Thomson Reuters (TRI): Shleifer Effect & Interpretation Arbitrage (?)

Part of my screening process is seeking out companies whose investors have become captive to the Shleifer Effect, overreacting to ostensibly bad news to drive the stock price down. I use "ostensibly" because I'm looking for instances in which:  

A.) Interpretation Arbitrage

(Forgive my feeble attempts at coining a new phrase. I won't promise it will stick. I'll probably forget about it myself.)

Investors have interpreted declining earnings - and the resulting earnings misses - as bad news and reacted accordingly by changing their opinions on the firm's future and selling off shares. They've misinterpreted the financial information or news, creating an "interpretation arbitrage" opportunity. 

Sometimes the EPS miss does not represent a change in the company's prospects. It can be random. It can be part of the grittiness of operating a business where you're just going to have down periods from time to time. Or (my favorite) it can be the result of management investing heavily in their advantages or best growth opportunities, driving up expenses faster than revenue can follow. 

Or, 

B.) Time Arbitrage

Investors have witnessed declining earnings, correctly interpreted the results as temporary, but determined other investors will likely sell-off as a result, decided their own investing timeline is not long enough to wait it out, and so sell their holdings. 

The business will be fine, and these owners have probably reached that same conclusion. But they must please their own investors this week, month, quarter, or year. The bad news might lead to several quarters or even a few years of depressed prices. The time arbitrage opportunity exists for anyone with the stomach and holding horizon to stick it out for the long-term gains.

*****

Enter Thomson Reuters (TRI), the information and business news giant. By way of background, Thomson acquired Reuters in 2007 for a whopping $16 billion. This for $600 million in operating income, indicating this wasn't a merger made primarily for earnings considerations. This was a strategic move to combine content offerings in an attempt to create a more perfect set of products. It was designed for synergy, and it was intended to create a viable competitor for Bloomberg, L.P. in the lucrative markets for trading desk data and information. 

Investors greeted the strategy warmly despite the price tag. Thomson traded in a $40 to $50 range for some time. It collapsed to $20 per share in late-2008, and understandably so given the uncertainty surrounding financial institutions, a group that represented the lion's share of its customer base. It recovered back to the low-40s by early-2011, but has since been on a long slide to mid-20s. 

At this writing TRI trades at 28.50, creating a market cap of $23.6 billion on trailing earnings (excluding a huge non-cash write-off of $3 billion) of about $2.3 billion. That's 10x semi-normalized net earnings, which looks pretty cheap. Of course the company has been reinvesting upwards of $1 billion each year in capex, suggesting (in the roughest of calculations) that owner earnings are probably more like $1.3 billion.

Despite plenty of ups and downs, the stock price has not generated wealth for its investors since the acquisition. Indeed, long-term owners (in particular, the Thomson family which owns about 55 percent of the business) are suffering.

The stagnant price, in and of itself, could be enough to indicate an investment opportunity. The Thomson Reuter combination story is clearly out of favor with Wall Street. But more interesting to me is the heavy investment the company has been plowing into a product it calls Eikon.

*****

Eikon is meant to be the culmination of the synergies between Thomson and Reuters...the ultimate justification for the expensive merger. (Take a look at the terminal/service here.) 

Joanna Pachner of Canadian Business put together an excellent overview of TRI's great hopes for Eikon in a February 2012 piece here. She writes:

The Eikon platform, which cost a billion dollars and took more than two years to build, gave users access to the two companies’ combined intelligence on one desktop—hundreds of news sources, research reports and analytical and trading tools that brokers, bankers and analysts rely on to weigh investments, assess risk and conduct transactions.

There's no question that TRI has leaned heavily into this investment. Both sales and earnings have suffered as a result. This has all the hallmarks of a Shleifer Effect opportunity. While revenue has grown year over year, reported earnings have declined each year since 2008. This creates a narrative for Wall Street of a business in a holding pattern (at best) or whose offerings are in decline (at worst).  As the Shleifer Effect describes, investors tend to see patterns in the earnings. Unless they have strong reason to believe otherwise, they interpret a down-sloped trend line to keep the same trajectory in the future. Owners sell. New buyers are loathe to come in. The long-suffering of shareholders tends to chase away all but the most entrenched interests. 

The great hopes for Eikon and the stability of the Thomson family 55 percent stake in the business have probably mitigated the effect somewhat. 

Eikon holds out a double-sided promise to expand operating margins from 18 percent to mid-20s. On the revenue side, it is meant to drive TRI into new markets with new clients. It's supposed to be so cutting edge and so easy to use, it will cast a halo on the company and the rest of its products, easing the growth path into new geographic markets and adjacent line expansions. 

On the expense side, it allows TRI to cut 200 expensive legacy systems with their equipment costs, maintenance, and separate silos for sales, customer service, etc. In its 2011 investor day presentation, TRI anticipates Eikon allowing it to consolidate from 172 data centers to six, from 19 delivery infrastructures to one, and from 1,600 developers to only 1,000. 

The ambitions are large. Each percentage improvement in operating margin is $130 million-plus increase in earnings. If TRI can accomplish its goals - successfully launch Eikon, realize the strategy behind the Reuters acquisition five years ago - the business should be much more valuable than Mr. Market gives it credit today.

Eikon creates a binary decision-making process on TRI as an investment. If Eikon succeeds, TRI will look cheap a few years out. But if Eikon fails, the Mr. Market has probably been too generous with his 18x market cap to owner earnings multiple.

*****

Strategies that look so good in investor presentations, and whose numbers hold such great promise for enriching shareholders, are not implemented in a vacuum. No, companies must execute them in the live-fire world of resource constraints, operational hurdles, and constant competitive challenges.

In a previous life I was part of a software company that sat on a cash-cow of legacy products used by a couple hundred hospitals nationwide. The products were solid, but the limitations of the old technology meant there was little we could do to expand their functionality. And (even worse) the legacy platform was becoming passe. No one was buying the operating system anymore. We had a decision to make...milk the cow until it ran dry, or try to reinvent the business.

Given the ambitious management team, we chose the latter path. (The ambitious are prone to action even in the face of difficulty and often despite odds stacked wildly against them.) We transitioned to a new platform. First we called it ASP, then SaaS, now cloud-computing. Using the legacy features as our blueprint, we built several new products from scratch. They were a thing to behold! The latest. The greatest. We expected the market to beat a path to our door, demanding the products immediately and waving crisp dollar bills under our noses.

That didn't happen.

Well, at least we had our fallback. We would offer our existing legacy customers the opportunity to transition to the new products, revel in their benefits, and spout the benefits to the rest of the world. Well, they didn't want to change.

We were stuck. We went through a couple rounds of lay-offs. And then the president went for the hail-mary. He sunset the legacy products, announcing to the customers that they had 18 months to transition to the new platform before we stopped supporting the old. The gamble paid-off. Mostly. With much grumbling and gnashing of teeth (we heard the term "extortion" over and over again), we managed to swap over a little better than half of existing customers. We survived the loss of clients because we forced them to pay a premium for the new products.

What happened to the others? This is the most informative part of the story when thinking about introducing new technology products...while they would have continued paying us for years on the legacy products (inertia is a powerful force when dealing with IT buyers), when we forced them to make a decision they decided to open up their process to our competitors. And our competitors got fat and happy off the defections.

Lesson for all...heavy investments in technology upgrades are painful for everyone involved. Even if you think you're loved by your customers, pushing an upgrade (that requires new equipment, new training...just change in general, even if there is no additional cost) creates opportunity for your competition. In the enterprise software business, the long knives come out when a foe is pushing an upgrade or transitioning to new platforms. From a sales and marketing perspective, you know you can ramp up your prospecting when there is an opportunity to drive a wedge between a previously unbreakable bond between client and vendor.

Such is the reality that Thomson Reuters has faced with attempting to funnel hundreds of legacy applications into a single platform. One, there is the normal intransigence from existing clients around IT changes. And two, change gives those clients an opportunity to get cozy with the competition.

*****

As measured by nearly all significant metrics, the Eikon launch has been a dud. This despite a two-year development effort, involving the work of some 2,000 programmers, a reported 1,000 client beta test, and a heavy marketing push through major financial media. 

The results? According to the Canadian Business article, nine months into the launch only 25,000 of TRI's 400,000 financial product users have transitioned to the new platform. Worst yet, only 3,500 new users have signed up. The CEO of the Eikon division left the company with several of his lieutenants. The company CEO, Tom Glocer, took over. Soon enough, he was shown the door. 

According to this FT.com article from July 2011...

...deployment of the platform has been marred by poor product integration, cumbersome technology, and a fragmented sales effort. One industry executive familiar with the company said that where co-operation over the implementation of Eikon had been required, there had instead been “territoriality”.

The Economist supplies this graph, comparing the market share of Thomson Reuters financial offerings versus those of Bloomberg. At the merger, TRI had a distinct advantage. But Bloomberg has closed that share at an astonishing rate. Indeed, Bloomberg defines the competitive environment into which Eikon is attempting its launch.

What has Bloomberg done during the Eikon launch? A lot. This is, I think, the most damning evidence against the long-term potential of Eikon competing against Bloomberg.

Computer World UK reported in February 2012 that Bloomberg dived into its own platform redesign...Bloomberg NEXT. The results versus TRI's attempt could hardly diverge more. Bloomberg spent a reported $100 million versus TRI's $1 billion. It programmers worked extensively with end-users, making sure to track their acceptance of changes and new features. It was an Apple-like design approach. Bloomberg moved some 100,000 of its 300,000 customers in the first few month and said it expected to move the rest by end of 2012. 

And Bloomberg isn't stopping there. Sensing a weakened opponent, it's pushing its advantage by going even deeper into markets that TRI has traditionally dominated. From the Canadian Business article: 

This month, Bloomberg launched another salvo across TR’s bow by unveiling a new tool that will let clients freely access information for which TR charges fees. The private company has said it expects its fiscal 2011 revenue to rise 11%, to $7.6 billion—a much steeper growth curve than the 2% Burton-Taylor projects for the industry. The two companies’ market-share trajectories sum up the momentum: both now have around 31%, but for Bloomberg, that’s up from 25% in 2005; TR is down from 37%.

I'll use two more quotes and then end this comparison between rivals. First, Bloomberg executives are displaying thinly veiled schadenfreude at TRI's troubles. Regarding NEXT, Tom Secunda (Bloomberg co-founder) states: 

Simplicity has tremendous value. A function that's brilliant and never used is worth zero...Our business model is that we keep our price fixed but we dramatically increase the value of our product. 

Second, the Candadian Business article winds up using this conclusion (apt, I think):

TR executives may be confronting a disheartening realization: that even a huge investment in state-of-the-art technology, which is in many ways superior to its main competition, may not be enough to reverse its slide and Bloomberg’s gains—“which goes to the core of how entrenched Bloomberg is,” says Aspesi. TR admitted last year, he says, that it doesn’t expect to regain the market share it’s lost any time soon. In what promises to be a very tough year in the financial markets, amid economic weakness and European instability, Thomson Reuters may have to significantly change its game plan. “The merger could not have made more sense,” sums up Taylor. “The strategy is still sound. But the tactical implementation just hasn’t worked.”

*****

Using screens to identify investment candidates, Thomson Reuters showed some early promise. While somewhat cheap on a reported earnings basis, the company was clearly investing heavily in what it saw as a future franchise...Eikon. It just might be a Shleifer Effect interpretation arbitrage opportunity. For purpose of our assessment, the success or failure of Eikon really is the driver, creating a decision based on a very simplified question...

Do we have good reason to believe that Eikon will succeed, creating stronger earnings in the future, and protecting the business with a competitive advantage against the likes of Bloomberg?

From the evidence we collected, it seems the answer is "no." Reality might very well play out differently. Perhaps there's something going on behind the scenes that we just don't understand. Perhaps TRI is worth considerably more after another year or two of getting Eikon (and its other businesses) right. I'll accept that possibility while understanding that I don't see a clear, conservative path to it. The shallow competence I possess calls TRI a pass.