Heller House Opportunity Fund - 2018 Q2 Letter - Public

Heller House Opportunity Fund, L.P.
Q2 2018 Letter to Investors
August 28, 2018
Dear Partner,
It has been a choppy year for our holdings when it comes to stock prices, but in terms
of growth in intrinsic value, I believe the portfolio is extremely well positioned. Eventually,
the prices of the businesses in which we own a partial interest will catch up with growth in
value and the improvement in long-term prospects we have seen in quarterly earnings
reports.
We are invested in exceptionally strong businesses with widening moats and great
management teams. Our businesses are growing and reinvesting their earnings into very
large addressable markets. We own these companies because I believe these trends can
continue for many years. As a result, our returns will, over time, mirror their underlying
performance. My thinking on business and investing has evolved considerably over the past
several years and we now have the best portfolio, in my view, the partnership has ever had
in its history. And given the fact that our performance is flat for the year while these
businesses continue to grow robustly, makes our portfolio a “coiled spring.”
Software… coming now to an industry near you
The big picture is that software is eating the world—that is, many of the products and
services developed over the past 150 years are transforming into, or being disrupted by
software (full credit to venture capitalist Marc Andreessen for articulating this idea years
ago). The implications are enormous; software is infinitely replicable and, through the
internet, can be delivered at zero marginal cost. When a major input to business—
distribution cost—goes to zero, entire industries get disrupted. When one can build a
business model from the ground up with entirely new assumptions, one can attack
incumbents in a way that is very difficult to defend.
This shift has resulted in the creation of new business models that would have been
impossible in the previous era. One example of this is software as a service (SaaS).
Previously, software was sold in shrink-wrapped boxes in retail stores once every several
years. The consumer had no way of knowing if the vendor would be in business for
improvements down the road. The vendor’s sales were lumpy and there was no feedback
loop between usage and product improvement. Enterprise sales involved lengthy and
expensive installation periods followed by similarly expensive maintenance contracts.
1111 Brickell Ave, Suite 2135 hellerhs.com 1

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With software that is delivered as a service, all of this changes. The financial
incentives between consumer and vendor are better aligned. There is instantaneous
feedback in usage and indeed the vendor can update the software yearly, monthly or even
by the minute. You can already see this in large consumer businesses: Google, Facebook,
Netflix are all examples of software businesses that live in the cloud (computer servers
around the world) and are delivered to you on a continuous basis, with seamless feedback
loops providing the vendors with ample data to improve and expand the service.
Cloud computing, the hosting of these services, which is a business led by Amazon,
Microsoft and Google, has the potential to be a platform: a surface that itself is very
profitable, but that enables an even larger ecosystem of companies to be built on top of it. A
good example of a platform is Microsoft’s Windows: it was (is) an incredibly profitable
franchise, and allowed an even more profitable ecosystem to evolve around it. I’m optimistic
about the future of the partnership not only because of our existing investments in this area,
but also because of the deep pipeline of interesting cloud-enabled companies we are
evaluating.
As we have explained in our recent Q3, Q4, and Q1 letters, as well as during our
investor day, our focus is increasingly in exceptional franchise businesses that can grow and
reinvest for many years. We plan on holding these businesses indefinitely, subject to our
evaluation of their underlying competitive advantages (we want growing or at least stable
moats over time), and valuation (even the world’s best business at too high a price is not an
attractive investment).
We have good reasons for our shift in focus. First, I believe that the traditional “value
investor” mentality of buying cheap securities, waiting for them to bounce back to “intrinsic
value,” selling and moving onto the next opportunity, is flawed.
In today’s world of instant information and fast-paced innovation, cheap securities

increasingly appear to be value traps; often they are companies ailing from technological
disruption and long-term decline. This rapid recycling of capital also creates an enormous
drag on our after-tax returns. In addition, by focusing on these opportunities, we incur
enormous opportunity costs by not focusing instead on the tremendous opportunities
created by the exceptional innovation S-curves we are currently witnessing.
There is another reason “cheap” is a poor proxy for value: the new business models I
described above—SaaS in particular—are not well suited to traditional GAAP accounting.
Here’s why: if distribution costs are zero, the optimal strategy is to gain as many customers

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for your software product, as quickly as possible. In digital businesses, there are increasing
advantages to scale, and many of these companies operate in winner-take-all or winner-take-
most markets. The name of the game is thus to build, grow, then monetize. Frequently, this
means spending a lot of money in sales and marketing, which depresses reported earnings.
Thus, SaaS companies spend to acquire customers upfront, and recognize revenue
from those customers over many years. This mismatch burdens the income statement. Some
of the most successful—and highest performing stocks—in the SaaS world have spent many
years growing despite producing no meaningful accounting profits. They are very profitable
in terms of unit economics (as we’ll explain below), and once they stop reinvesting every
dollar generated into further growth. The traditional method of screening for low P/E stocks
doesn’t work in this scenario.
We expect the world to have more of these types of businesses in the future; we are
not going back to the old world. The diffusion of the internet around the world, and cloud
computing on top of it, will see to that. The investment in exceptional businesses riding these
trends is our primary goal.
Ditch the cigar butts
We talked about a useful example of investing in secular trends during our investor
day: In 1948, the most famous value investor of the “traditional” variety (Benjamin Graham)
put 20 percent of his fund in GEICO stock. It wasn’t traditionally cheap; indeed, Graham noted
that “Almost from the start the quotation appeared much too high in terms of the partners’
own investment standards,” referring to his and his investment partner’s traditional
valuation metrics.
Over the following 24 years, the stock went up 145x, or about 23 percent
compounded per year—a fantastic result. Graham later wrote, “Ironically enough, the
aggregate of profits accruing from this single investment decision far exceeded the sum of all
the others realized through 20 years of wide-ranging operations in the partners’ specialized
fields, involving much investigation, endless pondering, and countless individual decisions.”
(Emphasis mine)
In my view, GEICO was the only real value in the portfolio; the rest were distracting
cigar butts. Imagine if Graham had recognized the characteristics of GEICO that made it so
exceptional, and had instead focused his efforts on finding more investments like it?

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This begs the question of hindsight bias: would it have been possible to foresee
GEICO’s success? Perhaps so; after all, Graham thought it was a good enough business to
make it a large position.
In 1948—indeed, decades earlier—it was clear that cars were here to stay.
Government data since 1900 shows that by 1947 the registration of cars and trucks in the
US had grown at 20 percent compounded over the previous 47 years. The population of the
country had compounded at 1.4 percent per year during the same period. There was only
one car or truck for every four people in 1947. Looking at this data, it was clear that there
was room for continued growth.
Indeed, a New York Times article from February 1947 quotes an auto dealer, “Go to a
dozen or more showrooms and try to buy a car. The average terms set for delivery will be
four to six months and these will be hedged in with provisions. Some will not even accept
orders because of the size of the backlogs, while others will designate them for late 1948 or
even 1949.”
It’s fair to say, then, that autos were clearly a growth industry. Here’s how the future
unfolded: in 1948, there were about 0.28 cars and trucks per person in the US; this increased
to 0.8 in the late 90s, up nearly three-fold. Similarly, there were 41 million cars and trucks in
1948 and 251 million in 2014, up six-fold.
Below are a couple of charts showing these adoption curves. These aren’t unique to
automobiles; we can find similar curves for the diffusion of the printing press, electricity,
indoor plumbing, radio—all technologies predating 1948. Graham could have plotted the
growth in the auto industry through 1948, reasoned by analogy, and observed that with
GEICO, he was riding a powerful adoption curve.
What else did GEICO have going for it? It was direct-to-consumer, bypassing the sales
agent and therefore offering a product at times up to 30 percent cheaper. It also had superior
risk targeting, underwriting lower-risk customers like government employees, teachers and
veterans. GEICO was therefore a superior, disruptive product, riding a growing S-curve (car
and truck adoption).

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Cars and trucks per capita in the U.S., 1900-2014

0.9 0.9
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
1948, 0.280
0.2 0.2
0.1 0.1
0.0 0.0
Sources:
https://www.fhwa.dot.gov/ohim/summary95/mv200.pdf
https://www.fhwa.dot.gov/policyinformation/quickfinddata/qfvehicles.cfm

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Cars and trucks in the U.S., 1900-2014 (millions)

300 300
250 250
200 200
150 150
100 100
1948, 41
50 50
0 0
Sources:
https://www.fhwa.dot.gov/ohim/summary95/mv200.pdf
https://www.fhwa.dot.gov/policyinformation/quickfinddata/qfvehicles.cfm
https://www.tsl.texas.gov/ref/abouttx/census.html
The logical conclusion by an intelligent investor would be to find more GEICOs and
eliminate the cigar butts from the portfolio, and that’s exactly what we have done. GEICO was
ultimately acquired by Benjamin Graham’s student, Warren Buffett, and now thrives inside
Berkshire Hathaway. It continues to gain share in US auto insurance.
Advertising for customers
GEICO is typically among the top five advertisers in the US. Advertising is GEICO’s
expense for acquiring customers—both direct response advertising (you go to Google.com,
search for car insurance, see a GEICO ad, click and purchase)—and brand advertising (you
need car insurance, and the first brand you recall is GEICO and its friendly gecko). As a large
advertiser, GEICO has enormous customer acquisition costs.

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Why is Buffett, a savvy investor, willing to pour so much money into advertising?
Because the payoff is huge: once you buy car insurance from GEICO—input your credit card,
social security and vehicle identification numbers, and print out the insurance card to keep
in your glove compartment—it becomes a hassle to switch. The product is sticky, it has high
switching costs. It’s essentially a subscription product (that auto-renews) with a very high
lifetime value. When a business has a high ratio of lifetime value (LTV) to customer
acquisition costs (CAC), it’s rational to invest as much as possible in acquiring new
customers, and that’s exactly what GEICO is doing. (Think back to the SaaS example above.)
GEICO worked out for Graham and Buffett because of these superior characteristics:
the company had the ability to grow, and to do so while earning high returns on capital.
Grow… but only if you have high returns on capital
In the latest, sixth edition of the book Valuation, Measuring and Managing the Value
of Companies by McKinsey & Company, the authors wrote, “We’ve found, empirically, that
long-term revenue growth—particularly organic revenue growth—is the most important
driver of shareholder returns for companies with high returns on capital. We’ve also found
that investments in research and development (R&D) correlate powerfully with positive
long-term shareholder returns.”
Growth works for companies with high returns on capital. (In lousy, low-return
businesses, growth actually destroys value.) The internet has enabled two very interesting
dynamics: huge growth (with zero distribution costs, companies can scale globally), and the
use of very little capital (no expensive factories and stores to build). Internet-first businesses
therefore score very highly in the high growth, high return on capital metric. And as the
authors point out, this metric is highly correlated with attractive shareholder returns.
They also mention investments in R&D. Innovation and investment in the business is
key. What’s the point of attracting the world’s best, brightest employees, showering them
with stock options, only to deprive them of growth opportunities? Not only that, but
competition—capitalism—will ensure that a stagnant company that isn’t constantly
learning, growing and improving will no longer have a business in the future.
Yet most corporations are incapable of innovating because of misaligned incentives.

I saw this first hand at this year’s Consumer Analyst’s Group of New York (CAGNY)
conference, which hosts presentations by most of the world’s leading packaged goods
companies, like Unilever, General Mills and Johnson & Johnson. The entire conference had a

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funereal atmosphere, with all executives complaining about “disruption” to their businesses,
guiding to tepid revenue growth, and promising more cost cuts (anything to juice earnings).
While some of these companies pay lip service to innovation, overall they are run by
management teams focused on keeping margins consistent and earnings per share growing
or at least stable. True innovation requires pain; the reason is that innovation requires
attacking new markets, and by definition, new markets cannot be analyzed (because they
don’t yet exist). Most companies cannot stomach the short-term hit to earnings required for
innovation because management incentives are not aligned. These managers are
mercenaries; they’re in it for the money. Most management teams’ goals are to grow earnings
per share over a certain number of years, collect their yearly bonuses (which are predicated
on these metrics), and then retire with a golden parachute. As Charlie Munger said, show me
the incentives, and I’ll show you the outcome. Incentives really matter, and when it comes to
the majority of corporations, the incentives are at odds with those of long-term shareholders.
The McKinsey book cited above notes that “in a survey of 400 chief financial officers, two
Duke University professors found that fully 80 percent of the CFOs said they would reduce
discretionary spending on potentially value-creating activities such as marketing and R&D
in order to meet their short-term earnings targets.”
What advantages do truly innovative companies have? They tend to be run by

missionaries, not mercenaries. Missionaries will do whatever it takes to reach their mission
and are willing to experiment, disrupt their core businesses, invest for growth, and seek out
new markets for expansion. Alphabet’s mission is to organize the world’s information and
make it universally accessible and useful. Amazon’s is to be the world’s most consumer-
centric company. At any given point in time, Amazon is running dozens of experiments with
two-pizza teams (teams small enough to be fed by two pizzas), in search of innovation and
growth. These experiments have resulted in countless businesses and three main pillars:
Prime (Amazon’s membership program), Marketplace (opening up the platform to other
sellers, now around half of Amazon’s unit sales), and AWS (cloud computing). Ongoing
experiments are aiming to develop more such pillars.
Jeff Bezos has said that he’s willing to lose money for several years on any experiment
before harvesting a return. Indeed, Bezos and his management team have studied the
seminal work on disruption, The Innovator’s Dilemma, by Clayton Christensen. Reading the
book, one has the impression that Bezos systematically built Amazon as a disruption
antidote, doing the exact opposite of what Christensen explains is the problem with
companies that get disrupted. This is why it’s so hard to compete with Amazon, and why the

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company is growing into a natural monopoly in general goods and an oligopoly on the
compute economy (with Amazon Web Services). Their incentives are aligned in a way that
other companies can’t even imagine.
Growth is the product of return on invested capital (ROIC) and the investment rate.
In other words, companies that have high returns on capital and can reinvest a lot of their
generated cash flows will grow faster. And because shareholder return is closely correlated
with growth and ROIC, owning companies with these characteristics will over time result in
very attractive returns for the fund.
S-curves of the future
If Benjamin Graham was—unwittingly—riding the adoption curve of the automobile

in the 20th century, which technology adoption curves are we riding with our investments?
There are several of them. Overarchingly, we are riding the adoption of the internet and
particularly broadband around the world. It’s hard to believe, but we’re only halfway
through that curve (only 50 percent of the world by population has internet access). On top
of that, we have the shift in computing platforms from desktop to mobile; every new user
accessing the internet is likely doing so on a smartphone, not a PC. Hooi Ling Tan, the co-
founder of Southeast Asia’s Grab (Uber-like competitor), shared some interesting statistics
at a recent conference I attended. She noted that there are 650 million people in Southeast
Asia (compared with 326 million in the US), with a total GDP of $3 trillion ($18 trillion in the
US). Over the next five years, that region will add 124,000 new internet users per day, every
day. That’s 226 million new customers for internet-enabled businesses, albeit with a very
low—but growing—spending power.
On top of the smartphone, then, there are several S-curves unfolding: the rise of
ecommerce, which even today is only 6.5 percent of U.S. retail sales; the rise of social media
(only 33 percent penetrated globally); video and music streaming; gaming and esports;

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travel and leisure; the secular shift in advertising from

traditional media to online; ride-sharing and autonomous
vehicles. Our investments are advantaged by each of these
secular trends.
Advertising and commerce
It seems that on a long enough timeframe,

advertising businesses will get into ecommerce, and
ecommerce businesses will get into advertising. For
example, Facebook is building out its ecommerce
capabilities within Instagram, allowing sellers to tag photos
of apparel, and customers to tap and buy, for a seamless
visual shopping experience.
Google is also expanding its ecommerce presence.

The company recently announced partnerships with
various global retailers to better surface their products on
Google search, improve the placement of ads, improve their
data productivity by migrating to the cloud, and eventually,
enable autonomous delivery with Waymo-enabled vehicles
(Waymo is Google’s autonomous driving unit, discussed Google’s Shopping Actions
below). Google has also made a strategic investment of $550
million in JD.com, the second largest ecommerce company in China. In the US on Google
Express, shoppers can buy from 100 merchants including Walmart, Costco, Target,
Walgreens and PetSmart, and get quick delivery, often for free and on the same day. If you
open your browser and search for a product—for example, funky socks—you’ll see a
carrousel of options that Google presents, called Shopping Actions. This is also an area of
increasing growth for Google’s ecommerce efforts.
On the other side, Amazon’s advertising business is growing dramatically. We don’t

know exactly how dramatically, because the numbers aren’t broken out, but it’s likely
growing 40-60 percent year over year. Advertising is now a multi-billion-dollar business for
Amazon, around $6-7 billion per year at the current run-rate. These incremental ad dollars
flow through to Amazon’s bottom line at a very high—nearly 100 percent—profit margin.
Amazon is probably the best-positioned company in the marketing funnel. Imagine a

funnel going from consumer awareness, to interest, consideration, intent, evaluation and

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finally, purchase. Compared with Facebook and Google,

Amazon is much lower in that funnel, that is, much closer to
the actual purchase transaction; recent surveys have
estimated that 40 to 50 percent of product searches no
longer start on Google, but on Amazon. And once you search
for a product on Amazon and find it, you’re likely to just
click “buy”. This is why Amazon’s advertising business is so
compelling. Whenever you visit Amazon on your PC or
smartphone, look out for “sponsored” products: each of
these is an advertisement. In the days of the supermarket,
companies would advertise on TV or radio, and then pay
slotting fees for shelf space and endcaps. With the decline
of TV and radio, those investments are no longer enough to
reach consumers (nor, in many cases, are they sufficiently
targeted—why spend money advertising tampons on TV to
a male octogenarian?). Instead, companies are increasingly
paying Amazon for privileged real estate on your
smartphone—the new endcap. Witness this example of a Advertising on Amazon
search for “toothpaste,” where Procter & Gamble is paying
Amazon to promote its “Crest Gum Detoxify Deep Clean Toothpaste,” which sells for $1.22
an ounce, compared with Amazon’s Choice (products that have great reviews and few
returns) at only $0.82 an ounce—a better choice for the consumer and a less profitable one
for P&G.
The tug-of-war among these players is likely to continue, but the market is large
enough to accommodate growth for all. In commerce, Amazon represents only about 6.5
percent of total US retail sales (50 percent of ecommerce, which is about 13 percent of retail
sales). In advertising, there are large pools of money still chasing TV advertising, while TV
viewership continues to decline and is replaced by subscription products with less or no
advertising, like Netflix. There are pools of spend not traditionally thought of as advertising
which are quite large: trade spend (the money consumer packaged goods companies spend
to promote their products on supermarket shelves) might be as large as TV advertising. Rent
is another expense that new brands might choose to forgo as they increasingly use digital
channels to fulfill their sales. In addition, there is likely growth in the total addressable
market for advertising as Google and Facebook provide the same tools to one-person small
businesses as they do to multinationals, enabling the explosion of digital-native brands we

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are seeing today. One can see the opportunity for Facebook: there are 25 million businesses
on Instagram, but only 2 million of those are advertisers. On core Facebook, there are 80
million business Pages, but only 6 million of those advertise.
Portfolio review
Alphabet, the parent company of Google, is one of our largest positions. The core
search business, which earns revenues through targeted advertising on desktop and mobile,
remains extremely attractive and growing strongly in the US and even more quickly abroad.
Second quarter revenues were up 23 percent overall with particularly strong growth outside
the US (Asia up 34 percent, “other bets” over 45 percent).
The data that Google collects from users feeds its machine learning flywheel and
enables continuous innovation—and keeps Google ahead of competitors. Andrew Ng, a
professor of machine learning at Stanford who previously worked in the search teams at
both Google and Baidu (the Google of China), said at a recent talk that even though he knows
a lot about building a team for search, he could never displace these companies, given their
massive data advantage.
Google’s Assistant can now call businesses on your behalf and make restaurant
reservations (the Assistant’s voice is so lifelike, it’s impossible to tell it’s a robot). On G
Suite—its office productivity tool—Google is now offering automated grammar correction
and smart compose, which forecasts what you’re trying to write and makes intelligent
suggestions.
Alphabet stock is attractively valued for the growth of this core search business; yet
in addition, there are three opportunities within the company that I believe have enormous
potential and are not properly valued in the stock price today.
The first and most obvious one is YouTube, which has over 1.4 billion logged-in
viewers around the world. Netflix, in comparison, has 130 million subscribers (one tenth as
much) and is valued at over $160 billion. This is an apple-and-oranges comparison because
the subscription model that Netflix operates is very different from the ad-based model of
YouTube, but it hints at the potential value of YouTube, given its scale. Alphabet is investing
aggressively in new ways to compensate creators on YouTube; whereas traditionally the
business model rested on advertising, they’re experimenting with subscription and gifting
options, both of which have been successful on other platforms.

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The second opportunity is Google Cloud Platform. As we’ve noted above, cloud
computing means running everything that used to be on-premise (that is, inside a company’s
walls) in a datacenter owned by a third party, in this case Google. Why would companies do
that? Because it saves them enormous amounts of money by not having to buy, maintain, and
upgrade hundreds if not thousands of machines, software and licenses; not to mention
having to worry about patches, security, authentication, user management, engineers, etc.
Cloud isn’t just cheaper, it’s also dramatically more secure. For example, the
combination of Chromebooks (a laptop that runs Google’s Chrome OS), G Suite and a Yubikey
(a physical device you must plug into the Chromebook in order to digitally sign in), is the
most secure personal computing platform available, with all documents living on Google’s
cloud. Reed Hastings, the CEO of Netflix, is said to be a huge fan. The use of G Suite also
eliminates 99.9 percent of phishing attacks, which have been responsible for so many
security issues around the world (large corporations and government agencies have been
exposed to such attacks, which frequently involve the use of ransomware and the request of
payment in bitcoin).
Once a company has transferred its workloads to the cloud, any new features
introduced by the cloud provider can be used by the customer. Increasingly, tools like
machine learning, which require dedicated hardware, and massive amounts of storage and
compute, are compelling reasons to run on the cloud. Google is making investments like
designing its own machine learning chips, the Tensor Processing Unit, which is adept at the
matrix algebra calculations required for ML applications.
The democratization of these tools is amazing: I saw a demo of a high school student
who, with simple code, created a program on Google’s cloud to classify diseased plant leaves.
The results were incredibly accurate. New products like automatic translation among 27
language pairs, once introduced, are available to all customers.
Machine learning is an all-purpose technology, like electricity. We’re still in the early
days, but Jeff Dean, head of Google Brain, recently gave a talk showing the implications for
medical imaging. It’s already possible to train machines to detect diseases of the retina at a
level better than board certified ophthalmologists.
The cloud computing model, pioneered by Amazon, is turning into an oligopoly

outside China, with Amazon, Microsoft and Google taking the leading positions (Amazon is
still far ahead in terms of market share).

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Cloud is a business rocket ship. The only company that reports its public cloud
business as a separate segment—Amazon Web Services—is now a $21 billion run-rate
revenue business with year-over-year revenue growth rates over the past four quarters of
43, 43, 45, and 46 percent. Notice the acceleration over the past three quarters. The
operating margins at AWS are around 25-26 percent; this is extremely attractive, especially
for a business that is investing so much in growth. If industry-wide revenues are around $40
billion, this means we are a mere four percent of the way there, with there being existing
workloads estimated at $1 trillion, not counting the enormous growth that is enabled by the
cloud existing in the first place (it would not have been practical for businesses like
autonomous driving to exist without the existence of cloud infrastructure).
Using the analogy of GEICO above, cloud computing is a fast-growing business in a

growing market. Google’s Cloud is tiny compared to Amazon; in the fourth quarter call the
company disclosed it was a $4 billion per year business, but that it’s the world’s fastest
growing public cloud business (i.e., growing faster than AWS). Microsoft Azure doesn’t break
out its public cloud revenues, but they’re likely around $10 billion per year.
The third opportunity hidden inside Alphabet is Waymo, the autonomous driving
company. Waymo has accumulated 8 million miles of actual self-driving in the real world,
with billions more in simulation. It is by far the leader in safety as measured by
disengagement data provided to the government in California (this means Waymo cars can
drive many more miles than competitors before a human intervention is needed). It is
growing real-world data at about 1 million miles every three months, and that pace should
accelerate as the fleet grows. Waymo already operates a commercial self-driving pilot
program in Arizona, open only to early riders. It’s already providing over 400 autonomous
trips per day, and that program is expected to expand later this year to the general public.
Autonomous and electric vehicles are the future for most of our transportation needs.
In the US, according to recent data from energy.gov, nearly 60 percent of trips are under six
miles, 75 percent are under ten miles, and nearly all (95 percent) are under 30 miles.
As modes of transportation become autonomous, Waymo could become a utility to

the trillion-dollar transportation industry, providing cloud-based self-driving services for a
fee. This could come about in several of modalities, from running its own ride-hailing
network, to providing autonomy services to cars and trucks and licensing its data to
operators like Lyft and Uber. It is difficult to quantify the potential size of Waymo; but
reasonable assumptions on miles driven, revenue per mile and net profit margins result in
tens of billions of dollars in value. One sell-side analyst whose models I’ve studied believes

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Waymo has a present value of $175 billion, or $245 per Alphabet share (about 20 percent of
the current share price). I believe parts of the model might be aggressive, but others appear
conservative.
For instance, this model assumes that miles driven in the US grow at only 2.4 percent
compounded through 2040. This is slightly lower than the rate of previous decades but
higher than the 2 percent rate over the past three years.
Is 2.4 percent growth in miles driven reasonable? Perhaps. But currently it’s 60
percent cheaper to drive an electric vs. gasoline car in the US (using nationwide average
prices for gas and electricity—and yet, fewer than 2 percent of new vehicle sales are electric;
we have a long way to go).
In addition, what happens when the largest cost component of driving—labor—is

eliminated? The combination of electrification and autonomy thus results in a dramatic cut
to the cost per mile driven—by about 50 percent or more. In this scenario, it’s likely that
miles driven go up dramatically. While hard to quantify the size of the opportunity, Waymo
does appear to be a potentially valuable business at the start of a long technology adoption
curve.
Amazon reported excellent second quarter results. Overall revenues grew 37

percent, with revenue growth in the core online store segment of 14 percent. The other half
of revenues—third party seller services, subscription services, Amazon Web Services, and
“other” (which includes credit cards and advertising) experienced exceptional growth of 51
percent overall.
Amazon’s Echo devices, which have the Alexa voice assistant, are the dominant voice
assistants in the US, with about 70 percent share of this nascent market. Amazon is investing
smartly in building out the ecosystem, and there are now tens of thousands of developers
across 150 countries building new devices using Alexa. The assistant is now present in
speakers, headphones, smart home devices, PCs and cars.
This ubiquity is strategically important. Alexa improves with usage; the more data it
has, the better its machine learning algorithms can get. Amazon has begun offering Alexa for
Business, partnering with hotels and homebuilders to have Echo devices preinstalled in
rooms and homes. Revenues from Alexa are likely not yet meaningful, but as modes of
interaction move beyond the smartphone, voice is likely to become increasingly important.

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Internationally, Amazon continues to invest heavily, burdening current margins for

the benefit of long-lasting customer relationships. In those markets, Amazon offers Prime
memberships—with free music, video, books, and a plethora of other benefits—before
reaping the rewards of increased shopping activity. Amazon is willing to invest billions—
international operating loss in Q2 was $2.9 billion—to establish a footprint and grow from
there.
Amazon’s data experiments have shown that once a customer becomes a Prime
subscriber, shopping habits change and they spend an increasing amount of money on
Amazon. Prime Video is yet another add-on to increase customer loyalty. As Jeff Bezos
explained, “When we win a Golden Globe, it helps us sell more shoes.”
One relatively recent Prime benefit was the addition of Twitch, which Amazon
acquired for $970 million in August 2014. Prime members get access to Twitch streamers
and to free games and other benefits. Twitch—if you haven’t heard—is the largest gaming
streaming company. Every day, 10 million fans tune into Twitch to watch and talk about
video games being played by more than 2 million streamers. In terms of concurrent viewers,
Twitch is likely already over 1 million, which is higher than MSNBC and CNN.
Gaming is an enormous industry, with over $100 billion in revenues and over 2 billion
gamers around the world. Streaming (on Twitch and other platforms) and esports
(organized leagues that play games that are webcast or showcased in fan-filled stadiums)
are growing trends.
Twitch makes money from fan subscriptions, advertising and endorsements.

Incredibly, Twitch had to create additional subscription tiers at higher price points for fans
who wanted to support their favorite streamers. Recently, Amazon has begun allowing
advertising on Twitch. Amazon doesn’t break out Twitch financials, but it’s an interesting
and underappreciated asset.
How big can cloud computing be?
Last month I attended my second cloud computing conference, Google Next 2018. As
with AWS’s conference, I watched dozens of very interesting sessions showcasing new
features, new types of workloads being run, and how various well-known companies have
migrated to the cloud. While much smaller than Amazon’s cloud, Google is working hard to
catch up. A couple of years ago, Google hired Diane Greene, the co-founder of virtualization
behemoth VMWare, to be Google Cloud Platform’s CEO. In her public statements, Greene has
outlined the massive opportunity she sees in growing this business.

Miami, FL 33131
Both Jeff Bezos and Andy Jassy (CEO of AWS) have said that they believe one day AWS
will be Amazon’s largest business. That’s a tall order; Amazon is generating $187 billion of
revenues per year excluding AWS. Can AWS, with a “mere” $21 billion of revenues, get there?
I think the answer is a resounding yes. There is about $1 trillion of information

technology spending that is still on-premise. As this workload moves to the cloud, expenses
are cut dramatically, since the same workload can run for 20-30 percent of its cost on-
premise (that is a very rough estimate based on industry sources). However, once companies
have their data on the cloud, they can access other services that were not previously
available to them, like machine learning and advanced analytics. This drives increased usage
and revenues. In addition, as mentioned previously, cloud computing is enabling entirely
new uses that previously couldn’t be performed on-premise. Put all of this together, and most
observers believe the opportunity is at least $1 trillion.
Assuming that’s true, and given the growth rate of the major public cloud vendors
(Amazon, Microsoft and Alphabet), it’s not unreasonable that within a decade AWS will have
revenues of over $200 billion, larger than Amazon’s current non-cloud businesses.
At that point, what would AWS be worth if it were a separate company? We can apply
a reasonably conservative revenue or profit multiple, discount at 10 percent per year, and
estimate that the present value of AWS alone is greater than all of Amazon today as measured
by enterprise value (market cap plus net debt).
I’ve run this analysis for the other cloud vendors and the results are similar. At that
point, the vendors would have about one third of the total addressable market. We’ll see if
this pans out, but given current trends, it’s hard to bet against it.
Facebook reported stellar second quarter results. Revenues were up 42 percent, and
profits up 32 percent. The number of users—a massive 1.7 billion daily and 2.2 billion
monthly—grew by 11 percent. Prices per ad were up 17 percent and ad impressions up 21
percent.
In his forward guidance, however, CFO David Wehner announced a decline in the
revenue growth rate going forward (implying growth of over 20 percent by the end of the
year), and a glide path towards a lower operating margin of mid 30s (from the current mid
40s) over the next two years.

Miami, FL 33131
These metrics are astonishingly good, but they surprised the market, and Facebook’s
stock sank 20 percent the following day (as our largest position going into earnings season,
it hurt our returns in the month of July).
Financially, I believe the market was rational in its rapid reappraisal of Facebook.
Certainly, lower revenue growth and lower profit margins—while still very high—imply a
lower present value.
But let’s dig into the why. Since the dawn of social media—when there were
competitors like My Space, Orkut and Friendster—Facebook won by providing a superior
user experience. The social network that sprang from a Harvard dorm room in 2004 never
stopped growing for precisely that reason. Over time, through acquisitions and new product
development, Facebook became a social media conglomerate spanning 2.5 billion users of
core Facebook, Instagram, Messenger and WhatsApp. It’s developing an exciting slate of
upcoming products such as Direct (Instagram chat in a separate app), Portal (a rumored
voice assistant), and innovations from its virtual reality company, Oculus, to mention a few.
First, let’s look at the expense side of Wehner’s guidance.
As you’ve probably heard, Facebook has been used by folks who want to influence
elections or spread fake news. To ensure election integrity, remove fake content and bad
actors, the company is investing a lot of money into its content filtering, using both humans
and machine learning to go through the billions of pieces of content uploaded every day. In
fact, Facebook has been warning for several quarters that investments in security would
“significantly impact our profitability.” Adding more features for protecting privacy might
also impact marketers’ ability to target ads, potentially resulting in lower ad prices. All of
these investments are very likely to result in a better user experience, at the expense of lower
profitability.
But that’s not all. As Mark Zuckerberg explained in the Q2 call, “In light of increased
investment in security, we could choose to decrease our investment in new product areas,
but we’re not going to—because that wouldn't be the right way to serve our community and
because we run this company for the long term, not for the next quarter.” These new product
areas include building out eight new data centers (there are currently six) to deal with what
Zuckerberg called “hyper-growth” in machine learning across the products, as well as in
WhatsApp and Instagram. These investments also include augmented and virtual reality,
marketing, and content acquisition (Facebook has been investing aggressively in original
video content and sports broadcast rights).

Miami, FL 33131
These investments are exactly what the long-term owner of a business would want to
see. Now, let’s look at the revenue side.
Here, Wehner said that Facebook is building and promoting engaging new
experiences like Stories that “currently have lower levels of monetization.” This is a bizarre
excuse, given that Stories is one of the fastest-growing media formats ever. But the reason is
that many advertisers aren’t yet aware of Stories, and those that are, haven’t yet figured out
how to create ad content for it. This is typical of new ad formats, and because Facebook’s ad
system is set up as an auction (much like Google’s), fewer bids translates into lower ad prices.
Stories—ably copied by Instagram CEO Kevin Systrom from rival Snapchat—has

since eclipsed its creator:
Source: https://www.recode.net/2018/8/8/17641256/instagram-stories-kevin-systrom-facebook-snapchat
Facebook is leaning into this opportunity, emphasizing this experience for users, and
this emphasis will decrease revenue growth; better user experience at the expense of short-

Miami, FL 33131
term profitability, which exactly the right approach. Going back to the origins of Facebook
and throughout its history, management’s playbook has been to first grow the audience for
a particular product or feature (grow users), increase engagement (grow minutes or hours
of use per user), make it sticky (create the habit, make sure users keep coming back), and
only then, monetize.
Strategically, then, it seems that the reasons for Facebook’s lower revenues and
margins will only serve to widen its long-term moat. Better user experience with new media
(Stories), less fake news, more election integrity, and additional privacy options. It seems to
me that these investments, while painful in the short term, might in fact allow Facebook to
make more money in the future, because a better user experience will result in more engaged
users and more advertisers. In fact, as I re-read Facebook’s conference call transcript weeks
after the call, it seems obvious that the company remains a very compelling investment.
The near-term future of Facebook
Facebook’s stated mission is to “give people the power to build community and bring
the world closer together.” And that includes bringing businesses closer to consumers. One
achievement of Facebook’s has been the removal of friction for small businesses; with
Facebook, they have access to the same advertising tools as multinational advertisers.
I believe the near future will see more of this. One new format the company
highlighted in its Q2 call is Click to Messenger ads. These allow businesses to interact directly
with consumers inside Messenger, from an ad placed in News Feed, for example.
In India, Facebook’s WhatsApp has 200 million users, and the app is frequently used
for commerce. Using the country’s direct payments protocol, WhatsApp is working to obtain
approval to create an in-app payments system. Globally, WhatsApp Business was launched
and is being tested by three million businesses, who will pay to interact directly with
consumers.
Longer term, it’s interesting to think of Facebook as a toll booth on the world’s
economy. Below is a chart showing revenues per user by geography (we used this chart in
last quarter’s letter too—this one updates it to include Q2 results). In more advanced
geographies—like North America—advertising markets are more developed, consumer
incomes are higher, and therefore ad prices are much higher. Notice the gap between North
America and Europe, and then between North America and Asia and the rest of the world.

Miami, FL 33131
As broadband and smartphone penetration continues to increase; as ad markets

develop; and as income levels grow, we should see a continued rise in revenue per user
around the world.
Facebook yearly revenue per user, by geography
97
North America
91
Europe 84
77
Worldwide
72
Asia 67
62
Rest of World 56
50
46
42
37
34 32
31 30
29 27
26 24
23
21 21 22
17
19 18 19
13 14 15 14 15 17
11 12 12 13 12 13 13
9 10 11
8 9 10 11 12 21 22
7 19 20
6 17 17
5 15 16
4 13 14
6 7
1 2 3 4 5
Aena, our Spanish monopoly airport operator, remains a large position. The stock
price has been disappointing this year, down 8 percent through the end of the quarter,
despite continued business growth. In Q2, revenues were up 5.6 percent, and profits up 11.6
percent.
There are at least two proximate causes for the stock price decline. First, the new
Spanish government made some noise about Aena’s dividend payout, but has since
confirmed that it will retain the same policy followed this year, which is to pay out 80 percent
of accounting profits (which are significantly less than free cash flow, so the actual payout is
much less than 80 percent of actual profits). Second, the company’s second largest
shareholder (after the government), a UK fund, sold a portion of its stake, depressing the
stock.

Miami, FL 33131
I view this investment as a growing “bond” because of its stability and safety, and
expect mid-single digit revenue growth and low double-digit profit growth to be the norm.
Forterra, our UK brickmaker, is an 8.2 percent position. As a reminder, we acquired

these shares very cheaply after Brexit, and the investment was up over 100 percent by the
end of the quarter.
Sales for the half-year were up nearly 11 percent, although part of this number is
flattered by a recent acquisition. Profits were up 3 percent, and were hurt by bad weather in
Q1. Industry fundamentals for UK housing remain very solid, with all homebuilders
reporting strong demand and consumer confidence. While the shares remain cheap and the
industry backdrop favorable, I don’t expect this to be a fast-growing business. As new
opportunities materialize, our inclination would be to slowly sell off our interest in this
business.
Compagnie des Alpes, our French ski and parks operator, is also an 8.2 percent
position. We acquired these shares very cheaply last year and our investment was up over
40 percent by the end of the quarter. As we’ve explained previously, what attracted us was
the ski business, but it turned out that the parks business was actually more interesting.
Revenues—the company reports based on the nine-month period ending in June 30,
2018—were up 2 percent for the ski business and 5.1 percent for the parks. We won’t have
profit numbers until year-end, but I expect the company’s positive development to continue
its multi-year path. While still very undervalued, we also expect to trim our position in this
investment as we redeploy into opportunities more in line with our long-term vision for the
partnership.
The same is true of Sirius Real Estate (6.7 percent position), our German flex office
operator, ably led by ex-Regus executive Andrew Coombs. The stock is up over 190 percent
since we first invested in 2013, and now pays us dividends of nearly 16 percent on our cost.
For the fiscal year ended in March, organic rental incomes were up 6.2 percent. The company
continues to pursue its strategy of acquiring underutilized real estate, investing capital to
refurbish it, and attracting tenants to its various types of office products. While these
investments provide a high return on capital, I do think Sirius’s growth is constrained by
having to pay out dividends (that’s part of the promise the company has made to investors)
and by the size of the market in which it operates.
Aena, Sirius Real Estate, Compagnie des Alpes and Keck Seng Investments (our hotel
operator) have hurt our returns this year, with share prices down 8 percent, 5.1 percent, 10

Miami, FL 33131
percent and 4.3 percent respectively. There doesn’t seem to be any bad news to blame this
on, so I fully expect a rebound as their positive financial trajectory continues. AB InBev
shares are down 7.1 percent for the year, and this can be blamed on disappointing beer sales
in North America. With this region being 20 percent of beer volumes and 30 percent of cash
flow, it’s a bit of a case of “the tail wagging the dog,” but there’s no question that North
America—and the US in particular—is very challenging for Budweiser drinkers.
You can expect us to monetize these investments as we lead the partnership into
greener pastures more in line with our long-term thinking. As mentioned above, our pipeline
of exciting, wide-moat businesses participating in growing markets is strong. We have
already made several small investments in these and expect to scale them up as we free up
capital in the partnership. As always, I look forward to updating you in the future about all
our investments and divestments.
Incentives matter; with about 24 percent of the partnership’s net assets, my family
and I are the largest investors and well aligned with you. We truly have our skin in the game.
We seek to make investments optimized to grow our collective wealth as quickly and with
as little risk as possible.
Thank you for the trust and commitment you have in Heller House. Should you have
any questions about this letter or the partnership, or any other concerns, please do not
hesitate to contact me.
Sincerely yours,
Marcelo P. Lima
Managing Partner
marcelo@hellerhs.com
+1-305-854-0675

Miami, FL 33131

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Heller House Opportunity Fund, L.P.

Q2 2018 Letter to Investors

August 28, 2018

Software… coming now to an industry near you

1111 Brickell Ave, Suite 2135 hellerhs.com 1

In today’s world of instant information and fast-paced innovation, cheap securities

1111 Brickell Ave, Suite 2135 hellerhs.com 2

Ditch the cigar butts

1111 Brickell Ave, Suite 2135 hellerhs.com 3

1111 Brickell Ave, Suite 2135 hellerhs.com 4

Cars and trucks per capita in the U.S., 1900-2014

1111 Brickell Ave, Suite 2135 hellerhs.com 5

Cars and trucks in the U.S., 1900-2014 (millions)

Advertising for customers

1111 Brickell Ave, Suite 2135 hellerhs.com 6

Grow… but only if you have high returns on capital

Yet most corporations are incapable of innovating because of misaligned incentives.

1111 Brickell Ave, Suite 2135 hellerhs.com 7

What advantages do truly innovative companies have? They tend to be run by

1111 Brickell Ave, Suite 2135 hellerhs.com 8

S-curves of the future

If Benjamin Graham was—unwittingly—riding the adoption curve of the automobile

1111 Brickell Ave, Suite 2135 hellerhs.com 9

travel and leisure; the secular shift in advertising from

Advertising and commerce

It seems that on a long enough timeframe,

Google is also expanding its ecommerce presence.

On the other side, Amazon’s advertising business is growing dramatically. We don’t

Amazon is probably the best-positioned company in the marketing funnel. Imagine a

1111 Brickell Ave, Suite 2135 hellerhs.com 10

finally, purchase. Compared with Facebook and Google,

1111 Brickell Ave, Suite 2135 hellerhs.com 11

1111 Brickell Ave, Suite 2135 hellerhs.com 12

The cloud computing model, pioneered by Amazon, is turning into an oligopoly

1111 Brickell Ave, Suite 2135 hellerhs.com 13

Using the analogy of GEICO above, cloud computing is a fast-growing business in a

As modes of transportation become autonomous, Waymo could become a utility to

1111 Brickell Ave, Suite 2135 hellerhs.com 14

In addition, what happens when the largest cost component of driving—labor—is

Amazon reported excellent second quarter results. Overall revenues grew 37

1111 Brickell Ave, Suite 2135 hellerhs.com 15

Internationally, Amazon continues to invest heavily, burdening current margins for

Twitch makes money from fan subscriptions, advertising and endorsements.

How big can cloud computing be?

1111 Brickell Ave, Suite 2135 hellerhs.com 16

I think the answer is a resounding yes. There is about $1 trillion of information

1111 Brickell Ave, Suite 2135 hellerhs.com 17

First, let’s look at the expense side of Wehner’s guidance.

1111 Brickell Ave, Suite 2135 hellerhs.com 18

Stories—ably copied by Instagram CEO Kevin Systrom from rival Snapchat—has

1111 Brickell Ave, Suite 2135 hellerhs.com 19

The near-term future of Facebook

1111 Brickell Ave, Suite 2135 hellerhs.com 20

As broadband and smartphone penetration continues to increase; as ad markets

Facebook yearly revenue per user, by geography

1111 Brickell Ave, Suite 2135 hellerhs.com 21

Forterra, our UK brickmaker, is an 8.2 percent position. As a reminder, we acquired

1111 Brickell Ave, Suite 2135 hellerhs.com 22