars out of 5 in the Apple App Store out of 31,675 reviews as of 3/30/19. This rating is impressive, as the number of reviews make up almost 6% of their total 550,000 subscribers. This is a pretty high percentage considering some subscribers don’t use Apple products, and many other people never leave public reviews. Netflix is rated 4 stars in the App Store out of 109,187 reviews. Netflix has 139 million paying members, meaning 0.07% of members gave a review on the App Store. Gaia’s reviews are 30% of Netflix’s, while Netflix has over 250 times more subscribers. While this is interesting, there are no guarantees in regards to overall customer satisfaction or loyalty.

In the third quarter of 2015, the company focused on profitability to prove the viability of the business model. They reported profits of $212,591 in the quarter for their streaming service with 117,000 subscribers. You have to be able to trust management a little bit with these numbers, as there is some room for manipulation. Back then, the company was called Gaiam and they had multiple business segments other than video streaming. It is difficult to tell how much overhead they attributed to the streaming service versus some of their other businesses. I am comfortable at least that the business is able to be profitable and produce positive cash flow with a much lower subscriber base. As of 12/31/2018, Gaia had 550,000 subscribers. The business is growing fast, but even if their subscriber count dropped 79% back down to the 2015 Q3 level, they could potentially adjust their operations to become slightly profitable or near break even and remain in business. I don’t think the downside is too terrible here.

The reason for low content costs is probably due to the fact that most of their videos are low quality. Low quality products should worry me as an owner of the business, but my hope is that this quality level sufficiently serves the customers in their niche. You don’t need to pay Leonardo DiCaprio to star in “Revelations From Alien Encounters” or “Aliens on the Moon: The Truth Exposed”. The key will be whether or not their niche customer base finds the content valuable. The ‘industry’ dynamics, or in this case the dynamics of the niche Gaia is in, has the potential to create a moat for Gaia as the low cost producer of content. If Gaia can capture a large enough share of this small niche, then businesses may think twice before attempting to enter the market. Since Gaia is already operating in the niche, they get to enjoy the benefits of the low cost of content. One counterpoint to this argument is that technology these days reduces barriers to entry. Anyone can produce a cheap video on Youtube, and this could cause competition within Gaia’s niche.

In the middle of 2016, Gaia’s management laid out their plan to grow the business. They started off strong, accomplishing the revenue goals set for the first two years. 2018 fell short, but 51% growth is still impressive. In the 2018 Q3 earnings call, management stated that they were still on track for 1 million subscribers. However, they changed course just one quarter later and are now focusing on profitability. The stock price took quite a hit after this announcement, dropping more than 20% since then. When the plan was originally made, management set a goal of 1 million subscribers because they wanted to capture such a large market share in this tiny niche that it would create a barrier to entry. Management claims that they haven’t seen the new entrants that they expected. Also, the cost of acquiring subscribers has grown. These two reasons led to the abrupt change in plans.

 

	Goals Set in 2016	Actual Result
2016	Grow subscribers by 50%	52%	Complete
2017	Grow subscribers by 80%	80%	Complete
2018	Grow subscribers by 80%	51%	Fail
2019	1 million subscribers	?	Plans Changed
2020
2021	Pre-tax income of 40% of sales	?	Plans Changed

 

With the business selling for $160 million, Gaia doesn’t look cheap based on traditional metrics. If you dig deeper though, there is value here. The business produced streaming revenues of $42 million, and had operating expenses of $27.9 million before customer acquisition costs. Since I consider customer acquisition costs to be growth capex, that leaves us with about $14.1 million in operating profit before growth spending. This is a yield of about 8.8%. As I mentioned before, revenue grew by 80% in 2017 and 51% in 2018. If we assume 30% growth over the next two years, as management is projecting, that would bring us to almost $71 million at the end of 2020. While revenue grew fast, operating expenses have grown at a much slower rate. Operating expenses before subscriber acquisition costs grew 17% in 2018, from $23.8 million to $27.9 million. Let’s say that increases to 20% over the next two years. This brings us to about $40.2 million at the end of 2020. The net result would be operating profit before customer acquisition costs of $30.8 million, or 19.3% of the current market value. These are not very conservative assumptions, but there is potential that the current stock price would look cheap in a few years.

An important piece to this investment is Gaia’s management. While I am personally not a fan of Gaia’s content, it does seem to fit the lifestyle of its CEO, Jirka Rysavy. In 1998, long before Gaia was created, Fortune magazine featured Rysavy in a story on the homes of 5 business leaders. At the time, he was living in a small cabin in the Rocky Mountains without indoor plumbing. He slept in a sleeping bag, cooked outside over an open fire, and used an outhouse across a dirt road. I can’t be sure of Rysavy’s motives with Gaia, but I get the sense that he felt a genuine purpose for starting the company. He owns 32% of the company’s stock, aligning his interests with shareholders. Also, he has been candid with shareholders in the sense that he has set clear, defined goals for the company. Some of these goals have seemed a bit extreme or aggressive, but Rysavy and his team has found a way to accomplish some of the aggressive goals so far. I will be interested to see if this continues.

Gaia reminds me of two businesses discussed by Buffett and Munger: the Daily Racing Form and the magazine Motocross. Berkshire used to own Capital Cities/ABC, which was a business that had many advantages of scale. In the book ‘Poor Charlie’s Almanack’, Munger discusses some of the disadvantages of scale that they ran into. Capital Cities/ABC struggled to compete in businesses that had narrower and narrower specializations, like trade publications.

 

“That’s what happened to the Saturday Evening Post and all those things. They’re gone. What we have now is Motocross – which is read by a bunch of nuts who like to participate in tournaments where they turn somersaults on their motorcycles. But they care about it. For them, it’s the principal purpose of life. A magazine called Motocross is a total necessity to those people. And its profit margins would make you salivate.” – Charlie Munger, ‘Poor Charlie’s Almanack’

The other business that Gaia reminded me of was the Daily Racing Form, which was owned by Billionaire Walter Annenberg. Decades ago, Annenberg told Buffett that “there are three properties in the world that have the quality of Essentiality. They are the Daily Racing Form, the TV Guide, and the Wall Street Journal. And I own two out of three”. (He also owned the TV Guide.)

 

“What he meant by essentiality was that, even during the Depression, he saw the Racing Form being sold for two and a half bucks down in Cuba.”

“The Racing Form had that quality because there was no source of better or more complete information about handicapping horses.”

“It sold a hundred fifty thousand copies a day, and it had for about fifty years. It cost more than two bucks, and it was essential. If you were headed to the racetrack and were a serious racing handicapper, you wanted the Racing Form. He could charge whatever he wanted, and people were going to pay it.” – Buffett, ‘The Snowball’

 

Motocross and the Daily Racing Form were so successful because they gobbled up most of the market share within a small niche, had very low operating expenses, and had high customer loyalty. Since their niche was so small and they already dominated the market, it would be extremely risky for a new business to enter the market. They would have to invest quite a bit compared to how little market share potential there was. This small of a niche wouldn’t support multiple businesses. They were able to have incredible profit margins because their operating expenses were so low, and because they had pricing power due to customer loyalty. Gaia definitely has low operating expenses, but the key question is whether or not they have high customer loyalty. We still don’t know the answer to this question.

 

Conclusion:

 

Is this a good business?

 

We don’t really know that answer to this yet. In order for this to be a good business, Gaia must have the ability to retain customers at a high rate. Since there is no disclosure on customer loyalty at this time, this is an unknown. However, if Gaia can achieve a decent level of customer loyalty, it has the potential to be a great business with high returns on capital.

 

Is this stock safe?

 

No, the stock is not safe. It is a young startup business, so we have little history to analyze in regards to operations. The business has been burning cash quickly, the company produces controversial videos, and management has set lofty projections. With so many unknowns, Gaia should be considered a risky stock.

 

Is this stock cheap?

 

This is not a cheap stock in the traditional sense. Gaia would not appear favorably in any type of screener that value investors may use. However, I believe the current stock price is cheap when taking into account all of the business dynamics discussed above. For the current valuation to be appropriate, Gaia must have some decent growth, as well as be able to dramatically reduce the ‘Selling and Operating’ line on the Income Statement. Since management plans to reduce growth spending over the next few years, my thesis is about to be put to the test.

* I own shares in GAIA