Fundamental Value had a solid quarter, essentially flat against a loss of -4.6% for the S&P 500. Our short positions made the difference. Our average short name was down -17% and the short book contributed 5.5% to the quarter’s return. FV has compounded at 24.7% net of fees since inception in 2016, outperforming the S&P 500 by 8.6% annually.1
Market commentary
As we did in January in our 4Q21 letter, let’s check on our predictions from Part III: Apex of a Bubble. In Part III, published last September, we said that the US capital markets were mired in an “everything bubble,” presaging real returns that investors would find severely disappointing – and likely negative – for many years to come. And we predicted an imminent top and a proximate cause:
We believe inflation is likely to be the catalyst that ultimately pops the everything bubble. If we are correct, eventually the Fed will have to reverse course, tightening policy and raising interest rates. When this happens, investors who have speculated in low or no-yielding assets like SPACs, high-flying growth stocks, and NFTs may find their portfolios permanently impaired.
These predictions had already largely come true by January – perhaps even quicker and more definitively than we had anticipated. And these worrisome phenomena have only accelerated since then.
Back in September, traders were predicting less than one interest rate hike for all of 2022; now they are pricing in ten.
2 Fed officials are openly discussing the possibility of a massive 75bp hike at a
single meeting.
The most speculative securities continue to be decimated. The ARK Innovation ETF, the standard-bearer for valuation-agnostic, meme-chasing investors everywhere, has plummeted -55% since last September.
We predicted “the death of easy real returns from passive investing.” And the fixed income universe has indeed been a disaster: the Bloomberg US Treasury Index is down -9.5% since September. The current drawdown is by far the worst in data back to 1973.
But while bond indices have been pummeled, the main equity indices have been eerily resilient. Through April 22nd, the S&P 500 is down only -1.1% since we wrote “Apex of a Bubble.”
Investors seem increasingly in denial of what is an unequivocally disastrous fact pattern for an equity market that is still trading near all-time high valuations. And despite all the bad news that has come in since September, the worst is yet to come.
While monetary conditions have tightened, the vast majority of interest rate increases are still ahead of us. The Fed has only just begun one of the sharpest – if not the sharpest – tightening cycles of all time. And the great balance sheet unwind has yet to even begin.
Fiscal policy is contracting as well. Bloomberg’s survey of economists predicts a budget deficit of 5.3% of GDP in 2022. This is an enormous budget deficit – in fact, bigger than all deficits from the start of data in 1968 until the financial crisis. Nonetheless, the deficit in 2021 was 10.8%, so the fiscal stimulus impulse is sharply negative. This 5.5% contraction in spend is unprecedented, several percentage points larger than all pre-covid reductions.
Real yields have soared: the 10y real yield briefly turned positive after being at roughly -1% last September. This creates competition for risk assets which had been priced in comparison to deeply repressed – and deeply negative – real risk-free rates. We expect real yields will continue to increase, as they will need to be substantially positive before inflation can be reined in. Rising rates will likely cause substantial multiple compression.
Furthermore, we expect equities to be pressured by falling corporate profitability. Corporations have benefitted from insatiable consumer demand created by unprecedented government largesse. But that is ending, and demand destruction is coming. High inflation is a tax on the consumer, especially the spikes in the cost of food, energy and shelter. Margins are at all-time highs and have likely peaked. Corporations will be squeezed by rising labor and input cost inflation and many will have difficulty passing those costs through to consumers.
Credit risk metrics are flashing warning signals. Five-year CDS spreads are up 50% since September for both investment grade and high yield credits.
This is all deeply troubling. And equity investors seem to be aware of it on some level. In one survey, they
report being more bearish than they’ve been in thirty years. But, given the buoyant S&P 500, they don’t appear to be backing up their words with actions.
We suspect that many equity investors are playing an extremely dangerous game of musical chairs. They know that the music is about to stop, but they are
still dancing. They are betting that they will be able to find a seat before the person next to them. Unfortunately, most of them will not.
Investors are poised with their fingers over the sell button. This creates the conditions for a crash. Caveat emptor.
Despite this dire warning, we believe the return prospects for Bireme clients are strong. The calm surface of the equity market conceals significant volatility underneath. This idiosyncratic volatility presents opportunities for disciplined and discerning investors to add value regardless of the direction of the broader market.
We continue to find significant underpricing in our core value names, and international equities remain priced at substantial discounts to their US peers. We also maintain a substantial short book; many vaporware and meme stocks still trade at comical valuations. We have begun to sift through the rubble of the growth stock mania for discarded treasures.
The past decade has rewarded valuation-agnostic and meme-chasing investors, culminating in the unhinged growth stock mania that defined 2021. We think the next era will be marked by a return to sanity, rewarding disciplined, discerning and value-conscious investors – and we think that era has just begun.
It’s not too late to join us at Bireme. Please reach out.
Netflix
At the beginning of April we made an investment in Netflix. We posted the thesis on our blog
here.
We wrote that “we would not be surprised if NFLX traded down from here” and that “we would be eager buyers on further weakness (assuming the NFLX business case isn’t materially impaired in the meantime.”
When we wrote that we would not be surprised if Netflix declined, we were envisioning potential valuation compression from a further wash-out in the growth stock bubble. We were not envisioning the dramatic negative turn in subscriber growth and company guidance revealed in Netflix’s Q1 results that sent the stock down more than 30% overnight.
Shares now trade at around $215 per share, a steep fall in a very short time from our average price around $350. We should note here that our Netflix position was conservatively sized; our losses to date on the Netflix position amount to less than 2% of our portfolio NAV. Furthermore, our significant short book of correlated stocks has also mitigated the hit to the portfolio. As of April 21st, FV remains up 3.6% for the year compared to a loss of -7.5% for the S&P 500.
Nonetheless, our NFLX bull thesis has been severely tested by the disappointing results.
Results
The primary cause of the share price drop was a miss in subscribers, both in the Q1 results and in the company’s guidance for Q2. For Q1, Netflix lost 200k subscribers. Although they gained 700k subs if you exclude the impact of exiting Russia, this was still a miss of over 2m subs relative to their January guidance. On top of that, the company guided for a loss of 2m subscribers in Q2, which would be their largest ever subscriber loss in a single quarter.
The company blamed the disappointing numbers on high penetration, increased competition, macroeconomic factors, and lower sales of smart TVs. Management does not believe the subscriber declines are solely due to a hangover from the pull-forward of COVID-era demand, which was their original explanation for the late-2021 sub growth slowdown.
That being said, the company made clear that they will not stand still and watch the subscriber base wither, and are moving forward on several new initiatives to re-ignite growth.
First, they plan to start charging password sharers. Management claims that 100m households globally share passwords without paying, including 30m in the US and Canada. We are very confident that Netflix can accomplish this technologically. However, the difficulty is in doing this in a way that doesn’t cause a large number of cancellations. In South America, Netflix has begun testing various methods to unlock this value.
While this will only be a one-time boost to subscriber growth, the numbers are nonetheless compelling: if Netflix could extract an average of $5 per month from all 100m households who currently pay nothing to enjoy the service, Netflix’s profits would double. $5/mo is a small fraction of their ARPU and we think is doable.
Second, they plan to eventually sell an ad-supported tier of the service. This will come as a shock to many, considering how consistent co-CEO Reed Hastings has been on the benefits of an ad-free experience. But with subscriber growth waning and many competitors – including historically ad-free
HBO – going this route, he changed his mind. On the conference call he argued that the benefits of consumer choice trump the simplicity of the current model.
While it may dilute the purity of the Netflix brand, the financial promise of an ad-supported tier is large. Hulu paved the way on this many years ago as the first streaming service to offer an ad-supported tier. Hulu’s results show that this lower-priced tier is not necessarily dilutive to revenue. In fact, Hulu appears to generate roughly the same amount of revenue from both their $6.99 (ad-supported) and $12.99 (ad-free) tiers,
collecting $12.75 per month across all subscribers despite having previously
disclosed that most of their subscribers are on the ad-supported plan. This is extremely significant, since it means that subscribers who cannot afford or justify $12.99 have another option to watch the service – and at a price point where Hulu is largely indifferent between the two options. This surely results in more subscribers, more revenue, and a larger content budget than Hulu would have if it only offered an ad-free product.
Advertising is a large portion of Hulu’s business, with eMarketer
estimating that Hulu generated $3.1b in advertising revenue in 2021. The advertising business at Netflix has the potential to be multiples of this size as Netflix
averages more than twice Hulu’s share of total US TV time. We suspect that given their technical chops, ability to recruit talent, and the TAM of the opportunity, Netflix will be able to build out a world-class programmatic advertising business in short order that will bring in substantial additional subscribers and revenue.
Reunderwriting
We now expect the next few years to be difficult at Netflix, and the growth outlook is cloudier than it has been for a long time. The business model may need to be adjusted and budgets may need to be cut.
But at the end of the day, most of what we wrote in our original thesis remains true. The company sells a fantastic product at a great price point in a secular growth industry. Though an earnings miss of this magnitude will always lead investors to question management’s judgment, we still believe management is best-in-class, and are encouraged by management’s willingness to change their minds about the fundamental structure of the business when faced with new evidence.
When a stock makes the transition from being perceived as a growth stock to being perceived as a value stock, it can often engender precipitous declines. Essentially the entire investor base needs to turn over, and the price necessary to elicit interest from value investors is usually dramatically below the price which growth investors were willing to pay for it. Netflix’s transition from a perception of growth to that of value seems to have happened abruptly over just the last two earnings calls. Part of that is due to legitimate business trouble; part is just that Netflix had so far to fall given the high expectations baked into its pandemic-darling status.
Sentiment has never been more negative than it is today. Even some value investors are
giving up on Netflix due to the dramatic change in business prospects and industry uncertainty.
But this creates opportunity. At 20x trailing GAAP earnings, investors are essentially paying a market multiple for Netflix.
We have re-underwritten our investment with what we think are extremely conservative assumptions: annual subscriber additions of only 5m, a meager 3% ARPU growth, long-term margins plateauing at 25%, and a terminal PE of 20. This pessimistic scenario would still generate a double digit IRR from today’s prices. Any upside from reaccelerating subscriber growth, above-inflation ARPU growth, or significant margin expansion due to Netflix’s immense operating leverage, is pure optionality.
On this basis, we increased our stake in the company to make it a 5% position.
Portfolio commentary
Overdue for an update is our largest position, North American cable operator Cogeco. The company continued to chug along over the past few quarters, with revenues and EBITDA up about 14% in the first half of their fiscal year 2022.
The company operates the eighth largest US cable business, a segment it renamed “Breezeline” last quarter. This segment did CAD 1.2b in revenue and 589m of EBITDA on a trailing 12 month basis, and has doubled EBITDA since 2018 through a series of midsized acquisitions. Their latest deal saw them buy a chunk of cable assets in Ohio from the publicly-traded Wide Open West for $1.125 billion.
The firm’s Canadian segment has also performed respectably, with last twelve month EBITDA of CAD 750m representing low single-digit growth from the 2017 level of 680m. Backed by local government incentives, this segment is embarking on a multi-hundred million dollar network expansion which it says will generate a ~15% IRR. Notably, the company recently revised the capex required for this expansion materially downward, and now expects CAD 400m of FCF, up from a Nov 2021 guidance of CAD 300m. The company generated 285m of FCF in the first half of the fiscal year (ended in February), so this revised estimate may prove conservative as well.
We remain confident in the long-term value of in-ground cable and fiber assets. The stock trades at a mere $82 per share, and we think the company can generate $10 in FCF per Cogeco share in the medium term. In our view the stock price would have to roughly double to reach its fair value. This makes Cogeco the most undervalued stock we own.
During the quarter we reinvested in Facebook.
This is not the first time we’ve held a position in the company, which operates the largest and most profitable social media business in the world. We first bought shares in Q4 2018, after the Cambridge Analytica scandal caused the stock to drop to less than 20x earnings.
That investment was successful, with users and advertisers largely shrugging off the scandal and causing revenues to grow from $40b in 2017 to $86b in 2020. EPS rose from $6 to more than $10 in 2020, and we sold our shares between $250 and $300 in mid-2020 to reinvest in stocks that had seen share price dislocations due to the COVID-19 pandemic.
In Q1, Facebook investors once again got spooked, with shares falling almost 50% to under $200 per share. Today, shares trade at their lowest valuation ever: 12x earnings net of cash. We think the core business remains one of the best in the world and that issues surrounding TikTok competition, Zuckerberg’s investments in virtual reality, and changes to iOS tracking policies are largely overblown or over-discounted in today’s price.
For our full thoughts on Facebook, please see our blog post
here.
We are grateful for your business and your trust, and a special thank you to those who have referred friends and family. There is no greater compliment.
- Bireme Capital
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1 Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016.
2 Bloomberg’s World Interest Rate Probabilities function using Fed funds futures curve from 9/22/21 and 4/22/22.
