Dalton's Free Lunch #23
New Year, New me (Got engaged...) + 2024 Market view + Trade & Stock Ideas
Update on Me
I got engaged! January 8th in Phuket.
Well it’s a new year, and a leap one at that. I personally feel ‘very good’ about 2024. Perhaps because I like even numbers more than odd, or perhaps I’m nostalgic for my 2014 (where a lot of great things happened to me). Regardless it’s a year full of hope, where the lingering effects of COVID should hopefully dissipate and the world is able to truly ‘move on’ as the monetary and fiscal regimes begin to ‘normalise’ (if such a thing exists), and the reckoning of interest rates starts to bite.
Personally, for me and my life, I think it will be a year of ‘high convexity’ or ‘high gamma’, that is, after the big ‘restart’ in the USA with an MBA, I now have enough of a grounding to start accelerating. There are a few more aspects left to resolve (such as helping Maria move over), but they are manageable enough to keep life interesting, especially in context of us now being engaged.
I am quite fortunate that this is now my third time in a new culture - previously I was with Deutsche Bank in Hong Kong, and then in Singapore (and then back to Australia, and now here). In a sense I am grateful for what it means to have a ‘global career’ as it has helped frame how I see such big jumps. My journey through life so far has consisted of taking major calculated risks and then working hard to execute to the best of my ability on the opportunity I had then secured. Over this time I have come to realise a deeper understanding of what maturity is - in a way it is truly adopting an investor’s mindset, holding onto a core ‘something’ (whether that be a view of who you are, your values), or ‘thesis’, and then exposing it to different things that time throws against you to see if it changes, or breaks. The end result is you as a person are able to chart not only the best path forward, but one which when looking back from the vantage point of being say, 80, you are truly onboard with.
Don’t get me wrong, I’m not saying just live ‘carpe diem’ and then hope you can rationalise your life in hindsight. Instead I’m arguing something a bit more nuanced - live your life as the author of a story being read by your past and future self. Remind yourself of how the 10-year-old version of you, with all of their hopes and dreams, sees you today, are they proud? Reflect on how the 80-year-old version of you, with all their wisdom and regrets, sees you today, are they satisfied? Allowing your mind to journey between these two poles and then back to the present provides (at least to me) significant empowerment - I can still write my story as I desire, but I must be mindful of my audience, I must be authentic to that audience, else I will eventually have to pay for that inauthenticity.
Why am I writing about all this? I guess as I grow older and have more life under my belt I realise the ‘story’ of my life is beginning to take a larger part of my mind. In a way it’s a calming understanding that I have had previous success, and I will probably have more to come, but that given time passes only once, to be myopically focussed on the ‘next thing’ is ultimately less fulfilling if there is no genuine narrative to it. As the new year begins, and I head into the intensity that is the HBS MBA curriculum, it’s a good time to stop, reflect, and renew my energy.
Reading list
Elon Musk by Walter Isaacson - Picked up a copy signed by the author in December and have begun to unpack it. I do think Walter Isaacson is one of the best ‘business biographers’ around; he matches an accessible prose with real historical information and from a relatively balanced, understanding perspective (not just a puff piece, not just a ‘take down’ piece) - what he did for Steve Jobs I think was incredible, and you can see the direct comparisons to Musk in the first few pages. Definitely recommend so far.
Productivity stack (software I use people may be interested in)
Superhuman (reach out for a referral) - e-mail
Roam Research - general note taking / second brain
ChatGPT - for brainstorming
Financial tools I’m exploring:
Mosaic - You can build models in under 30 minutes flat; seems more useful for LBO type analysis that valuation, but not bad as a framework provider.
Calcbench - Mass processing of data for financial analysis (still exploring it’s viability)
There’s some more on the way, but I’m still giving them a swing.
What I’m thinking about
How do you figure out what the next year is going to be like, or the next 10 in markets? There’s no crystal ball, and narratives sometimes work until they don’t (just ask bond and equity bears over the last 2 months…). What you can know though is how generally these different markets tend to interact (from a ‘trading’ or price to a more fundamental ‘investor’ perspective).
A good model I like to use is Assets = Liabilities + Equity. Here the Assets are the underlying economy, while the Liabilities are the debt markets and equity is well, the stock market. Just like with a normal business, if you make $10 in net operating profits, but have to pay $6 in interest, then you only have $4 left for yourself (or equity returns). If that $6 becomes $4, then you get $6 for yourself. In the same way, understanding the interest rate market is essential to understanding the equity market.
Where the world gets in trouble is when the Asset side suddenly doesn’t produce $10, but produces $5 and you still have to pay $6 in interest.
In a nut shell that’s basically what the entire market debate is about when thinking about a ‘soft landing’, that the Assets will return $5, but that interest rate costs will be closer to $3, which leaves $2 for equity holders today (and means if next year the Assets can produce $10, they can get $7).
The final element to all this is that you are simultaneously ‘betting’ on how much each component (Assets and Liabilities) will move, and when this move will happen. That is, do interest rate costs associated with Liabilities go to only $1 or stay closer to $4? Or do the Assets actually return $20, so $6 doesn’t really matter too much (or only return $1, in which case it does).
Complicating matters even more is the person setting the interest rate costs doesn’t want Assets to return $20, and they will pre-emptively raise their interest rate costs or keep them high to scare such a case off. (A more complicated aside is also Taxes which is a sort of ‘liability’ for existing in the country)
As well, the Assets side is really just a function of how much you spend (i.e. costs or ‘investments’ in marketing, employees, machinery etc) vs. how much you get back from the market (which can be thought of as either ‘selling more stuff’ (which can be ‘sell more stuff to the same people or sell more stuff to new people’) and selling stuff for a higher price.
With this ‘lens’ I then like to look at what the stock market, interest rate markets and currency markets are betting on, but with the added view of historical regimes. People can argue that the market is completely efficient, but I would argue a cross-asset perspective that looks at historical relationships with an overlay of fundamental understanding is rarer and therefore has some degree of alpha (this is really what Bridgewater sells itself as doing for instance).
So, prepare for a chart-dump!
VIX (or US stock market volatility)
How to read = Lower numbers mean options are less expensive, and steeper lines mean that the market is pricing in more equity price volatility in the future than today. More volatility = bets Assets will be lower. (currently bets are that Assets won’t be lower here)
US Rates
How to read = “Interest rates” are different depending on what time period you want to borrow (or invest) in, they give a good sense about how expensive it is to finance things ‘today’, the US government provides a baseline for the rest of the world
Higher = more expensive to borrow TODAY; they don’t ‘predict the future’ (i.e. the 30Y rate is not the ‘prediction’ where the current interest rate will be in 30 years time (but it DOES factor in these predictions implicitly).
What’s important to think about here is how many companies (and governments) are coming to borrow at today’s rates (there’s about $1trn in Corporate Debt refinancing to be done by 2025)
US Rates - Futures
This is the ‘future’ predictions for where current cash-interest rates are (lower means the market is EXPECTING and PRICING IN lower rates). This is not a crystal ball however, as you can see below there are two lines, one for 3rd Jan and the other for 2nd Nov. It is this ‘big shift’ that’s then been reflect in the curve above.
The cones provide the overall ‘range’ of likelihoods
In short, the futures market is pricing interest rates to go from ~5% on average to 3.25% on average by September 2025. Markedly different from the 4% ‘priced' in’ just 2 months ago in November.
USD Basket (DXY) / JPY / CNY
As the USD is the world’s reserve currency, when it is stronger for longer (indicative by a higher number), it ‘hurts’ the rest of the world which borrow in USD, and discourages incremental investment. It also makes it more expensive to invest in the US market.
The second chart is JPY, which was the world’s ‘funder’ currency. What this means is that institutions (both Japanese and global) would ‘borrow’ cash in JPY and then invest in other higher returning asset classes and markets (such as the US stock market, bond market, or AUD). Higher USDJPY means people need to borrow more JPY to invest for the same ‘bang for buck’ if they invest in the US.
The third is CNY and is China’s onshore currency - it is watched by the Chinese Government as a proxy for stability in the economy, as China relies on exports to fuel itself. A higher USDCNY means a weaker CNY, meaning China can export more for cheaper. A strong CNY means it is more expensive to buy Chinese goods. There’s a recent shift in capital flows where China now like Japan can invest it’s financial resources into other markets.
Oil
The price of Oil is a key driver of inflation, as oil not only ‘fuels’ the economy but is required in manufacturing processes. Higher for longer is inflationary, leading to cost pressures. In 2020 there was overcapacity in supply leading the futures price to go negative (that is people would pay you to take their oil). Why? Because it’s expensive to house barrels of oil and so if all the storage facilities are full, you have no where to store it and literally have to pay to give it away.
Bitcoin
I put bitcoin here because it is an emerging asset class that could be a viable alternative avenue to the stock market during ‘risk on’, in a sense it is a potential liquidity drain on the SP500. Overall while there are market structure implications as more institutional investors provide access to the underlying (and therefore upward pressure on the market), I don’t see it as having too much of an impact on the real world economy (but I will make a bet that we will see a ‘bitcoin’ mania again this year)
So there is a lot of data above, to summarise what I think it all means, let me provide below:
Looking at the VIX term structure, it’s clear we are in a ‘risk on’ regime closer to 2020, but not as stretched as the levels in 2017 and 2018 (which is a good thing given the amount of vol-selling that took place during that period). The SP500 returned 18.4% in 2020 (off the back of a 2019 performance of 28.88%), the 2023 year closed a performance of 24.23%. So there’s at least a ‘historical rhyming’ argument to be made that the coming year’s ‘risk on’ can continue to outpace qualitative calls that it may underperform.
What undermines this narrative however is our current interest rate regime; looking at the red line in the second chart, we are currently experiencing the most restrictive monetary conditions in the US in the last 7 years. But then looking at the futures curve the market is currently ‘betting’ that this restrictive environment gets better by about 1.5% in the next 18 months. This is what effectively drove the rally in November / December. The key question is then, whether there’s more than 1.5% of cuts in the next 18 months, and whether the economy outperforms current expectations (which will act as a ‘drag’ on the interest side, but a boost on the equity returns side).
Further adding texture to this is where current international real economy and funding markets are. With DXY still quite strong, and both USDCNY and USDJPY at historical highs (with both of their respective economies having their own issues), there’s a question mark around how much more net money flow into the US there will be.
Looking at Oil and Bitcoin I don’t see any particular key historical rhymes (though noting the negative oil, I don’t think we will have a similar supply glut issue).
Putting it all together, what do I see as a macro-backdrop?
From the charts, it is giving a sense that we may see a 2020-esque rally as markets are dragged up a wall of worry around an impending US recession. I see some different qualitative features here though, including (as I rightly called before) the rise of Convertible Bond issuances as companies used to 0% cash rates struggle with higher rates given refinancing needs, and a rise in stressed / distressed opportunities. I am still bullish overall on the direction of the “Asset”, driven by exponential productivity gains to be achieved by AI (just reading some of the latest research shows that the worries around energy efficiency and technological limits at the chip-level are over stated as 100x more efficient models are increasingly being developed - read here about MAMBA).
Risk to my views here is the distorting ‘bullwhip’ effect of rates volatility on underlying corporate activity. This means I see a regime shift away from the past decade of covenant-lite debt to fuel growth towards something closer to hybrid financing like more convertible bonds, the rise of private credit deals using Liability management tactics to burn ‘dumb’ debt money, or on the asset side - growth CAPEX decisions being stalled until ‘it gets cheaper’, which drags down longer-term growth.
Adding to this is demographic drag which will increasingly bite more (with more people aging in the West and in traditional funding markets like Japan, and even China, retirement accounts will shift cash-out of the market). This may rebase broader equity multiples lower in the longer-term (this rebasing I think has a higher likelihood of then triggering further volatility given the sheer amount of crowding in trades from Private Equity markets, through to ‘Pod Shop’ hedge funds and the like. As we sit at a 25 P/E for the SP500, ~33% of which can be accounted for with the ‘Magnificent 7’, a rate that is at a 23 year-high, the concentration (and therefore implied lack of liquidity) hides significant volatility, when compared to SP500 (this could actually be a volatility arbitrage trade idea, short Staddle Magnificent 7, long Straddle SPY ETF).
Given all that above, I personally see a ‘barbell’ approach here as favourable (i.e. try and maximise your convexity/gamma), where I would focus my ‘upside leg’ on a core bucket of Growth-at-a-reasonable-price stocks with an eye to venture into the opportunistic space (Distressed / and value turnaround stories - I talk about why I love Visa, Disney, CommScope as stock opportunities below, and my current thoughts on ELF Cosmetics). On the other side, plan for rates to continue to drag lower to rebase at around 2% in the long-term (which gives us about another 1.5% in cash rate move over the next 36+ months), as well as the overall curve looking to flatten more than steepen (as Fed contemplates ending Quantitative Tightening in the coming years). With credit quality, and the sheer amount of covenant-lite documents (and dry Private Credit powder looking to be deployed), there’s a boon for active credit investing, favouring in-the-weeds reads of loan documents, over more ‘macro-level’ general purchase of buying High-yield bonds.
Put another way, we have a clear guide-path to risk-on over the next year, and more secularly the next 3-5 years, but I don’t think it will be a smooth ride. A lot of market participants (and corporate participants) don’t have experience with interest rate volatility, and the structural changes of an aging population (meaning less productive labour and a higher need for cash-paying assets), with the medium-term effects of the Fed and traditional purchasers (China, Japan) leaving the longer-part of the interest rate curve, means we will have a steeper, more volatile curve in the longer-term. Therefore this favours owning more convexity than less, and favours more duration over less, if you can weather the MTM risks.
Quick Pitches on what I like
High Yield / Equity Turnaround
Company: CommScope;
Expression: Long Stock & 2029 Secured Bond
Story: A stressed, cyclical business will successfully de-lever over 3 years without Chapter 11
Return Target: 5-6x over 3 years
Financials & Business Summary
CommScope has 30,000 employees and, according to IBIS data it has about a 22% market share in Communication Equipment Manufacturing (Market leader), 1.5% in Telco Equipment Manufacturing and 15.5% in Wire and cable manufacturing (4th largest). It has four segments, Connectivity and Cable Solutions (FY24 Revenue $3.7bn, EBIT $440m), Outdoor Wireless Networks ($1.1b, EBIT $200m), Networking Intelligent Cellular and Security Solutions ($1.2bn, -$50m (but normalising around $60m)), Access Network Solutions ($900m, $90m EBIT). Overall the business has about $426m in Depreciation (and about $51m in stock-based compensation).
Given the stability of the industry, the company originally pursued a strategy of leveraged buyouts to grow market share, and had successfully executed this 3 times over the past two decades. Given it’s cashflow profile it was bought and relisted by Carlyle who remains a key sponsor (with over 1.1bn in convertible preference notes + interests in the debt and equity). In 2018 it acquired ARRIS for $7.4bn, and was hit by macro headwinds (COVID etc) that meant it has so far been unable to organically de-lever, in 2020 new management was installed by Carlyle to reorganise the business to further this aim, currently inorganic deleveraging is actively being considered.
CommScope now has a $581m market cap (down from $2.7bn in 2020) with an enterprise value of $10.7bn (which includes $1.1bn in preferred shares, $9.5bn in debt, and $618m in cash). It’s shares are trading at $2.7, down from ~$15 two years ago.
FY24 Core Sales is estimated at $7.9bn (reflecting a total growth of 4% YoY, driven largely by growth in it’s Connectivity and Cable Solutions segment), with FY24 EBITDA of $1.2bn (~15.3% EBITDA margin, an improvement of ~1.4% on better operating mix).
The company is incredibly levered with ~$8.6bn in Net Debt (~$10bn if considering the preferred shares liquidation option). It has a FY24 Net Debt/EBITDA of 7.4x and a FY24 Interest Coverage ratio of ~2x (on estimated interest paid of $580m). It’s current effective interest rate is ~6%.
This puts it trading at a FY24 EV/EBITDA of 8.9x, historically it has traded closer to 10.5x.
Thesis
I think that Management, which has an excellent track-record of working with the Company’s sponsor (Carlyle) in turnarounds (including divesting divisions), will be able deleverage via an asset-sale of either a sub-division (RUCKUS) or an entire division (NCIS) at a higher multiple than is currently traded (closer to 10-11x), in addition to successfully restructuring the 2025 debt.
Specifically I think RUCKUS it’s Campus Wifi business which is estimated to throw off ~$250m in FY24 EBITDA could be worth around $2.5bn-$3bn. Detailed legal due diligence on the loan documents support the view that this is secured to the 2026 debt, and therefore the priority for repayment would flow first to that bond before 2025 is to be repaid (but that with the debt restructure taking place, the 2025’s will be pushed out to a later maturity). The above view has been tested with former company staff in the corporate development function, which gives confidence that an asset-sale is a legitimately considered option. Furthermore there has been active buying from both management team and the Carlyle appointed board member into the stock (suggesting management will ‘stave-off’ Chapter 11 as much as possible).
If pulled off this would improve Net Debt/EBITDA to 5.9x to 6.4x ($5.6bn/$950m or $6.1bn/$950m); levels lower than the ~7x in 2019/2020 when CommScope traded at 10.5x EV/EBITDA, and corresponded to a market capitalisation at around $2.7bn (trading at a share price around $13-$14).
With the paydown of debt shifting the narrative to a company with a sustainable amount of leverage (and therefore exiting stress/distress), I see a reflation in the multiple, effectively boosting the total equity component to be worth $3.8bn-$4.3bn. Netting out Carlyle’s $1.1bn in preferred stock, this gives a market cap of $3.3bn or a 5.7x return over the next 1-2 years.
If the above does not materialise, and the bear case occurs of a reorganisation under chapter 11 (which would look more like a breakup of the business, again at closer to a 10x multiple given it’s leading position in market and general trading levels of comps) there is still a 2.1x coverage of the secured debt of $5.8bn. Here I would go with the 2029’s over the 2026’s or Term Loan, where you give up temporal priority for pay out in exchange for much cheaper creation value (the 26’s are trading at ~86c while the 29’s are at closer to 60c due to lower coupon/duration effects (which is also something I’m happy to be long here in the current rates cycle).
Furthermore, with supportive macro tailwinds in the form of the government’s $42.5bn Broadband Equity Access and Deployment and $10bn in FCC’s Rural digital Opportunity fund due to come online over the next 1-2 years, and the abatement of the current overstocked inventory levels (a normal cyclical factor), there’s room for an further improvement in core sales and EBITDA that could speed up the above.
Risks
The biggest potential risk is the what has made the position attractive, a Chapter 11 scenario. However given the amount of value that Carlyle has to lose in the current capital structure, their control of the board and management, there’s enough comfort at the ‘insider’ level that this would be a last-resort.
Further risks include legal ‘games’ being played with various Liability Management techniques under the loan documentation to rob economics from the outstanding secured debt in favour of any new capital. Given that the documents are relatively covenant-lite, pursuing further leverage using either an ‘up-tier’ or ‘drop-down’ on the debt, CommScope would be able to kick the can down the road until the macro tailwinds manifest themselves, allowing them to organically de-lever. I believe while it may appear initially attractive, this is unlikely due to the potential need for an additional sponsor in the form of a private credit player (which Carlyle may not want), and the fact that the current interest rate environment is too high. If they have an effective interest rate of 6%, refinance would be closer to 12-15%, with the $1.5bn 2025 debt followed by over $4.5bn in secured debt in 2026, they’d need to secure a package of ~$7bn, which alone would consume too much of their EBITDA (assumed to stay relatively flat around $1.2bn into FY27).
Investment Idea
Therefore, to participate in the reflation of the multiple and own a quality business for the long-term equity upside, create a ‘synthetic convertible’ by going long the stock at 2.60 (I went long at $2 via calls given cheapness in the volatility profile), but to protect from downside of a Chapter 11, also long the 2029 Secured debt at a yield to maturity of ~12% (I went long at 14%).
Equity Longs
Core Holding (short and simple, buy growth and quality)
Company: Visa
Expression: Long Stock at $260 and look to opportunistically build more during market sell-offs
Story: Best business in the world.
Return Target: 5x over 10 years
Financials & Business Summary
Visa in short has effectively a monopoly on payments with over 55% global market share (MasterCard has closer to 22%), approximately evenly split between US and International. It has 28,800 employees around the world. It has over 4.5bn cards in circulation around the world (world population is ~8bn…), processes 277bn transactions globally a year for a total FY24 payment volume of $13.4trn.
It’s revenues of $36bn, grow at approximately 10%+ a year (FY24 est. 10.4%, FY23 estimated at 11.4%, FY22 was 21.6%). It has an estimated FY24 EBIT margin of 66.5%. It’s one of the primary beneficiaries of the digitisation of cash in the world. It has an estimated $18bn of cash to $21bn in debt (or net debt of $2.4bn), putting EBITDA/ Net Interest at 35.3x, and Net Debt to EBITDA at 0.1x.
Given all this, Visa is a $522bn Market cap company, trading at a FY24 P/E of ~26x on an estimated FY24 $10 earnings per share and an estimated dividend yield of 0.8%.
Thesis
The irony is the better the business, the simpler the case to own it, the only real question is around price and whether there’s a legitimate long-term differentiated view to the terminal value of the stock and the market’s style emphasis (growth vs. value).
However as this is pretty much the highest quality publicly listed business in the world, and it is heavily followed by research analysts, and is effectively owned by most money managers in the world, there is little alpha to be generated here. It also has moderate growth and therefore won’t compound faster than say the market (in fact it has a Beta of 0.86).
The idea then, is to keep an eye on it when there is a liquidity driven market dislocation or sell-off, and then load up on it for cheap.
If timing isn’t something you’d like to do, then just buy it and let it compound.
Risks
Is there too much of a good thing? The underlying business given it’s systematic importance and essential link to the US may be subject to political or regulatory risks that are currently unforseen, however with 55% of the world using it, it’s pretty difficult to say this would put it out of business, but it may, when combined with the crowding in the stock lead to higher price declines than other stocks.
However it may be subject to a melting icecube problem, where it does not grow as fast as other constituents in the market and is slowly out-innovated by the likes of more tech-oriented players.
Finally, as with respect to the security’s price, there may be hidden re-rating risk. Trading at 26 P/E is not ‘cheap’ (although the P/E of the market is currently 25), and so a re-rating of the stock market (macro factor) may hit Visa from a total return perspective, depending on entry level.
Investment Idea
Long Visa when you can.
Turnaround Bet (something a bit more exciting…)
Company: Disney
Expression: Long Stock at $90
Story: Turnaround of a high quality business with ‘hair’ on it
Return Target: 2x over 3 years
Financials & Business Summary
The House of Mouse has been around for 100 years, it predates Cable TV, it predates coloured movies, it predates both world wars. It is today a media conglomerate employing over 225,000 people globally. It has the best library of entertainment IP in the world, and arguably the best machinery to monetise it with impressive content distribution via linear networks, streaming and physically via it’s cruises and theme parks. However, as a producer of content watched by the world it is a lightning rod for consumer sentiment that impacts its stock price. Over recent history it’s had a series of movie and tv-series flops that have put it out of favour with consumers, and it is subject to a structural trend in TV, where people are ‘cutting the cable’ in favour of online streaming.
But as a media conglomerate it’s a complicated business. According to IBISWorld it participates in 11 industries, it leads in Amusement Parks with a 54% market share, Intellectual Property Licensing with a 17.3% market share, It’s #1 in Movie and Video production with a 16.2% share, #2 in Television production with a 37.2% share, and is second in Video Streaming services with a 21% (Netflix has a 62% share, again according to IBISworld)
In addition to it’s wide mix of businesses many are inherently cyclical, from a traditional economic point of view (consumer spend goes down in a recession etc, physical capex cycles required to upkeep the parks etc), as well as in less traditional ways (I have a differentiated view here that it’s content has always been inherently cyclical, but most people don’t recognise this given they are caught up in nostalgia - same effects can be seen for Politicians, most are hated during their terms, and then some are lucky enough to be remembered as heroes after the fact).
It has three reporting segment for FY23 Entertainment ($40.6bn Revenue, $1.4bn EBIT), Sports ($17.1bn, $2.5bn EBIT) and Experiences ($32.6bn Revenue, $9bn EBIT). It has an estimated $5.3bn in normalised Depreciation & Amortisation and 1.1bn in Stock-based compensation and is estimated to deploy an annual $8bn in CAPEX over the next decade.
The Key takeaway here is that given it’s seen as ‘old’, it’s underlying complexity, and the emotional content of its products, it gets hammered when it doesn’t do well at the movies, and it’s other qualities are ignored - this has happened over the past decade. This has attracted the likes of activist investors including ValueAct and Trian management to come in and try and ‘unlock’ value. This has led to a legitimate effort to turn around the business (and as per it’s latest earnings release, it’s been working better than expected).
The core debate on this stock is whether it’s an ‘expensive’ quality trap that will slowly fade into oblivion as Streaming eats its lunch, or whether the current turnaround led by Bob Iger, a deal-guy who got it out of it’s last set of doldrums in the 90’s can repeat the magic.
Thesis
The thesis has three key parts to it, but one central theme ‘The turnaround will work’ and break Disney out of being a ‘Quality trap’ because:
With market concentration in the Magnificent 7, active investors will need to figure out a way to diversify away, Disney is a candidate for a ‘look’ provided it can sell the market past the ‘hairy narratives’ of cable cutting and content irrelevance, which it can when you look under the hood....
There’s too much value on the table (Experiences segment = $102 per share, Streaming is $105 a share, Sports at worst would be worth $8 per share, and Movies turning around from being flops adding further upside for a total of $215 per share or a 2.4x multiple), unpacking a bit further…
Not only do you have the quality of the IP, you have an Experiences Segment that has an estimated FY24 EBITDA of $12.9bn (37% margin on ~7% growth), on a multiple to peers, say Marriott which trades at 17x EV/EBITDA (a fair comparison given Disney is a leader in the experiences space, one could get more if they used say a Hilton at 22x), this puts an effective floor of $219bn in EV (taking out $32.1bn in Net Debt on 1.83bn of shares on issue gives a price of $102 per share). The rest of the business is free. The math is simple, MoffetNathanson has pointed this out multiple times, even Elon Musk tweeted Disney is just trading as a hotel stock right now. The key thing is that the investor community doesn’t like the Cable Cutting narrative (seeing a low to negative terminal value) and the fact Disney is tanking in the box office (again seeing this as a low to negative terminal value).
Buyside is modelling (and subsequently misvaluing) the Streaming business like a mature business and therefore is missing a massive slingshot of earnings:
Users (where the dream died): Disney has ~220m subscribers growing by 7-10m a year. Global TAM of streaming estimated to be 17% of world population, growing to 22% by 2028, on 8bn people that means longer-term run-rate should be closer to 11m if Disney maintains it’s current share, this would be higher if it takes share from ‘losers’ in the streaming war and/or Netflix. Cracking down on password sharing added 8.8m to Netflix’s subs, or about 3.5%, taking the same for Disney, that’s another 7m users. Altogether that means I’d make a call that Disney will finish up FY24 with 238m users globally (in-line with the 215m-235m guidance provided by the company). Wallstreet punished Disney dearly here for re-forecasting this User growth down from 260m, but it misses the point as Netflix’s global user base is ~279.2m (including the new 7m of Ad-tier users), which means Disney is not too far behind here.
ARPU / AOIPU (what Wallstreet is missing): The real story is going to be Disney’s average revenue and average operating income per user, where they will finally turn around a loss-making business into a slingshot of an earnings business - this has definitely not been factored into price (as most are still calling for negative earnings into FY24 end, despite management saying they will hit profitability - this shows a legitimate upside to expectations). Disney’s ARPU including Hulu is ~$8.7 ($6.7 for Disney+$19 for Hulu), Netflix has an ARPU of $11.7 (up from $10.9 in 2019); Pricing power is in Disney’s favour. Doing a quick poll of 20 people in my network with families (across the world to ensure no US-bias) most would agree they’d be willing to pay closer to $20 per month for Disney+ & Hulu. This backdrop gives me comfort that Disney could either raise it’s Disney+ prices or improve Ad monetisation to a level closer to 75% of Netflix’s for ~$8.8 a month, bringing total average ARPU to ~$11 in the near-term. Over a longer-term period, it’s clear the lead Netflix has over Disney will begin to erode as competition in streaming shakes out (Netflix’s main user growth is now from ad-tier points to this) and content becomes king (again I’m pretty bearish on Netflix’s ability to consistently create new cost-effective content vs. Disney long term.
Brings a business currently doing an estimate $23bn roughly in sales today, to $31.4bn on pretty fair assumptions (or about $17 per share in sales). Netflix trades at a forward P/S of 6.1, taking the same multiple puts the business worth $105 per share.
The Counter-Narratives: Cable isn’t dead, it’s just sleeping / Disney’s always had a content cycle / House of Mouse is Empty but there’s a seat just for you
When looking at the aging demographics, there is a natural floor to how much more aggressive cable-cutting will be. Further, Disney’s content has always polarised for being ‘good, bad and/or irrelevant’ since it first made Snow White. These narratives are easy to hold on the buyside as the company continues to produce flops in content. Just look at Disney’s history, here are the following ‘flops / irrelevant content’ that had been put out ‘at the time’ that subsequently become a ‘classic’
Pinocchio
Sleeping Beauty
Alice in Wonderland
Bambi
The Emperor’s new Groove
Tron
What’s clear in the above (and there are many more) is that Disney flops are pretty regular, indeed almost cyclical throughout it’s entire history, it’s current poor run then, seen through this lens should not mean the current content-creation business has lost it’s touch, it’s in one sense more than ever too big to fail, it just takes time before the cycle restarts and it captures the zeitgeist of society again.
Taking the above segment-level valuations together, the market pricing the stock at $90 is saying there is a negative terminal value of -$125 per share, which is more than the current market cap of the company. Which seems completely dislodged from reality. When this narrative breaks, which it will from:
Subscriber growth starts to translate into into positive earnings
Movie content begins to turn around (more than a few new releases become critical and box office successes reigniting narrative Disney has it’s groove back)
Asset sales across Linear division / Sports unlocking value
You’ll see a rush to own the name as buy-siders looking for performance will look to diversify from the already well-owned and well-priced magnificent 7.
Risks
Core risk here is that it remains a quality trap, that subscribers don’t slingshot, and that the content continues to fail. But after 100 years in the business, it’s doubtful that Netflix is going to kill this business.
It may take longer than you think… this trade favours longer-term duration, and has less of an explosive upside than the other ideas, however it’s a quality name that’s under-owned by the buyside, which puts it as a prime candidate for having more of a margin of safety than owning some of the growthier players. This is why I’m ultimately comfortable owning it.
Investment Idea
Long Disney at $90, 3 year target at $215 for an IRR of ~34%.
Currently Investigating
Company: ELF Cosmetics
Expression: Long Stock at $160
Story: Betting on a compounding high-growth disruptor in Beauty
Return Target: 3x over 3 years
Financials & Business Summary
ELF is a $8.3bn Cosmetics company that’s been around for 20 years. It’s stock price is reflects a FWD P/E of 54 and a PEG of 2.2 (i.e. consensus is a 25-28% growth rate). Last year it grew earnings ~50% from ~$1.66 to an estimated FY24 of $2.49 (on revenues of ~$790m). Peers trade at an average PEG of 4 and FWD P/E of 55 (L’Oreal (4.3) and Estea Lauder (PEG of 3.84))
ELF Cosmetics is a 20-year old cosmetics company that serves Gen Z customers with ‘entry’ level cosmetics that effectively copy prestige brands without sacrificing quality - in effect it has rewritten the book on cosmetic marketing (‘fast cosmetics’) in-line with what Zara has done for fast fashion. It’s the first and so far only cosmetics brand to truly crack TikTok and has shown 19 quarters of consecutive growth. It has roughly 320 employees who are mainly Gen Z themselves (and has a Glassdoor rating of 4.4. It has branched into Skincare (both with it’s own brand and through acquiring Naturium), as well as expanded into the UK, Canada and Italy. It has a strong management team with the CEO having deep experience with CPG, including Revlon where it took it from a $100m to $2bn brand.
It’s playbook is high quality, entry level pricing that copies leaders; advertised on TikTok and distributed via retailers (Top 3 Revenue from 25% Target, 20% Walmart and 15% Ulta beauty)
It has Gross Margins of 67%, an SG&A Margin of 48% but 330 employees all Gen Z (Rev / employee = $2.3m) and an EBITDA Margin of 21%
It has above average RoE in FY24 of 27.5%, FY23 25%, lowest ever was 14% in FY2020 (SP500 average RoE is 15%).
I estimate an EPS of $1.66 in FY23; est $2.49 FY24, $4.12 FY25, $5.24 FY26, $6.8 FY27
Working Capital requirements are lowish; 11.7% AR of LTM Sales, 14% Inventory LTM Sales.
It’s a highly cash generative business; throwing off ~$100m in FCF per year.
There is a legitimate moat here as Brick and Mortar penetration is slow for new entrants, while incumbents are too slow to match (and wouldn’t want to) the marketing strategy of ‘copy catting’ prestige at a lower price point. In essence, there’s only space for one copy cat and it’s this one. Finally, the management team is excellent; Tarang has taken brands from $50m to $2bn (revlon); knows the playbook.
Stock math
I see 82% upside (to price of $274) due to PEG re-rating as it continues to hit growth targets on higher base in 1 year’s time
If they continue to beat I see the above compounding on higher EPS of 40%; (which is a successful drive of Naturium through their strategy) FWD P/E of 220 (on 4 PEG) given the market potential; or a 7x return over the next 3-5 years
Thesis
ELF’s PEG will improve as it proves it can hit the forecast 28% growth rate on a higher base; from 2.21x to 4x.
ELF actually has enough runway to maintain its growth rate at closer to 40% over the next few years when looking at TAMs of Cosmetics and Skincare (Mass Cosmetic market is est. at 16.7bn @ 6% CAGR, assuming inflation at 3%, 3% volume growth = $500m new customer runway a year) + Skincare penetration from 2% of market to
$1.4bn in FY25
$2.1bn FY26
$3bn FY27
Stock math: I see 82% upside (to price of $274) due to PEG re-rating as it continues to hit growth targets on higher base in 1 year’s time. If they continue to beat I see the above compounding on higher EPS of 40%; (which is a successful drive of Naturium through their strategy) FWD P/E of 220 (on 4 PEG) given the market potential; or a 7x return over the next 3-5 years
Risks
This is a high-growth, expensive stock, with good fundamentals behind it - there’s a lot to like about it, however I don’t think you can bank on the Core business delivering that growth, requiring additional lines and geographic expansion. Having been in a high-growth ‘start-up’ myself, the sheer amount of organisational change needed to shift this is something that I would be wary of. Now this might not blow-up the first or second quarter, especially if they can crack it with Naturium, however it’s a risk that compounds on itself given it’s relying on a fickle Gen Z to provide sales and so any lapse in product or brand quality could permanently take them off the super-growth highway as they become ‘uncool’.
That said, the fact remains there is only room for one copycat, and if they are able to succeed in the playbook adaption to skincare then they have a legitimate path to high-levels of sustainable. This coupled with the fact that Estea Lauder and L’Oreal have such high PEG’s gives ELF sufficient room to grow into over a longer-term holding period.
Investment Idea
Long ELF
Macro Investments / Trades
Rates Bet
Instrument: TLT (ETF on 20 Year Bonds) + Options (Call and Put)
Expression: Long 16 Jan 2026 70/140 Risk Reversal on TLT ETF
Story: Betting on a total of 3% Fed Rate cuts priced in by January 2026
Return Target: Receive 1.5k Debit, with upside of spread $6k-$11k (total return of 7.5k-14.5k) over 2 years.
Instrument Summary:
TLT is a bond ETF targeting 20 years, it holds 41 bonds. It has a duration of 16.98 and convexity of 3.82.
A Risk Reversal is an option strategy that cheapens calls (the right but not obligation to buy the underlying) by selling puts (the right but not obligation to sell the underlying), going long expresses a view the underlying will go up. Combining a Long Call with a Short Put allows for arbitraging mispriced volatility (where the Implied volatility of the Put is more expensive than the Call given it is downside oriented, this is known as “skew”) as well as provide lower exposure to Theta as the decay in the option prices offset one another.
Thesis
There will be 3% of rate cuts priced into the 20 year segment of the market by 2026 January. This will translate to a TLT price of roughly ~130 to 160 (depending on what has been currently ‘priced’ into the 41 bonds); rough math below:
Duration = 16.98 x 96.29 (current price) x 0.01% x [150 to 300] bps +
Convexity = 1/2 x 3.82 x (96.29 x 0.01% x [150 to 300]^2 bps
= 145.3 + 16.55 = TLT Price target of 161.89
If this occurs, then with the current delta of the Risk Reversal at 0.20, against the price move of $65 = +$13 on the Risk Reversal price from current levels (including being paid 1.5) for a total of $15.5 x 100 = $1,550 per spread put on. This doesn’t take into account the fact that this spread is deep out of the money with a tonne of time value left on it, and so it’ll start gaining additional gamma as the trade moves the right way.
All said and done if TLT hits 161.89, then that’s 21.89 above the 140 strike on the call, bringing PnL to $2,189 per contract.
The above essentially allows for an asymmetric bet on TLT benefitting disproportionately from the move in rates downwards. This is further compounded through use of options which have been structured in a way to give more Delta but also benefit from a better Gamma profile, and am paid a debit to put it on.
Risks
With options there’s always a risk that they don’t cross the strike, and by being short options, there’s a risk that the price moves the other way. Further there’s always a risk that the MTM volatility is too great to deal with.
Rates expectations remain high into 2026 (i.e. 20 year segment remains stubborn) leading to bleeding out in the option position.
Rates expectations flip and go even higher (overheating economy) leading to sell-off in TLT and leading to potentially levered losses on the Short call position.
News this week
Quick-fire takes:
The future’s future looks bright according to the WSJ (we will be able to better fight Alzheimers with lecanemab and donanemab, Ozempic to help ‘obesity’ and ChatGPT will do all our work…)
Economists failed to count ‘bullwhip effect’ with respect to ‘transitory inflation’
Mortgage rate spread to Treasuries is starting to contract to historical norms
Currently at 2.75%, it was closer to 1.5% in 2021; it highlights an interesting dynamic - Investors would love to have a higher rate as it flows through to holding RMBS, but has a greater prepayment risk when rates fall, but borrowers do not love the new rates and so mortgage financing has been in a ‘deep freeze’.
Disney moved ‘Binny’ the official mascot of the Disney Day Drinkers (a social club that day drinks at…Disney World) Below is the origin story of Binny
The Rose & Crown Pub at the U.K. pavilion, then operating under Covid-prevention protocols, required tipplers to go outside to imbibe. With few tables in sight, the group congregated around Binny, whose flat top made an enchanted place to set down drinks… “Someone said, ‘This club needs a mascot,’” says Skip Sher, a 57-year-old former radio personality and marketing executive from Richmond, Va., who founded the club. Fortunately, one of those present was Fr. Sean Knox, a now-retired Air Force chaplain and Roman Catholic priest from Tallahassee, Fla. He sprinkled a few drops from his pint of Smithwick’s ale onto the trash bin and said, “I now bless you the official mascot of the Disney Day Drinkers Club,” according to members who recall the moment. Then everybody toasted the wastebasket. Banks are betting on China’s rebound
FT estimates Net foreign investment into China’s stock market was just $4.3bn in end of December (down ~8x from 2021)
I was RIGHT - Convertibles are the new Hot Thing, thank’s FT
Issuance is up 77% to $48bn
The author raises some good points; history shows sector hype with Dot Com bubble in 2001, Finance sector hype in 2007, which may rhyme with today’s hype (will Apple losing a bit of it’s sparkle, lead to a loss of confidence in the sector?)
Is Private credit a systematic risk?
Short answer… no because, as per GS
Notion that corporate defaults can cause recessions has little empirical support when looking at the last four business cycles & The size of the direct lending market is too small ($530bn) and financial leverage is low
Yes Private Credit funds are less diversified in risks, but the losses really just accrue to the Limited Partners, at the end of the day. The root cause of bank runs are maturity mismatches between assets and liabilities. This mismatch is non-existent in private debt funds.
Rise of secondary market for LP’s creates needed liquidity if there’s a mismatch at the LP level, as the secondary market continues to expand, the NAV discount will shrink.
