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David vs. Goliath: Parker Vision's Battle Against Qualcomm
In this deep dive episode, we unravel the intricate legal battle between Parker Vision and Qualcomm, highlighting the underdog's fight against a tech giant. The episode explores the revolutionary D2D technology developed by Parker Vision, the breakdown of licensing negotiations, and subsequent lawsuits alleging patent infringement by Qualcomm. As we navigate through emails, internal documents, and courtroom battles, we contemplate the broader implications for the tech industry, intellectual property rights, and the future of innovation. This gripping tale of corporate drama, technological breakthroughs, and high-stakes litigation promises insights into the complexities and stakes in the ever-evolving tech world.
00:00 Introduction to the ParkerVision vs. Qualcomm Saga
00:27 Meet ParkerVision: The Innovators
01:58 Qualcomm Enters the Scene
03:53 The Legal Battle Begins
04:18 ParkerVision's First Victory
04:55 Qualcomm's Appeal and Technicalities
05:47 The Second Lawsuit: PRKR 2
07:45 Willful Infringement and High Stakes
09:26 Expanding the Battle: Other Tech Giants
10:20 The Bigger Picture: Why This Case Matters
11:38 Awaiting the Verdict
13:45 Final Thoughts and Wrap-Up
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Welcome to The Investors Corner: Evaluating the Pet Trade In the inaugural episode of The Investors Corner podcast, Paul Cerro, Chief Investment Officer at Cedar Grove Capital Management, discusses the investment learnings behind their thematic pet trade.
Paul explains the rationale for going long on Petco and shorting Chewy during the post-COVID pet adoption boom.
The episode covers industry trends, such as the humanization of pets, pet spending habits, and the impact of COVID-19 on pet adoption rates.
Paul also shares insights on the unexpected market reversals due to the return to work, economic factors, and consumer behavior changes.
The episode concludes with key takeaways and lessons learned from this investment experience.
00:00 Introduction to The Investors Corner Podcast
00:15 Overview of the Podcast Series
00:51 First Episode Focus: Pet Trade Post-Mortem
01:14 The Importance of Learning from Trades
02:18 Pet Ownership Trends and Statistics
07:19 Impact of COVID-19 on Pet Adoption
15:52 Investment Analysis: Petco vs. Chewy
28:55 Challenges and Unforeseen Changes
37:16 Lessons Learned and Future Outlook
40:43 Conclusion and Future Episodes
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
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TL;DR
* Red Cat Holdings (RCAT) is in the final two to be considered for a multi-year Army drone contract that could be worth ~$450 million; ~3.3x current market cap
* Strong probability the company wins the contract given current contractor's (incumbent) battlefield issues and arguably inferior drone design
* Additional exposure to other programs/contracts means a no-contract win does not mean the company’s future is not bright
* Massive tailwinds for American-made drones to be built and put into field use as a direct result of the Russia/Ukraine war and military build-up of China
Disclaimer: I/we (“Cedar Grove Capital”) currently do have a stock, option, or similar derivative position in Red Cat Holdings (RCAT) at the time of writing this article. All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security.
Background Context
A world-renowned video game popularized the saying, “War. War never changes.” For the ones who get the reference, good on you.
However, while war technically doesn’t change (death, destruction, chaos, etc.), the rules of war and how they are fought, do. Over time, more technologically advanced weaponry has been introduced onto the battlefield to improve precision, and intelligence, and reduce overall loss of life.
The war in Ukraine, brought on by Russia, has completely derailed combat as we know it with hard-hitting tanks and massive advances in infantry units being destroyed by something as simple as a 5lb drone.
This explosion in drone interest comes as global warfare is entering a third age of drone warfare, defined by autonomy, saturation attacks, increased precision and range, and full-spectrum drone warfare across land, sea, and air.
In early 2024, Ukraine’s Minister of Digital Transformation stated that Ukrainian drones had destroyed or damaged 73 tanks, 10 howitzers, and 369 Russian personnel, all in just one week. As much as 50% of Russia’s modern T-90 tank combat losses are attributed to small first-person-view drones.
This level of success has not gone unnoticed. Countries worldwide have seen just how effective these unmanned aircraft systems (UAS) have proven to be and are rapidly expanding defense spending to buy more.
Despite all the success, that does not mean there haven’t been issues. When the Ukrainian war first broke out, Ukraine heavily utilized cheap Chinese commercial drones for tactical missions. Just a few months in, however, Kyiv began noticing problems: Chinese drone maker DJI appeared to be leaking data on Ukrainian military positions to Russia.
Chinese drones also proved susceptible to powerful Russian jamming and electronic warfare attacks. Then, in July 2023, the People’s Republic of China (PRC) began restricting drone sales to Ukraine while continuing to supply Russia.
The weaknesses in using Chinese-made drones — or technology for that matter — are a top cybersecurity concern for government/military officials. A recently House-passed Countering CCP Drones Act would prohibit DJI drones from operating on U.S. communications infrastructure, which–while not an outright ban–would effectively render the drones unusable in the U.S.
“Congress must use every tool at our disposal to stop communist China’s monopolistic control over the [US] drone market.” -Rep. Elise Stefanik (R-New York)
It can be expected to be passed sometime in 2025 should Congress approve.
Because of the U.S. limiting exposure to Chinese-made drones, which already account for ~70% of the market, hundreds of companies are rising to fill the void and produce American-made drones.
The U.S. Army has already launched its Short Range Reconnaissance (SRR) program 2 years ago which is exactly why I’m writing this trade for you.
Red Cat Holdings (RCAT), through its Teal drone-making products, is 1 of 2 finalists (out of 37 originally) for a nearly $450 million drone contract. Given the company currently has a ~$136 million market cap, you can see why this is a pretty significant deal for the company.
Should they win, the rewards could be multiples of what it’s worth today. Let me break it down for you.
Side note, if anyone is interested in looking more into defense spending, I put out a thematic research report on the industry with an emphasis on NATO and the U.S.
U.S. Army Short Range Reconnaissance (SRR) Contract
This trade has been one of the most intense connect-the-dots situations I think I’ve had to do. I combed through 5 years of U.S. Army aircraft defense budgets to try and piece together what exactly was going on and to what extent.
It was a lot to the point where I looked like this guy from Always Sunny in Philadelphia 👇🏼.
But in the end, I believe I have flushed out the contract as best as possible, outlined the flaws of the original research that was posted on Twitter ~2 weeks ago, and also provided financial reasoning behind the contract (no)win valuation.
This post is different than all the other ones I’ve done. For this post, I’ve made it into a downloadable PDF presentation and the accompanied audio for paid subs is what goes along with that. Forgive my lack of crazy formatting but I just wanted to get it across to you all in a very succinct and straightforward way.
I really hope you enjoy it as this is a new, first-of-its-kind presentation format I’ve done but also because the upside is pretty massive.
I implore you to read the presentation with the audio in the back and please be aware that earnings come out on the 25th of July (Thursday). Click below to access the PDF.
If you enjoyed today’s research, please make sure to ‘like’ this post, it helps with the algorithm. If you think someone you know might like this pitch, please share this post.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
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Preliminary disclaimer: In order to continue being completely transparent with you all, I need to disclose that I was previously an employee of Roman Health Ventures (“Ro”), a direct competitor of Hims & Hers Health (HIMS). While I have not been an employee of them for several years, I’m still very knowledgeable about the inner workings of this industry and still hold shares as a previous employee.
While I may drop in publicly available information about Ro for this particular research, I am not speaking for or on behalf of Ro nor do I have any inside information about anything since I left that position. This research will be strictly focusing on Hims and why I believe it’s a multi-year success story.
Hims & Hers Health (HIMS) has been on my radar for quite some time. As a previous employee of Ro, part of my job was to keep track of the competitive landscape and HIMS happened to be within that scope.
When the company first went public via a SPAC in early 2021, I was very open on Twitter about my pessimism about it being overvalued which inevitably was true and led to its nearly 80% decline.
It bottomed in May of 2022 and has slowly been climbing its way back up ever since by showing strong underlying fundamentals and eventually becoming GAAP profitable for the first time earlier this year. While it made no sense for me personally to increase my exposure to the space by double-dipping with Hims (since I already had my Ro shares), Ro’s public comments about not focusing on an IPO at the moment changed my mind on things.
In an effort to possibly reward myself with a competing company’s growing fundamentals and liquid nature, I ended up taking a very large position in Hims which I disclosed to you all on May 12th.
However, as sell-side reports claimed that Hims was getting too far ahead of itself and Andrew (CEO) decided to make some pretty unnecessary Twitter comments about the Israel/Palestine war, the stock dipped another ~10% after an already ~15% decline from the earlier SS reports.
Despite all that, Hims was able to show another strong earnings report (Q1’24), upbeat guidance, and a new compounded GLP-1 offering which has led the stock to return just shy of 85% since bottoming out in early May. My position alone is up >70% since the end of March.
As I mentioned in past posts, the positions that I hold are meant to be held for a while. I'm not good at trading for the short-term and the added stress of that does not interest me, especially when as an investor you need to consider the tax implications of such a strategy. Something I learned from Ron Baron.
But while the stock is up >560% since May 2022, and 133% year to date, I do not think that this means the story is fully played out. Trading at 3.4x EV/Sales and 33x EV/EBITDA with no debt, an >$200 million cash war chest, and positive FCF over the last 5 quarters (and growing), I think the execution of Hims and market potential is still very much in the early innings.
Below is why it’s (now) my second largest position and why I’ll look to continue sizing up as the opportunity presents itself. My valuation model is included at the end.
Thinking about if it’s worth it? Click here to see past work.
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This is a free preview of a paid episode. To hear more, visit www.cedargrovecm.com
As my first paid research post, I’m going to be going over the FTC complaint in detail and address all of their concerns, and provide rebuttals and counterpoints to each argument.
Those of you reading this for the first time can read my prior two posts below from December of 2023 and March of this year.
In each of those posts, I addressed the deal overall, and why before the FTC suit, it should not be blocked under anti-trust concerns.
However, as we all know by this point, the FTC sued to block the merger between Tapestry (TPR) and Capri (CPRI) on April 23rd. You can find a PDF copy below.
I will caveat that a lot is redacted to the point where you’d think you’re trying to read some CIA documents in certain places, but no matter, the points still got across.
This suit finally confirmed what the market was preparing for and as of May 7th, depending on your break price, the deal probability of going through sits anywhere from ~30 - 43%.
Before diving in though, I need to clarify a few things.
* Based on Tapestry’s response to the suit, it seems that Joanne (CEO of TPR) wants the Capri assets and will fight in court to get them. Quoting her directly
“There is no question that this is a pro-competitive, pro-consumer deal and that the FTC fundamentally misunderstands both the marketplace and the way in which consumers shop. We have strong legal arguments in defense of this transaction and look forward to presenting them in court and working expeditiously to close the transaction in calendar year 2024.”
* Prior to graduating college, I worked many retail jobs in the clothing industry here in NYC. Most notably, for Thomas Pink at Bloomingdale’s flagship on 59th street where I was very familiar with all the brands in question.
* I was interning at Merrill Lynch in the C&R group when the Michael Kors/Jimmy Choo deal took place. I was a part of the acquisition financing.
* The court date is set for September 9th.
* I do hold a long position in Capri (CPRI) at the time of writing this post.
So with that, let’s get into it and go point by point on each of the FTC’s complaints on the deal and then my odds on their case at the end.
First and foremost, I think we need to tackle low-hanging fruit here that I believe is just thrown in to provide some type of ammo in a suit but doesn’t hold much water.
In the FTC’s own words
“With Tapestry’s acquisition of Michael Kors, the closest competitor of Coach and Kate Spade, consumers will lose the benefit of head-to-head competition on price, discounts and promotions, innovation, design, marketing, and employee wages and workplace benefits.”
Let’s first address the employee wages and benefits argument.
1) Employee Wages & Benefits
The FTC claims that the combined company (“NewCo”) of Tapestry (TPR) and Capri (CPRI) will hurt employee’s ability to get better wages and benefits because there’s no more competition between the two.
They cite that in 2021, Tapestry publicly committed to a $15/hr minimum wage in the U.S. for hourly employees, and less than two months later, Capri also decided to raise the minimum wage to $15/hr. Good stuff!
The problem here is that this is not a competition issue. Salaried employees might be harder to retain or convince to join, thus keeping top talent — think Google, Amazon, Meta, etc — but retail has never been. It’s no secret that retailers always want to try and help the margins out in their stores and workers’ wages are usually only met to meet the requirements.
However, this claim that NewCo will lead to lower wages is completely false. Retail wage issues are nothing new. Take for example the tit-for-tat exchange with Target and Walmart.
In April of 2019, before the pandemic, Target raised its minimum wage to $13/hr from $12/hr with the plans of increasing it to $15/hr by the end of 2020. At the time, Amazon had raised its minimum wage to $15/hr in October of 2018 and Costco also raised its minimum hourly wage to $15/hr.
Pulling from the same Reuters article,
“Retailers have been finding it tougher to attract workers, with U.S. unemployment at its lowest level in nearly 50 years, while there has been growing political pressure on companies to pay workers a fair living wage.”
Given that unemployment is right on par with where we were pre-pandemic, I’d say not much has changed.
Additionally, the pandemic just made things worse for retailers as fears of contracting COVID and receiving enhanced jobless benefits, including a government-funded $300/week, paid more than most minimum wage positions. Tack on the lack of affordable child care, retail theft on the rise, and of course the big one being working retail just sucks in general, it’s no wonder workers didn’t want to come back.
This is why Tapestry felt it necessary to raise the minimum wage and according to Reuters, was the latest company to push incentives to lure people back into the workforce.
Also, just look at the GlassDoor reviews when it comes to employee satisfaction:
* Tapestry - Retail Associate - 3.8 / 75% would recommend
* Michael Kors - Retail Associate - 4.1 / 56% would recommend
* Jimmy Choo - Retail Associate - 4.5
* Kate Spade - Retail Associate - 4.1 / 74% would recommend
* Stuart Weitzman - Retail Associate - 4.4
* Versace - Retail Associate - 2.8 / 99% would recommend
So here’s the first dent to the FTC’s argument.
Given the low skills needed to perform these jobs, whether you work retail for Tapestry, Target, Costco, or wherever, retail is competing with retail, not the other retailers within the same sector.
This is a fact and Vox did a piece on the industry back in June of 2021 highlighting why retail workers are quitting to go elsewhere.
“Even before the pandemic, a lot of retail jobs weren’t good jobs. Jobs in the industry were largely ‘considered stopgap jobs’ with low status and low pay.”
This is just the mechanics of retail jobs that the FTC has completely missed the ball on. As long as labor is tight, and retail still sucks as a job, it’s going to take companies paying more and offering more benefits in order to retain talent.
Market dynamics are self-fulfilling here.
Also, the FTC complaint highlights that the company employs 33,000 in total who would supposedly be affected by the merger. Given that many workers are abroad and are making the physical goods to sell in the U.S. it makes little sense for the FTC to blindly loop in international employees into that calculation. It just doesn’t make sense. International employees are out of the scope of the FTC.
Takeaway: The facts speak for themselves. Tight market + shitty job type in general = employers needing to pay up or not have enough workers. Slim chance to none this works.
Odds: 0-5%
2) Market Definition
The main FTC complaint is that NewCo will command too much of the “accessible handbag” market share in the U.S., thus hurting consumers.
“Accessible” being the term coined by Tapestry 20 years ago to bridge the gap between mass-market and true luxury. Mass-market is addressed in her complaint as typically being anything that is below $100 and luxury being priced to be out of reach to the masses (relative and also subjective).
That’s the core argument, albeit a very vague one. Because of this, Tapestry filed a motion over the weekend arguing that it is the FTC's burden to define the relevant markets in any of its merger challenges, something that the regulatory agency has "continuously refused" to do since it moved to block the megadeal last month.
The FTC,
"fails to answer the basic question of what the FTC defines as a ‘handbag’ or ‘accessible luxury.’ For example, the complaint gives no guidance as to whether "handbags" include some or all of women's and men's handbags, backpacks, duffel bags, cross-body bags, business bags or other small bags. The complaint's definition of ‘accessible luxury’ relies on ‘vague, hedged and sometimes contradictory language’ to differentiate it from ‘mass market’ and ‘luxury.’
The FTC provides no clarity as to what products fall within which categories. Simply put, defendants do not know if the FTC's 'accessible luxury handbag' market is defined around certain brands, is bounded by price points, or is defined by the consumer's household income.’ ‘All of these factors are splayed throughout the rambling complaint — and yet there is no simple definition. What is in the market and what is out?’"
You can find the formal TPR response via the PDF below.
In my personal opinion, I think TPR really ripped the face off the FTC and made them look bad. Based on the rebuttals, it made the FTC look like they had no idea what they were talking about, especially when it came to defining the market.
“The FTC mistakenly believes there are only three options for a consumer seeking a high-quality handbag in whatever price range the FTC ultimately settles on for its untenable “accessible luxury” handbag market: Tapestry’s Coach and Kate Spade, and Capri’s Michael Kors. Indeed, the FTC’s Complaint incredibly goes so far as to decry that these three brands constitute a “duopoly” in that market.”
Hard to say you don’t control 100% of the market when the market you’re defining is literally just 3 companies.
To further reinforce this market definition point, using Euromonitor data (below), the market definition between “luxury” and “affordable luxury” can very well mean the difference between having a 45% market share in North America or 22%.
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My old man had a philosophy: peace means having a bigger stick than the other guy.- Tony Stark
Ever since the dawn of time, men have been engaged in conflict primarily for economic, religious, and political reasons.
From the ashes of WW2, the United States rose to become one of the world’s superpowers and thus, a key player in shaping the new world order.
However, to be the keeper of the peace, wars still need to be fought both directly and indirectly and deterrents need to be put in place to prevent conflicts from occurring more frequently in the future.
With the introduction of nuclear weapons — which to this day the U.S. is the only nation to use them against an adversary — and the adoption of globalization, both were meant to be those deterrents. Since then, the number of worldwide battle deaths has decreased dramatically since the bombs were dropped on Hiroshima and Nagasaki.
But stability and security come at a cost. With the formation of NATO in 1949 to protect Europe from the USSR, that cost was pegged at ~2% of the annual GDP of respective countries (more on this later).
This has largely benefitted U.S. defense contractors over the years as upgrading and maintaining weapons has allowed America and its allies to be multiple steps ahead of another potential adversary.
Yes, the above returns you’re seeing are not deceiving you. After defense administration changes in the early 90s coupled with the first Gulf War, defense contractors seized the opportunity of looser policy and new wars.
But after we left Iraq and Afghanistan, many thought that America’s major wars were long gone and defense contractors would only benefit from conservative spending during peacetime.
However, the “Special Operation” in Ukraine by Russia quickly destroyed that logic as the largest invasion of Europe since the Second World War by some 150,000 troops put the continent on high alert. With new conflict comes new rearmament and replacement of weapons given to Ukraine in order to defend themselves.
But I write this post not to bring up history or current politics but to share my thoughts on the future and what that means from a defense contractor perspective which can be boiled down to one broad-based theme.
A rising tide (geopolitical risk) lifts all boats.
Let me break that down one part at a time.
Rearmament
Since the invasion of Russia, the U.S., NATO, and its allies have given >$178 billion in support to Ukraine. This does not include the recent $54 billion from the EU in February or the $60 billion from the U.S. This aid has come in the form of direct military hardware (weapons, missiles, ammo, etc), financial, and humanitarian assistance.
As a baseline, one would already imagine the need to ‘replenish’ their stockpiles after gifting Ukraine this weaponry which will directly cause weapons manufacturers to win new contracts associated with that.
That math is simple. For example, to meet demand for missile defenses, production of Patriot interceptors for the U.S. Army will rise from 550 to 650 rockets per year. At around $4 million each, that's a potential $400 million annual sales boost on one weapons system alone.
"Each day the munitions are being fired reinforces the need for substantive stockpiles, and I don’t see that going down.” - Tim Cahill, LMT Missiles and Fire Control business
Since increasing production volumes of older systems is always more profitable than the high investment costs associated with ramping up production of new systems, stronger demand will flow quickly to the corporate bottom line.
“We are probably looking at about $10 billion to replace everything, everything that we’ve given in terms of supplies to Ukraine.” - Pentagon official
Granted the above is more of a budget shortfall when in reality the number is closer to $20 billion though I will caveat that there’s no guarantee that the government will approve further budget increases in the future to make up for the windfall.
Making sure America has enough weapons and munitions for war plans and training is of the utmost importance, especially as aggressive threats around the globe continue to reveal themselves.
The 2% Target
In 2014, NATO Heads of State and Government agreed to commit 2% of their national GDP to defense spending, to help ensure the Alliance's continued military readiness. This decision was taken in response to Russia’s illegal annexation of Crimea and amid broader instability in the Middle East.
The 2014 Defense Investment Pledge was built on an earlier commitment to meet this 2% of GDP guideline, agreed in 2006 by NATO Defense Ministers. The 2% of GDP guideline is an important indicator of the political resolve of individual Allies to contribute to NATO’s common defense efforts.
In addition to the replenishment and rearmament, Europe and its allies have come to the stark realization that from a military POV, they may not be prepared for a potential full-scale war in Europe and French President Emmanuel Macron has openly admitted this.
“There is a risk our Europe could die. We are not equipped to face the risks. There is no defense without a defense industry ... we’ve had decades of under-investment. We must produce more, we must produce faster, and we must produce as Europeans.”
To build reassurance with its own populace and amongst its allies, additional measures need to be taken.
Historically speaking, this broader target of 2% was barely reached by its members. However, in 2024, two-thirds of Allies are expected to meet or exceed the target of investing at least 2% of GDP in defense, compared to only three Allies in 2014.
Over the past decade, NATO Allies in Europe have steadily increased their collective investment in defense – from 1.47% of their combined GDP in 2014, to 2% in 2024, when they are investing a combined total of more than $380 billion in defense.
Aside from the increased urgency in commitments from existing NATO members, we’re also seeing the introduction of both Finland and Sweden into the alliance.
Finland has already stated it plans to spend 6 billion euros ($6.48 billion), or 2.3% of its GDP, on defense in 2024, which has increased significantly in recent years, even before becoming a NATO member.
Sweden also has boosted its military defense spending to ~2.1% of GDP to $2.44 billion which is nearly double what it was in 2020.
With the introduction of two NATO allies on top of increased spend from existing members, we’re looking at an increase of tens of billions of dollars in incremental defense spending from this region alone.
U.S. officials have indicated that they intend to starve the Russian arms export industry, encouraging their allies in Europe and globally to buy American weapons instead.
These massive deals will help reduce European reliance on Russian arms, especially the eastern block of NATO members.
The World Prepares for Future Conflict
In September of 2023, I hosted a Twitter space with Monetive Wealth Market Musings specifically on defense stocks and shared our thoughts on how geopolitical risk was changing faster than people were acknowledging.
You can find the link to hear the recording below.
The short end of the recording is that I believed the world was becoming an increasingly less stable place and that continued conflict would only grow larger as a result of increased global instability.
Since then,
* Hamas attacked Israel
* Israel invaded Gaza
* Israel is under constant threat from terrorist organizations that want nothing else than to wipe it off the map
* Tit for tat missile exchanges with Iran
* Houthis are seizing ships in the Red Sea
* China keeps taunting Taiwan and reaffirming its unification
* oh, and Russia is still pressing its invasion of Ukraine
Not things you want to hear when you’re trying to live in a world of peace instead of conflict however, U.S. arms manufacturers are there to remind the world that weapons are still needed.
Last year, spending on defense by countries around the world reached $2.43 trillion with the U.S., China, and Russia leading the way. While global military spending has grown every year for nine straight years, the nearly 7% rise in 2023 from 2022 marks the sharpest year-on-year increase since 2009.
‘The unprecedented rise in military spending is a direct response to the global deterioration in peace and security” - Nan Tian, Senior Researcher with SIPRI’s Military Expenditure and Arms Production Programme
This is by no means a coincidence. With Russian aggression on the eastern front of Europe, China's aggression in the Pacific, and now conflict again in the Middle East, surrounding countries are fearful of new conflicts and relying on the U.S. to protect them.
In the Pacific, China’s more frequent comments on the reunification of Taiwan have countries on edge, especially as they build manmade islands in the South China Sea for military purposes.
Just last month, China announced a 7.2% increase in its defense budget, which is already the world’s second-highest behind the United States at 1.6 trillion yuan ($222 billion), roughly mirroring last year’s rise.
China’s defense budget has more than doubled since 2015, even as the country’s economic growth rate has slowed considerably, but that’s not stopping them from growing their forces in what could only mean future active conflict.
In a direct response to China’s military growth, Japan allocated $50.2 billion to its military in 2023, which was 11% more than in 2022. Taiwan’s military expenditure also grew by 11% in 2023, reaching $16.6 billion.
Estimated military expenditure in the Middle East increased by 9% to $200 billion in 2023. This was the highest annual growth rate in the region seen in the past decade.
Military spending in Central America and the Caribbean in 2023 was 54% higher than in 2014. Escalating crime levels have led to the increased use of military forces against criminal gangs in several countries in the sub-region.
No matter where you look, states, countries, and regions are all becoming more unstable and dozens of countries are already re-militarizing for a potential future war which contractors will benefit from.
Military Exports
While the previous sections mainly talked about the U.S. and its allies, do not forget that many other countries also need weapons to defend themselves. It’s no secret that the U.S. is really good at making weapons which is why many countries around the world love to get their hands on them.
The U.S. accounted for 42% of total exports from 2019-2023, up from 33% in the previous five years, while Russia declined from 22% to 11%.
Just looking at foreign military equipment sales, the U.S. sold $238 billion to foreign governments in 2023, a 16% increase from the year prior.
The U.S. provided more than half of the weapons purchased by 13 of the top 17 arms importers, with Saudi Arabia, Japan, and Australia buying the most from the U.S.
“Arms sales and transfers are viewed as ‘important U.S. foreign policy tools with potential long-term implications for regional and global security’.” - the State Department
There are two major ways foreign governments purchase arms from U.S. companies: direct commercial sales negotiated with a company, or foreign military sales in which a government typically contacts a Defense Department official at the U.S. embassy in its capital. Both require U.S. government approval.
The direct military sales by U.S. companies rose to $157.5 billion in fiscal 2023 from $153.6 billion in fiscal 2022, while sales arranged through the U.S. government rose to $80.9 billion in 2023 from $51.9 billion the prior year.
Looking at just a few examples outside of Europe, we have South Korea paying $5 billion for F-35 jets and Australia spent $6.3 billion on C130J-30 Super Hercules planes and separately, nuclear-powered submarines back in early 2023. Japan reached a $1 billion deal for an E-2D Hawkeye surveillance plane.
As countries continue to order hardware, U.S. companies will be there to continue fulfilling these contracts which have pushed backlogs to the highest they’ve been in nearly a decade.
Closing Thoughts
Sometimes it’s hard to invest in companies that directly sell products/services that result in deaths around the world. However, the reality is that war never stops, it just changes from conflict to conflict. The defense industry is a necessary cog in a machine we call world order and for the right investor, backing this industry could reap plenty of rewards.
While I didn’t go directly into company-specific financials, capabilities, or capacity, I hope this quick article at least piqued your interest in this industry that will massively benefit from a multi-year, even potentially multi-decade shift.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
“Once a $3 trillion asset class, offices now are probably worth $1.8 trillion. There’s $1.2 trillion of losses spread somewhere, and nobody knows exactly where it all is.”
- Barry Sternlicht
The first real public domino to fall in the CRE trade was New York Community Bank NYCB . In one day after the company reported $185 million in net charge-offs in the fourth quarter and cut its dividend, the stock closed down ~37%.
This sent shockwaves in the market about the rising risks associated with the current state of the CRE market. Borrowers are due to repay $929 billion of U.S. commercial real estate loans this year, and $573 billion the year after, according to the Mortgage Bankers Association.
Banks alone are holding almost $700 billion worth of paper maturing in the next 2 years with ~43% having current interest rates below 5.00% (14.7% of maturing loans in the next two years have an existing interest rate under 4.00%).
The problem that has been widely talked about over the last year is the refinances coming home to roost. Barry Sternlicht has been sounding the alarm for some time and has gone as far as calling for a backstop of these loans before an “existential crisis” takes hold.
But how bad is it? Well, Fitch forecasts overall U.S. CMBS loan delinquencies to double from 2.25% in November 2023 to 4.5% in 2024 and 4.9% in 2025.
Commercial office is the worst of them all. CMBS office delinquency rates rose progressively through 2023, beginning at 1.9% in January and ending the year at 5.8%. The rate kicked off 2024 at an even higher 6.3% and Fitch believes it will end 2024 at 8.1%.
Meanwhile CMBS loan delinquencies in commercial multifamily — housing properties with more than five units — are expected to touch 1.3% in 2024 versus 0.62% in 2023.
Despite the double in projected delinquency rates for commercial multi-family, apartment landlords are facing much different issues than office owners with a glut of space; there’s still a shortage of housing across most cities. Distress in the sector instead stems mostly from surging borrowing costs.
After investors clamored into the market in the easy-money days of 2021, spiking interest rates took a bite out of building values, just as owners needed to refinance. Rent growth has flattened since then, as developers added new apartments at the fastest clip in generations.
However, what’s making the office situation way worse is that over the last couple of years, vacancy rates and yields have been making the values of these assets crater.
The national office vacancy rate rose to a record-breaking 19.6% in the fourth quarter of 2023, according to Moody’s Analytics. That’s the largest quarterly increase since the first quarter of 2021, and larger than the 19.3% level reached twice in 40 years.
Because of this lack of paying tenants and the WFH trend continuing, properties being sold at a loss have risen dramatically since 2022.
Among five of the largest states with the most office property transactions, namely California, Florida, New York, Illinois, and Arizona, there has been a consistently large uptick in the percentage of office properties sold at a loss in Q3. Collectively, these states accounted for 39% of all properties sold at a loss.
Notable transactions include 14 53rd Street in New York, which was sold at a loss of $42 million as part of its acquisition by Capstone Equities. In Arling Heights, IL which is part of the Chicago metro, 1421 W Shure Drive, originally sold for $41 million in 2018, was sold for $28 million as part of United Airlines' plan to expand its office spaces.
With so much uncertainty in investors’ ability to not only fill space but also at an attractive NOI, required cap rates have also gone up which inherently affects valuations.
To give you an example of how valuation changes based on cap rate expectations, J.P. Morgan put out a hypothetical example via the chart below.
In the chart above, our hypothetical example shows how the value of a USD 100 million office building would decline to USD 72 million if cap rates increased from 4.5% to 6.25% (holding NOI constant). If the borrower were to look at refinancing the loan at this lower valuation, keeping the loan-to-value ratio constant, the borrower would have to contribute an additional USD 18 million in equity to get the refinancing done.
This example demonstrates just how vulnerable commercial real estate is to rising rates assuming that there was no impact to NOI, which we all know is not the case.
All this brings me to my next point. With so much debt maturing over the next two years, who are the most exposed, and what’s the saving grace?
Let’s start with the latter, shall we?
1) Saving Grace
What many have hope for, and would benefit (or at least cushion the blow) holders of CRE loans, would be the Fed aggressively cutting rates. Many investors on both sides have argued that with real rates being so positive at the moment (currently 3.3%), the time to cut is now while inflation is also coming down.
Others have argued that the economy is doing more than fine and in fact, higher rates haven’t seemed to put a dent into slowing down growth. So why cut?
Based on the Fed’s projections, we’re looking at potentially 3, 25bp cuts in 2024.
The immediate saving grace is not only the Fed following through with its projections of cutting rates, but the market has gone one step further and priced in 4-5, 25bp cuts (100-125bps in total). Some sell-side have even suggested upwards of 175bps in cuts.
The issue with this is possibly that the cumulative effect of the Fed's rate hiking cycle hasn't been fully felt yet across the economy. The idea behind tighter monetary policy is to cool down inflation by reducing spending and growth, and based on the Fed's own 2% CPI target, there's still more work to do.
Even if you don’t believe in that scenario, most of the cuts are only starting to begin in the summer (presumably) and continue into 2H.
For the CRE maturing this year, refinancing options will need to be reworked or renegotiated in order to buy time with lenders (extend and pretend). Delaying also gives banks time to build reserves they’ll need to write down the value of troubled loans.
This might buy time to potentially get slightly more favorable rates during rolling time but it’s all very contingent on a) lenders agreeing to buy time, and b) the Fed following through.
It’s hard to say how much of a “sure thing” rate cuts are this year and to what degree but when you have hundreds of billions of dollars in paper relying on what one guy does, that doesn’t really bode well for the investors currently holding the bag.
2) Where’s the Exposure?
Banks provide approximately half of the total US commercial real estate debt, and most of that comes from smaller banks.
Small banks have been growing CRE lending faster than large banks. This has contributed to small banks accounting for approximately two-thirds of total commercial real estate bank loans in the US, and many with high exposures to the asset class.
According to FDIC reporting, CRE loans represented 44% of total loans made by small banks. That is in contrast to CRE loans as a percentage of total loans at the four large money center banks, which stood at 10%.
However, regional lenders account for 70% of the commercial real estate debt maturing through 2025 that’s on banks’ balance sheets, with the top 25 banks making up the rest, according to Morgan Stanley.
When diving deeper into bank-specific exposure, Bloomberg put out a chart of a list of banks with significant CRE exposure.
In total, nearly 1,900 banks with assets less than $100 billion had CRE loans outstanding greater than 300% of equity, according to Fitch.
Fitch, in a detailed report in December, also said if prices decline by approximately 40% on average, losses in CRE portfolios could result in the failure of a moderate number of predominately smaller banks.
So with an expectation for rate cuts and regional banks staring toward the light at the end of the tunnel not knowing if it’s a lifeline or an oncoming train.
No Systemic Risk
One thing that I want to make very clear from the start is that I do not believe this to be a systemic issue in the broader banking system. The fact is, the smallest banks in America just don’t control a large amount of the total assets floating around in the U.S.
Despite this, that doesn’t mean that regionals are safe. Hell, even J. Powell acknowledged in his "60 Minutes" interview that some smaller banks will "have to be closed" or merged "out of existence" due to losses tied to the falling values of properties across the US that are suddenly worth much less due to the Fed’s elevated interest rates and the effect of a pandemic that emptied out many city-center buildings.
There are plenty of opportunities out there for regionals with high CRE exposure but the problem with putting on this “big short” is timing. Plenty of funds over the last few years have folded while paying for premiums on swaps just waiting for CRE to collapse.
Just take a look at the 5 banks below and their YTD performance.
All have reported already and provided lackluster results and concerns going forward.
While I currently don’t have any positions in CRE at the moment, it is something that I’m actively looking into but wanted to at least share these notes with you now.
If you’re someone who has already done work and would like to exchange notes, either respond to this email or comment below.
I’d love to chat.
If you enjoyed today’s notes, please like, share, and consider subscribing.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: I/we (“Cedar Grove Capital”) currently do have a stock, option, or similar derivative position in the aforementioned companies at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
CRED IQ
Fitch
TD Bank
Reuters
Trepp
Federal Reserve
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Amer Sports, an outdoor and sports equipment maker, recently announced that it was going public and is looking to begin trading on February 1st, 2023 under the ticker symbol (AS). F-1 here.
The Finland-based company is looking to raise ~$1.7 billion at an $8.7 billion market cap.
For those of you who might not recognize the name (not surprising), you should hopefully recognize some of the brands in its portfolio.
I know I use Arc’teryx and Salomon for a lot of my footwear and outdoor gear for hiking/backpacking trips. They’re high quality and considered premium in their respective universes.
But how is the company doing and does the proposed IPO valuation make sense? Let’s dive into the numbers.
Overview
Amer Sports was bought out by Anta Sports-led group in 2019 for $5.3 billion to combine expertise in their respective fields and create value. Since then, the company has expanded into >100 countries, 300 retail locations, 3 brand categories, and a portfolio of 11 brands (after having divested Mavic in 2019, Precor in 2021, Suunto in 2022, and its whole Russian operation after the invasion).
For their retail locations, they currently have owned retail stores in 24 countries with layouts ranging anywhere from 1,000 to 10,000 sqft.
They segment their categories as you see in the above.
* Technical Apparel
* Outdoor Performance
* Ball and Racquet Sports
The 3 core brands that drive most of the revenue for the company are Arc’teryx, Salomon, and Wilson. Wilson, I’m sure many of you know from a lot of tennis starts; which as of Sep’23, is proud to support 27% of the top 100 men’s tennis players and 42% of the top 100 women’s players in the world.
The business itself is a straightforward one to understand so it’s not really rocket science which is a plus when you’re trying to learn about the company.
Financials
So since the Anta Consortium buyout, sales in the company have been doing quite well. From 2020 to 2022, the company has grown topline by a 20.4% CAGR.
How did they achieve such stellar sales growth do you ask? One word: China.
Like many other retail brands that found their origination in America or Europe, when looking for growth and consumers with wallets to spend, they all expand to Asia. Luxury brands have done this, most notably LVMH, Burberry, Moncler, etc. Amer Sports saw the same opportunity and took it.
Looking at their sales figures based on geographic location, Asia Pacific (excluding Greater China) and Greater China (includes: China, Hong Kong, Macau, and Taiwan) have seen YoY growths at mid to high double-digit percentages.
However, despite the impressive growth rates of the Asian territory, Greater China is what is really driving the top-line sales growth.
Looking at the chart below, Greater China, as a percent of total sales, has grown from 8.3% in 2020 to 19.4% as of the first 9 months of 2023.
This is on the back of slowing YoY sales growth in EMEA and the Americas. Not bad considering the company more than doubled a region’s sales in 3 years and will triple it by the end of 2023.
But here’s where things start to get interesting for me. While topline has grown, so too has operating income.
When you imagine a company really pushing into a new region heavily to drive sales, you’d typically imagine that margins would take a hit in order to get the growth you’re looking for.
Not an off assumption. However, Amer has been able to work with over 176 suppliers in 32 countries with 19 distribution centers to really cut down on supply chain costs and interruptions allowing for more timely and efficient manufacturing and logistics.
Gross margin has expanded from 47.0% in 2020 to 49.7% in 2022, while S&M and G&A have both grown as well albeit at a much slower rate. Sales and marketing increases mainly stemmed from the increased campaigns of their territorial pushes as well as headcount in retail locations and wholesale teams.
Because of this, adjusted operating income (adjusting for impairment charges) has been on the up and up.
Adjustment charges totalling $201.7 million in 2022 was a result of $19.1 million in trademark impairments and $179 in goodwill related to the Peak Performance brand.
Much of this margin expansion has actually come from the company’s shift from a predominantly wholesale model to DTC. For those of you who don’t know, brands make a lot more on DTC (retail + online). Wholesale margins are a lot thinner because while you can get growth and expansion of the product into doors, you still need to sell to these retailers at a rate where they can also make money.
This shift in strategy has really helped the company (see below).
DTC sales as a percentage of total was 21.7% in 2020. This has grown by 780bps to reach 29.5% in 2022 with the first 9 months of 2023 showing almost 1/3rd of sales being derived from the DTC sales channel.
All great news until you start looking into the brand segment-specific information.
While Technical Apparel (Arc-teryx) and Ball & Racquet Sports (Wilson, etc) have continued to grow and contribute more to adjusted operating profit, Outdoor Performance (Salomon, etc) has been slow to grow.
The Salomon brand has historically been wholesale (lower margins) with 60% of revenue coming from footwear in 2022. Despite having 114 stores with 30 being in China alone, this particular area of the business isn’t doing the best. Let me reiterate that it’s not doing the best but that doesn’t mean it’s doing bad, just not great.
DTC growth as a percent of total sales for this category has only expanded just shy of 200bps in three years, while Technical Apparel has grown almost 2,000bps in the same timeframe.
Even the search results for Arc’teryx have really grown over the years. (FYI - this business is seasonal so most of the sales actually come in Q4).
So with so much good going for it, why am I skeptical about this IPO? Let’s talk about it.
Valuation
Based on the company being able to sell the 100 million shares it hopes to between $16 - $18/share, the valuation post raise comes to ~$8.7 billion.
Figuring LTM adjusted EBITDA of $613 million, that means the company (ignoring opening price) would be pricing at ~16.1x EV/EBITDA (proforma IPO proceeds).
Valuation seems a little rich since its brands are sports-related but not quite on par with $NKE but much closer to $COLM .
Factoring in the opening price, this could easily get even more expensive. But besides the rich valuation here the use of proceeds is what really gets me.
Based on management’s commentary,
We intend to use the net proceeds we receive from this offering to repay all of our outstanding borrowings under our existing shareholder loans, JVCo Loan 1, JVCo Loan 2, Co-Invest Loan 1 and Co-Invest Loan 2 (each as defined below), after giving effect to the Equitization, and any remaining net proceeds to repay a portion of our outstanding borrowings under the Revolving Facility...
Looking at the cap table that they provided, you can see that a large portion of their debt will be eliminated.
What’s interesting is that given the IPO net proceeds (ballpark ~$1.6 billion), $4 billion of debt is basically being wiped out. How so?
They’re equitizing the debt of their existing debt holders. Prior to the offering, the company had ~115 million shares outstanding and is doing a 3.3269:1 split to bring it all under 1 ordinary Class A voting share.
Given a potential 15 million share over-allotment, shares outstanding could be just under 500 million shares. The kicker is that with the various ESOPs the company has, dilution can be another ~70 million shares under the plans,
While I’m not too concerned about that, it just seems like this company is going to be priced to perfection and I’m not sure if there’s really any value not being recognized in this IPO to capture. At least not right out of the gate.
Closing Thoughts
I love the brands and they do make some high-quality products and garments. While I’ll be cheering them on from the sidelines, I won’t be participating in this IPO.
For those interested in the company, I think this is definitely one to keep on your radar if growth continues the way it has been.
We’ll see what the appetite is for the capital markets to start off 2024 and perhaps will set the stage for what’s to come later this year.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: I/we (“Cedar Grove Capital”) currently do not have a stock, option, or similar derivative position in Amer Sports (AS) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
**First and foremost before I dive into today’s post, I want to apologize for not sharing this note sooner with you all. 2023 was quite a hard year personally as I had both parents dealing with cancer-related issues and a portfolio company to manage.
Because of that, I wasn’t able to really post my notes much last year as I clearly had other priorities. Thankfully, they’re both in the clear and the portfolio company has been sold. Going forward, I’ll be much more active and be back to my old self.
With that, let’s get into today’s note.
“As science advances rapidly, we know there is a significant opportunity to improve outcomes for those using medications…It is our responsibility, as the trusted leader in weight management, to support those interested in exploring if medications are right for them.”
- Sima Sistani, CEO
I’m all for companies trying to expand their TAM by adding new products or services that benefit their customers. Thousands of case studies prove how important it is in a rapidly changing business environment. However, Weight Watchers WW pivot to offering medication to help customers lose weight was anything but realistic from the start, and it has taken investors for a ride.
Before I dive into why WW’s acquisition of GLP-1 servicer Sequence made this a short trade, I need to highlight the issues that WW was dealing with before this pivot.
You see, WW’s historic record of helping people lose weight through their “points” system actually works. It worked so well that Oprah, who lost weight via the system, decided to invest in the company, buying a 10% stake in 2015 for $43.2 million and getting a board seat.
Given WW’s declining sales at the time (10 straight quarters), the company thought it made sense to bring on such an inspiring brand ambassador to be the company's new face and add validity to weight loss seeking customers of its program.
Initially, this investment worked. The stock doubled the same day as the announcement adding roughly $400 million in market cap. However, this was very short-lived, as the push to revitalize sales still resulted in a consistent decline after 2018.
Despite the increase in gross margin from 54.5% in FY’14 to 60.5% in FY’22, SG&A as a percent of sales still saw a greater increase of 1,200bps over the same time frame (33.5% to 45.7%) pictured below.
So, with a major celebrity brought on to try and reinvigorate sales failing, what does the company turn to in order to help its customers lose weight? Drugs.
And herein lies the problem with WW announcing this acquisition and why I decided to short the company.
March 6th, the company announced that it was acquiring 2-year-old weight loss startup, Sequence for $132 million (including $26 million of Sequence cash).
Quick deal highlights:
* $100 million at closing
* $65 million to be paid in cash (includes Sequence cash)
* $35 million of newly issued WW shares — 8.065 million
* $16 million to be paid on the first anniversary (coming up)
* $16 million on the second anniversary
So you had a little bit of dilution (11%) and were able to defer about 1/3 of the net cash needed for the deal between 1 - 2 years after close. Not a bad deal structure given you’re keeping cash on the sidelines for reinvestment and growth in a new category.
However, multiple issues arise for WW right off the bat.
1) Deviating From Core Competency
Everyone brags about how many “subs” the company has (those that may a monthly fee to be a part of the weight coaching point system) and how easily it would be to convert many of them to prescription weight loss customers.
Looking at their most recent 10-Q, at the time of the acquisition, WW had ~4 million subscribers and given its seasonality, ended Q3 with ~4 million.
Just from a very brief look, you can also tell that the number of subscribers has also been decreasing over time with that start quarter making lower highs. Not good.
Now here’s the problem besides the underlying business of their weight loss program struggling; subscribers don’t want to be fed medication. That was literally the whole point of why people signed up for WW in the first place.
If customers wanted the medical offering, they would have explored other options already. Historically, this decision to stay out of medical treatments benefited the company, especially during the whole Fen-Phen fiasco decades ago.
For decades, WeightWatchers taught dieters there was only one way to shed the pounds: hard-won behavioral change. However, with the news that WW was moving into prescription weight loss offerings, many customers voiced their negative opinions about the decision.
“Really disappointed by this news. I joined WeightWatchers in January. Their scientific approach to lifestyle changes has been transformative. I’m down 30lbs by changing my habits and relationship with food. I’m sad they’ve joined the quick fix bandwagon.”
-Journalist and WW customer Joe Enoch
“They’re not practicing what they preached … and now all of a sudden there’s a drug involved.” -Christine Sisterhenm
“WeightWatchers has kicked us to the curb.” - Bob Kline
Customers were in-fact, pissed. Not to mention that in an effort to cut back on costs, the company was also closing down physical locations where customers would normally meet together to share weight progress and support one another through the community.
It’s clearly a change in times for WW but optimists thinking that conversion amongst its current customer base is going to be immense don’t understand how quickly brand loyalty goes away when it starts doing something you don’t support.
2) Financial Upside
If you’re going to invest in a company that’s making a serious pivot to its business model, you really need to understand the upside that you’re underwriting. For most investors, they underwrote the broad-based theme of the GLP-1 hype coming out of Novo Nordisk and Eli Lilly.
Don’t get me wrong, I’m not against these drugs at all, in fact, Cedar Grove Capital Management (“CGC”) is long NVO and wrote about the bullishness of the industry below.
The problem is, when you looked at the chart above and saw the stock price jump from ~$3.90/share pre-Sequence announcement to ~$13/share by the middle of October (+240%), you must have been incredibly bullish on the future despite WW interim financials still diminishing.
Looking at the sales estimates through 2026, the initial spike has since tapered off since the summer.
If you were long and sold out near the top, good for you. If you kept holding on because you didn’t bother to do work, sucks.
Looking at the transaction details one more time, we know that Sequence had ~$25 million in run-rate revenue with ~24,000 customers.
Now while we don’t know the specifics, the “turned cash flow positive in late 2022” can mean a lot of things. Operating under the assumption that it’s legitimate and not just financial engineering, we can assume that at the very least, it’s self-sufficient but not booming.
With the acquisition of Sequence, forward earnings estimates shot up to just over 85x EPS and have settled in the 50x range over the last 3 months. This is a stark contrast from the historical 3-year average of ~12x pre-announcement.
In order for this acquisition to make any financial sense, the company a) would really ramp up GLP-1 adoption through their platform, or b) would need to control their ability to create operational leverage.
So let’s first talk about point A.
A) Incremental Business
To kick off the business of Sequence under WW ownership, have a look at my model below.
With low expectations for growth in the core business, these are my expectations in the model above.
* Core business decline to the tune of -3%/year with subs decreasing annually at 1%
* Conversion of current subs to GLP-1 membership at no more than .2% annually which I think is generous
* Flat $99/mo membership fee which does not account for any cross-selling or exact fee from medication
* With a flat interest expense from their debt of ~$90 million a year
* Modest 1% annual dilution in FDS
Even if WW can scale Sequence to a $100 million dollar business by the end of the year 2025, the forward estimate even at today’s prices is still nearly 2 times higher than the historical average.
Had you looked at this trade 4 months ago like we did, the multiple was senile. Complete and utterly euphoric.
So aside from the incremental revenue not really being able to help them, that brings me to point B.
B) Bloated Balance Sheet
Do you really want to know what makes a business pivot a reality? Make sure you do it without a bloated balance sheet. Something WW has.
As of the last Q, they had $107 million in cash and $1.4 billion in long-term debt.
With some simple math there, LTM EBITDA was $164 million putting net leverage to a whopping 7.4x. For my PE folks out there, you and I both know that even pressing the 5x line was stretching things and it usually was with massive assets as collateral.
WW really doesn’t have that.
While the company has been able to generate positive FCF over the years, it will take considerable investment to get the growth going. Even when you look at interest coverage, it’s been declining heavily over the last year.
Call me skeptical, but the execution risk of Sistani being able to accomplish this pivot while having to deal with the weight of over a billion dollars of debt should speak for itself.
What Differentiator?
With hype comes competition. The problem is that there really isn’t a defining reason why someone should stay with one company unless it is for a good reason. Aka, no real moat.
With GLP-1s, there’s hardly a moat. Plenty of telehealth companies have been moving to offer a GLP-1 solution, some faster than others.
Ro, Calibrate, Eden, and Weight Watchers (Sequence) are just a small sample size with others like Hims HIMS offering different medicated weight loss solutions.
Hell, even Eli Lilly announced their own telehealth offering to side-step middlemen like WW.
With no real moat, the costs can amplify if churn becomes a problem.
Even if WeightWatchers can satisfy Sequence customers, it could still fade into irrelevance. Kelly Steffee, a 46-year-old mom who lives in an Orlando suburb, was a WeightWatchers member on and off for years before she joined Sequence last fall. A clinician there prescribed Mounjaro, and she lost more than 50 pounds in six months. But the most dramatic results were the ones she felt inside. “That food noise, the lady in your head telling you to eat all the time—‘Get a cheeseburger from McDonald’s, it’s really, really good’—she’s not there anymore,” Steffee says.
Although Sequence helped WeightWatchers recapture her as a customer, it wasn’t a stable situation. For one, Steffee’s insurance wasn’t covering Mounjaro, and a coupon she’d been using, issued by the drug company, expired in June. She also wanted to keep losing weight, but her Sequence-appointed doctor didn’t want her to drop any more. So she quit and found another telemedicine provider that prescribed her Ozempic, at a dose she wanted. This time, her insurance covered it. As for WeightWatchers, Steffee isn’t interested in going back to paying for the warm and fuzzy sense of community it monetized for so long.
No moat and high competition will hurt their ROI to ramp Sequence up to be a formidable name in the space.
The funny thing is too that you openly had Oprah come out and say,
It would’ve been “the easy way out” to utilize a drug like Ozempic (in regards to her own weight loss journey).
However, she does use medicated products as a “maintenance tool.” Something to add to the list of things you don’t want the face of your company saying as a differentiator.
Parting Thoughts
Reiterating once again, I understand why Sistani is making this move. I would chalk it up there with, “change or die.” It’s a nascent market at the moment that is expected to have exponential growth in the company decade.
However, the numbers speak for themselves. Even if you quadrupled the business from 2022 numbers, it’s still hard to re-right this ship after the core business is slowly declining and the current base is upset about the facelift.
The other thing I wanted to point out, without saying names, is to also be careful of pushers of hype names. We all know people peddling shitco’s which don’t amount to anything but there was one large account on Twitter that was all for the future of WW on this news.
Did they make money? Yes.
Did they actually know what they were underwriting? I think they’d like to think so.
With the help of said Twitter bull and understanding of the GLP-1 market, CGC officially exited our position on December 13th for a 42% gain.
Again, I’m bullish GLP-1s, though not with WW. As I mentioned on Twitter before, I do think there’s still some juice left on the short side but at the moment, we’re not in it anymore.
Either way, YTD the stock is down 36% and price drives narrative…right?
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: I/we (“Cedar Grove Capital”) currently do have a stock, option, or similar derivative position in Novo Nordisk (NVO) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
TL;DR
* Having originally agreed to be acquired for $61/share in cash by Amazon in 2022, the deal price got revised down over the summer to $51.75/share
* Given the FTC’s assault on big tech, Amazon is coming under fire for its history of anti-competitive practices on the Amazon website, thus putting the deal at risk
* What was a rumored sure thing from the EU commission, they have changed their tune on the matter and believe that Amazon owning IRBT would lead to anti-competitive practices
* Given IRBT relies heavily on user data to map out their homes, the other questionable point comes in whether should Amazon have access to that level of user data
As you can see, iRobot $IRBT has had quite the rollercoaster of an acquisition journey. Here are some key dates to be aware of:
* 8/5/22 - Amazon $AMZN agrees to acquire IRBT in an all-cash deal valued at $61/share.
* 9/20/22 - FTC makes second request for more information regarding the acquisition.
* 7/16/23 - UK clears AMZN to acquire IRBT.
* 7/25/23 - Deal gets revised down from $61/share to $51.75/share, mainly driven by IRBT taking on a new $200 million credit facility to continue operations.
* 11/24/23 - Reuters announces that unconditional approval from the EU is imminent.
* 11/27/23 - EU says the deal raises antitrust concerns.
Needless to say, there’s been quite a lot of ups and downs for iRobot over the last 14 months. Regardless, I’m going to break down what’s been going on for this deal, the concerns raised by each commission, and any counterpoints to the risks.
Deal Mechanics
On top of the acquisition prices that I quoted earlier, we need to look at the original timeframe and terms of the agreement between both parties. In a filing from August 5th, 2022 (below), we can see that they marked the timeframe for “possible” termination after August 4th, 2023 — so 1 year from the original announcement date.
Additionally, in regards to the termination fee, iRobot would be entitled to receive $94 million under a few circumstances
* It takes longer than an additional year for the deal to close (two, 6-month extensions) to satisfy antitrust conditions.
* Under appeal, Amazon still loses.
Not bad and to put this into perspective, at the original offer price on August 5th, 2022, the termination fee was ~5.8% of the total market cap. Fast forward to the recent close and that fee is now ~8.6% of their total market cap.
So both parties still have time for the deal to go through but given that the EU Commission opened an investigation on July 6th, 2023 and the FTC has been on the case since a month after the initial announcement, I don’t believe that it will take that full year to satisfy.
The EU has even said that they have until February 14th to make a final decision on the matter.
But let’s talk about why there are even issues about this deal and the implications of each.
Antitrust Concerns
While the title of this section is very broad, there are a few sub-categories specifically that we need to talk about that directly lead to the EU and FTC having antitrust concerns.
Competition & Pricing Power
So when it comes to competition, several robot vacuums on the market are similar to iRobot. According to Statista, robot vacuums at the price point of $200 or more account for roughly $3.39 billion in 2020. Granted with the implications of COVID, that number has certainly gone up dramatically.
For well over a decade, iRobot fended off new entrants from some of the best-known names in vacuums — including Hoover, Black & Decker, and Bissell — and maintained its undisputed market leadership.
But even if we look at 2020 figures, iRobot only commanded 46% share of the market which I know many of you might read and think how could this deal ever happen? Don’t be too hasty though, that 46% worldwide share in 2020 is much lower than its 64% worldwide peak share in 2016, meaning that other players are doing well to compete with IRBT.
Take for example the Asian market. A company called Ecovacs Robotics is turning up the heat in its sphere of influence against IRBT. Ecovacs Robotics Deebot vacuum products range from 1,000 yuan to 6,999 yuan, or about $141 - $986 USD.
In comparison, iRobot's two-in-one top-notch model, the Roomba Combo j7+, carries a suggested price of $999.99 in the U.S. — and is apparently not officially sold in China.
While I don’t believe the real problem of antitrust concerns comes from how much market share the brand has, it’s the fact that Amazon is the one buying them. For everyone living under a rock, Amazon has been under fire over the last few years for using its ability to price out competitors on the very same marketplace it charges businesses to sell while humorously selling its own goods.
This is no bueno with the FTC and frankly, businesses in general. In its lawsuit, the FTC makes a few key points here.
Anti-discounting measures that punish sellers and deter other online retailers from offering prices lower than Amazon, keeping prices higher for products across the internet. For example, if Amazon discovers that a seller is offering lower-priced goods elsewhere, Amazon can bury discounting sellers so far down in Amazon’s search results that they become effectively invisible.
Conditioning sellers’ ability to obtain “Prime” eligibility for their products—a virtual necessity for doing business on Amazon—on sellers using Amazon’s costly fulfillment service, which has made it substantially more expensive for sellers on Amazon to also offer their products on other platforms. This unlawful coercion has in turn limited competitors’ ability to effectively compete against Amazon.
Biasing Amazon’s search results to preference Amazon’s own products over ones that Amazon knows are of better quality.
So basically Amazon is a bully to anyone but itself. And that is one of the main reasons why the commissions have a problem with Amazon buying the company.
The fear would be Amazon buying up IRBT, giving it the leverage of superior logistics, cost-based pricing, and marketing treatment to assert market dominance.
Pulling from the EU Commission warning,
Amazon could demote other robot vacuum cleaners on its platform and promote its own products with such labels as “Amazon’s choice” or “Works With Alexa.” The commission also said Amazon may find it “economically profitable” to shut out rivals.
Not a good look, but this goes directly against what its neighbor, the UK Competition and Markets Authority (CMA) had to say about the deal which was that it wouldn’t result in a lessening of competition.
Remind you, that this is the same CMA that I covered greatly during the $MSFT and $ATVI acquisition. The hardballers I believe just wanted to pound their fists on the table to get a conditional win which is why I don’t think this thing happens without some concessions.
Data Harvesting & Privacy
Amazon is already in the home robot space under the Astro brand. That weird little Wall-E-looking thing that literally no one wanted, asked for, or trusted.
But while it doesn’t vacuum anything at the moment, it still has much of the foundational technology that iRobot has to run its equipment. Meaning, that it still maps out your home, listens to conversations, etc.
Giving Amazon the data to map out your living space down to the inch might sound like an invasion of privacy, probably because it most likely would lead to that.
I mean, it’s not the first time that a hardware company spied on its customers. Take Ring for example. The doorbell security company was featured on Shark Tank and later acquired by Amazon in 2018 for $1 billion. A suit by the FTC was in regards to employees having unrestricted access to the cameras and consequently spying on women with cameras placed in their bedrooms and bathrooms.
In May 2018, an employee gave information about a customer's recordings to the person's ex-husband without consent, the complaint said. In another instance, an employee was found to have given Ring devices to people and then watched their videos without their knowledge.
In February 2019, Ring changed its policies so that most Ring employees or contractors could only access a customer’s private video with that person's consent.
All of which as a consumer you don’t want to hear. So with Amazon’s security products through Ring and Blink, which gives access to audio and video, pairing this functionality with understanding your home might set people off.
When you think about how Amazon would even try to leverage this information, the only real obvious path is to potentially recommend things in your UX to fill up space in your home. Amazon has denied this, saying
We do not use home maps for targeted advertising and have no plans to do so.
However, According to iRobot, customers can opt out of having its robots store the layout of their homes.
iRobot co-founder and CEO Colin Angle said that
iRobot does not – and will not – sell customers’ personal information. Our customers control the personal information they provide us, and we use that information to improve robot performance and the customer’s ability to directly control a mission.
But when you want to talk about customer data, Amazon was still cleared to acquire One Medical which arguably is way worse considering that the data under that company is all healthcare-related information, albeit protected (allegedly) under HIPPA.
So while we probably wouldn’t want Amazon to have more of our data, legally speaking, there isn’t much in the direct path of why they shouldn’t be allowed to. And in the courts, that’s all that matters.
If The Past Says Anything
One of the best POVs to look at is when you can see what deals have been allowed to pass through regulatory scrutiny, and Amazon has not been shy with its buying.
The announcement of the iRobot deal follows Amazon's previous acquisitions of Kiva Systems in 2012, Evi Technologies in 2013, Blink in 2017, Ring in 2018, One Medical, and MGM in 2022.
But let’s take a look at One Medical for a moment because there’s a key part that I believe applies to this.
When Amazon closed its $3.5 billion takeover of primary care provider One Medical in February, the FTC sent a warning letter citing specific concerns about the transaction but took no future steps.
The key part is “took no future steps.”
This is very similar to how the EU sent its warning letter (charge sheet) to Amazon last month. While Amazon might still gain unconditional approval to buy iRobot, the charge sheet indicates that officials are looking for remedies from the company to address their concerns.
This is why I don’t believe the deal will be struck down by the EU but rather, worst-case scenario, there will just be some concessions.
Pivoting to the FTC, they’ve been investigating the deal since last year and despite the multiple requests haven’t come back with anything meaningful as to why the deal should be blocked. Not that they still can’t but after 15 months, if you haven’t come points yet, the odds of you coming with any at this stage are unlikely.
Granted, this IRBT deal is unique because while there are plenty of instances where a big tech firm has bought product-related companies, IRBT commands a large market share in the industry.
Conviction or Lack Thereof
To evaluate arbitrage situations, you must answer four questions:
* How likely is it that the promised event will indeed occur?
* How long will your money be tied up?
* What chance is there that something still better will transpire -- a competing takeover bid, for example?
* What will happen if the event does not take place because of antitrust action, financing glitches, etc.?
To the first point, there’s still a large spread from Friday’s close to the amended closing price to the tune of about 32.5%. Given the concerns from the commissions, and one of them already signing off, I believe the deal will go through, conditionally.
I’ve provided an unbelievably simple representation of how I feel each commissions odds of approving the deal below.
The additional reason why I’ve applied such weight besides what I mentioned above is because of the way the stock price has reacted given both a) Reuters announcement of pending unconditional approval and b) when the EU announced it had issues.
In the span of 1 month, the price is already almost back up to where it was post Reuters making that announcement. This leads me to believe that investors digested both the good and bad and believe that the charge sheet will allow Amazon to ensure changes or conditions in order for the deal to go through.
To the second point, given EU Commission says they’ll have a decision by Feb 14th, we can most likely expect the FTC to follow suit shortly after with theirs if they haven’t given it by then. I suspect ~3 months timeframe is a realistic pathway without considering any appeal filings.
The third point is null, there’s no one going to be coming in to bid over this, mainly because that window has closed but also because if IRBT accepted, it would have to pay Amazon $56 million. Given its current financial status, that’s a no-go.
The fourth point is an interesting one because should the deal fall apart after appealing, the price of the company’s price will crater more than it already has since the announcement.
Looking at options chains 3 months out, things are still looking pricey.
There could be opportunities for an options trade but you’re going to have to determine your level of comfortability based on the premiums you’d be paying.
Bottom Line
This has already been a long and drawn out process but I believe that the end is in sight. The commissions will need to get comfortable that Amazon will make sure that pricing competition will not impede their competitors on the platform and consumers are protected from data harvesting.
While I believe there are remedies that can satisfy these conditions, IRBT getting almost 10% of its market cap in cash if the deal falls apart would support the fallout to a degree, though I would not be holding onto the stock in such a event.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: I/we (“Cedar Grove Capital”) currently do have a stock, option, or similar derivative position in iRobot Corporation (IRBT) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Last year in my “Winter is Coming” post, there was one particular callout I made around housing that I was concerned about if it materialized.
Post below and link to callout.
The call was regarding homeowners who, in a rush to purchase a home, would see their equity in the home significantly decrease or even face a total equity wipe. This was largely due to them paying ridiculous prices while rates did the job that rates do, affecting the homes’ value as they kept rising.
My example from the article is below.
For easy numbers, we’re looking at a home that was valued at $500k in 2020, and sold for 50% more in 2021 (more common than you think). With a 20% down payment for a 30-year FRM, that means that you’re putting up $150k in cash (excluding fees, etc) for the home and the mortgage is $600k.
Now that prices are coming back down to reality, the overpriced home you paid for is worth 20% less, at $600k.
You’ve been making payments for ~1 year but the value has taken such a hit that your equity is virtually wiped. Meaning, that $150k you put down to obtain the house in the first place is down to ~$12k after making nearly one year of payments.
This means that you’ve basically paid $150k to only own ~$12k worth of a home in just one year. Not ~$12k in incremental equity, but ~$12k in total equity.
Now why do I bring this up? For 2 main reasons.
* People offloading their homes (whether for STRs, moving, etc) likely either can’t or will need to significantly outlay some capital to pay back the bank debt leaving them in a worse-off financial status.
* This might set up a trade for homebuilders as supply comes back online and demand softens.
1) Selling Pressure
If you’ve been looking around Twitter, Reddit, or other “news” places, you’ve probably come across takes/experiences like the few examples that I’ve included below.
While the above is an extreme example, it is a reality for some. However, the next few examples are happening largely across the country at the moment.
They’re in a gallery format so you can select which one’s you’d like to look at.
Either way you slice and dice it, there are plenty of owners out there that are taking some massive losses on their properties, whether as a primary residence or investment, just to move on.
Now I want to clear up 2 important parts of my take on this.
* Despite the worrisome headlines and fear-mongering, I don’t believe this is a systemic issue at the moment.
* While people are offloading their properties, I still stand by the mortgage affordability claim since a majority of homeowners have a sub-4% rate.
So why do I find this important? Because not many people can afford to take on a loss of hundreds of thousands of dollars on a home let alone a loss in general. Not to mention you still need to pay your realtor commissions which just makes it even worse.
Taking a huge loss in order to move on just puts the consumer in worse shape especially if it’s them selling to relocate or for other reasons. What’s interesting is that I also shared this “negative equity” issue on Twitter about cars.
Edmunds released information on the issue of negative equity in relation to car values and now they’re back up to pre-pandemic highs. However, while homes are a different situation because you can still rent, downsize, etc. cars are a bit trickier. Pulling from the Bloomberg article;
"It’s a big challenge for owners looking to trade in their vehicle for a new one, since they would still be on the hook for the remainder of the loan balance. Plus, your insurance provider will typically only pay out the current market value of the car if you get in an accident and the car is totaled. If that amount isn’t enough to pay back the loan, you’ll have to come up with the rest yourself.
It’s particularly tough for people who are realizing they took out a larger car loan than they can afford. For instance, say someone borrowed $20,000 on their car and can’t keep up with the payments. They might try to trade in the car, only to find that the vehicle is worth only $18,000 now, and they still owe $19,000 on the loan. That means they have to come up with the $1,000 to repay their lender. "
Since the mechanics of a car owner’s lifecycle are different, the implications are much worse but for this article, I want to remain on the topic of homes but sprinkle in the contagion of falling asset prices on the everyday consumer.
2) Homebuilders Trade?
So far this year, homebuilders are on an absolute tear this year.
After bottoming out in 2022, many believed that despite rising rates, homes would still be in high demand, which in hindsight, seems to be very accurate.
However, this is where I believe a trade could potentially come into play in the very near future. The premise of when homebuilders continue to construct new homes is when they believe they can still be paid handsomely to do so. Homebuilders will never build if they believe prices will come down significantly.
It’s just a statement of fact. Why commit time, money, and resources to build homes in areas where the prices are going down? Doesn’t make financial sense.
Historically speaking, the U.S. has been in a housing deficit of roughly ~1.5 - 2 million homes over the last decade since the recovery from the Great Recession. While that is terrible, to say the least, it’s even worse now. Recent estimates are putting the housing deficit closer to 4 million units, over 2x what we were seeing just over 5 years ago.
If you’d like to read more on this topic, look at Kevin’s recent work on housing below.
But here’s the point I’m getting at. Rates have “peaked” (we hope) and people are deciding to get out while the going is still good and others are debating to jump in as prices are coming down and refinance later when rate cuts begin to happen.
Both of these situations on opposite sides of the fence still leave all parties stuck between a rock and a hard place.
Builders on the other hand just recently saw a very large uptick in housing starts from what was a disappointing summer.
To be frank, even I’m surprised at the rapid rise of starts. But here’s where I believe the trade could come from. Despite the rates, layoffs, inflation, etc, we still have quite the supply and demand imbalance for homes.
As rates come down, more people will want to sell before prices continue their downward trend.
Those people who were waiting on the sidelines will most likely snatch them up and play the refinance game when the time comes. This will give a temporary bump to housing prices as people rush to buy.
The issue lies with what happens when builders, perhaps similar to the run-up to ‘08, build too much too quickly as a) the supply-demand imbalance begins to normalize as rates come down and more supply hits the market, and b) consumers already burdened with everyday expenses increasing (insurance, food, etc), despite “flush accounts” begin to rethink what they can afford.
Currently, housing affordability is actually lower than it has been since the early 90s and when you factor in the cost of a new mortgage vs renting, consumers might think twice before signing on the dotted line.
So if a slowdown happens, homebuilders will definitely take the brunt of it. Take a look at D.R. Horton’s DHI earnings estimates since the start of the year. They’re up nearly 60%, priced for perfection.
If you believe that everything will continue to go smoothly, they might retain their current prices (albeit choppy) but if you believe more pain is coming and the supply/demand imbalance starts to correct, it seems taking the short side of this trade might actually play out.
Until more meaningful data comes out to convince me otherwise, this is just something I’m monitoring for the moment but actively considering how a play could be made.
If you think there’s something that can or can’t be done, comment below. Would love to hear your thoughts on the matter.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: I/we (“Cedar Grove Capital”) currently do not have a stock, option, or similar derivative position in any of the equities mentioned at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Slowly at first, then all at once.
- Ernest Hemingway
The dialogue above is from Ernest Hemingway's 1926 novel, The Sun Also Rises. It's often attributed to Mark Twain or F. Scott Fitzgerald, or misquoted as something like “At first you go bankrupt slowly, then all at once.” But the theme is the same.
Not much happens at the drop of a hat. A car traveling very fast down a road doesn’t abruptly slam into a wall without “things” happening along the way.
Just like nations, banks, and consumers, they don’t eventually run into trouble without there being warning signs. The problem is that the warning signs are only evident in an “of course” moment when looking backward. In the interim, you’re not entirely sure if the warning signs hold weight, if they’ll get worse, or if they’re even warning signs.
That’s when people get into trouble because it starts to happen very slowly until it reaches an inflection point where it just all comes at you at once.
The key is to position yourself in the best risk-adjusted way to capture momentum if and when it does take a massive dip but also not beat yourself up when it’s wrong.
Hell, Michael Burry had to wait almost two years before his infamous insurance swaps trade paid off.
So what’s the current state of the consumer as we see it? Let’s dive in.
Back in December of 2022, I posted my thoughts on the state of the economy from a consumer lens which incorporated many different data points. If you’d like a refresher, you can find it below.
The general gist was that things weren’t looking too great but the economy wasn’t falling apart.
My biggest call going into 2023 was two things.
* Consumers were going to run out of excess funds and spend would decrease
* Retail earnings were going to get hit and hit hard
Looking at the first point, it appears that consumers have indeed been running out of excess cash reserves.
Latest St. Louis Fed data reveals that around 76% of post-pandemic excess savings in the US have been depleted. With the remaining excess savings projected to run out by year-end, coupled with reduced household credit loans, US consumption is set to continue its slowdown.
This also tracks small business data from Bank of America when it comes to payment growth.
According to them, small business payments have continued their long slow decline through April as many Americans pull back on spending and businesses focus more on deleveraging rather than growth.
This brings me to point #2. Retail sales.
While nominal retail spending data has still been positive, looking at the inflation-adjusted growth has put YoY percentages well below 0% for some time now.
Since many in the market are praising consumer resiliency given the absolute dollar spend, it’s not really the case.
Home Depot $HD cut its annual profit forecast, citing a customer pullback. Target $TGT and Walmart $WMT warned that recent sales were at their strongest in February but weakened in March and again in April.
The reports signal rising anxiety about US shoppers, who are forgoing purchases of furniture, apparel and electronics in order to afford basic goods. That’s stoking fears of a long-term drag on the economy that some analysts see playing out for years.
With high rates of inflation, shoppers are on the hunt for deals. At TJX $TJX , the parent of discount apparel chains T.J. Maxx and Marshalls, average sales per customer was down in the first quarter, but overall store traffic rose. That suggests the company is adding new customers who are looking for lower-priced products.
Walmart, meanwhile, noted that demand from wealthier households was showing up in apparel and grocery, a sign that some shoppers are trading down. That helped it achieve robust sales growth, despite the expiration of a temporary boost in food-stamp benefits that hurt lower-income customers.
While US comparable sales beat expectations in the February-through-April period, Walmart CFO John David Rainey said the retailer is taking a cautious view on the health of its customers.
No matter how you cut it, consumers are just trying to keep up with price increases coming in from all sides.
About 90% of consumers are skimping on grocery bills, only buying what’s absolutely needed and ditching goods such as air fresheners and lawn fertilizer, according to NIQ. In March, 35% of shoppers were only buying essentials, up three percentage points from October, based on an NIQ survey.
If you want to talk about grocery bill increases, just take a look at something incredibly simple that many Americans rely on every morning. Cereal.
The issue here is that while many CPG players have taken advantage of inflation to significantly increase prices, they aren’t lowering them as cost inputs go down.
Hamdi Ulukaya, CEO of Chobani, in an interview with CNN earlier this month, said,
“Of course, you have to pass on some increases in prices to customers, but those inputs are coming back down and that hasn’t been reflected in the price of goods: They’re still elevated. It is troubling. I think food makers have to be very conscious that people are having a hard time affording food.”
This is what I believe is partially contributing to the rise in credit usage that’s putting many consumers on or near the edge.
While about 38.5% of American adults — or 89.1 million people — faced difficulty in paying for usual home expenses between April 26 and May 8, that’s down from the peak of just over 40% 6 months ago but up from 34.4% a year ago and 26.7% during the same period in 2021.
To combat these budget problems, many households are turning to credit cards for help.
Households added $148 billion in overall debt, bringing the total to $17.05 trillion, according to a report released by the Federal Reserve Bank of New York last week. Balances are now $2.9 trillion higher than just before the pandemic.
More than 25 million households say that they used credit cards or obtained a loan to meet spending needs. That’s up from 22.4 million a year earlier.
Pulling an interesting callout from Bloomberg in relation to credit card loans in first quarters of every year,
Consumers typically build up more credit-card debt at the end of the year, during the holiday season, and then reduce those balances at the start of the following year, sometimes with the help of tax refunds. But for the first time in 20 years, that wasn’t the case this year, suggesting some households are under strain from higher prices and may be relying on credit cards to maintain their spending.
The overall delinquency rate remained low by historical levels, at 2.6%. But the share of debt that became delinquent — meaning it was at least 30 days late — is rising for most loan types, including credit cards and auto debt.
But how Americans can afford everyday expenses is trumped by another type of debt. Mortgage debt.
Many Americans took advantage of super low interest rates during the pandemic to buy homes but the problem was that the prices went parabolic.
So while many locked in a lower interest rate, as the economy has begun to slow,
* The low mortgage payments have become assets → stable, secure, and predictable
* The home has become a liability → asset price crash, potential equity wipe
Mortgage originations dropped sharply in the first quarter, to $324 billion, the lowest seen since the second quarter of 2014. Balances on home equity lines of credit increased by $3 billion at the start of the year, rising for the fourth straight quarter after declining for nearly 13 years.
But everything isn’t all worrisome on that front. According to CoreLogic, U.S. homeowners had $270,000 more equity on average by the end of 2022 than they did at the start of the pandemic.
One of the more underappreciated aspects of the housing market is the number of people who don’t even have to care about interest rates anymore.
Almost 40% of homeowners have their houses completely paid off. That’s more than the proportion of people who rent in this country (around a third).
And when you combine that with the fact that nearly 30% of homeowners have at least 50% equity in their homes, we’re talking close to 70% of households who have more equity than debt in their houses.
So the good news is at least that unless unemployment ticks up, many will be okay in paying their mortgages, saving more (savings rate continues to tick up) from what seems out of necessity, and hopefully making payments towards their CC debt.
However, there is still a looming time bomb closing in on the horizon that might indeed blow things up. Student loans.
I wrote about this thought more fully but that was a few months ago. As of now, the time to destination is fastly closing in.
Americans are nervously waiting to hear back from the Supreme Court on whether or not their student loans will be forgiven (not all). Many point to the Biden promise as not happening which means that consumers are going to be even more stretched.
According to research from the Federal Reserve Bank of New York, the average student loan monthly payment is $393. They also found that 50% of student loan borrowers owe more than $19,281 on their student loans.
If the Supreme Court decides to block Biden’s proposal, that will take ~$400/mo out of the economy for ~44 million Americans. That’s ~$17.6 billion out of the economy on a monthly basis that isn’t going towards goods, services, or experiences.
However, the recently announced and tentative debt ceiling deal has effectively taken student loan forbearance out of purgatory.
“The pause is gone within 60 days of this being signed. So that is another victory because that brings in $5 billion each month to the American public,” - Senator McCarthy
As my fellow consumer and ex-investment banking refugee @NeelyTamminga put it so eloquently in a recent podcast she did,
"People spend in good times or bad. They don't spend when they're fearful or angry. Student loan forgiveness if not passed, will make them angry and cause a deep bruise and hopefully not a laceration"
Based on the above, people will most likely be angry that they were betrayed by this and then get pretty fearful about the potential new monthly costs entering their life.
Time will tell just exactly how bad it will be but there’s no way that people do not see $400/month coming out of Americans’ pockets as a tailwind for future spending towards the economy.
Wrap Up
While the economy is still chugging along and virtually no one knows with confidence where things will be in the next 6 - 12 months, it’s hard to see the warning signs not materializing further.
That’s why I started this post with that opening quote because things do move slowly until something happens that just causes the acceleration of deterioration to rapidly gain momentum.
Many thought the bank runs over the last few months would have been it but governments and central banks stepped in to reassure investors and their citizens.
Where will the next events come from?
My guess is to continue looking at jobless claims and where that eventually leads to with unemployment.
Either way, the consumer spending shift is looking to get another speed bump in the next few months at the very least.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech
Disclaimer: I/we (“Cedar Grove Capital”) currently do not have a stock, option, or similar derivative position in the equities mentioned at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
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Hi there, welcome to another earnings recap post by Cedar Grove Capital Management. Just a heads up, if you’re reading this in an email and it abruptly cuts off, that means it was too long to send this way so you’ll have to click through to read the rest.
Today we’re going to be going over earnings for two companies that I’ve talked about quite a bit over the last 1.5 years.
* Xponential Fitness XPOF 7.41%↑
* Peloton Interactive PTON -1.57%↓
One of these companies I have not completely taken a 💩 on which was Xponential Fitness. In fact, I was doing quite the opposite. This company was the one I was trying to get people on board with for the longest time. Going on podcasts talking about it, writing articles, and updates, and voicing how cheap it was on Twitter.
I literally made a post on June 22, 2022 where I visually outlined why it had immense operational leverage in its path of fitness franchise expansion in order to show people of its potential.
If you’d like a recap of this with nice pretty charts and visuals, you can click below, it’s free.
Since then, the stock has rebounded by over 163%, and before anyone says that “I just got lucky” with this stock seriously needs to go and read the post above because what I said was going to happen actually happened.
This isn’t me gloating since I definitely don’t bat 1,000 but one of the best things about this stock is that it’s not hard to understand the business, what drives it, and what was positioning it for success.
The reason I wanted to say this is that you don’t need to invest in tech to get tech-like returns.
So with that said, let’s dive into the recent Q1'23 earnings report and share my notes with you all.
Xponential Fitness (XPOF)
Aside from the stellar return that XPOF has had over the last 9 months, what’s important is understanding why it’s had the run-up that it’s had.
This all revolves around a few key points.
* Were they going to get affected by an inflation slowdown and consumers ditching fitness in the name of saving money?
* How have the number of studios grown and will continue to grow?
* How much is each unit (studio) making (i.e. AUV)?
All of these were necessary to reverse sentiment, pop the stock but also keep the momentum going. Any slowdown in these metrics would not allow it to keep up the momentum it was having.
Now I’m about to throw a few charts at you just to show you how the KPI performance has been related to the points I made above.
First off, since this is a franchise, let’s first look at how studio growth has been since that is a sign of franchisee demand to get in.
While it has decelerated slightly, it still grew by 4.4% with over 2,000 studios now contractually obligated to open globally. This is despite interest rates from lenders rising between 0.25% and 0.5%.
It’s important to note that because of Xponential Fitness’s smaller box footage, the ability to still attract franchisees is still there since the cost to open one is much smaller than say a traditional gym like Plant Fitness PLNT -0.81%↓ which can go well over in excess of $1.5 million.
If we pivot to how much these studios have generated in system-wide sales, the number is equally as shocking.
Like in good fashion, it’s quite literally up and to the right posting a 41.5% jump YoY.
But while overall SWS were up over 41%, how did same-store sales compare?
Still posting double-digit growth on units that have been open for at least 13 calendar months.
And the last chart that I want to share with you is the average unit volumes (AUV). I’m going to specifically show you North American AUVs because that’s where the bulk of the studios are located and where they drive most of the SWS at the moment.
Another home run on the KPI front. So the notion of the consumer pulling back on fitness, while might be happening for Peloton (more on this in a bit), is not happening at Xponential Fitness.
“The acceleration in growth in our North American AUVs and same-store sales in combination with the growing membership base, demonstrates that consumers continue to view their health and wellness as a vital part of their budgets and not discretionary spend.”
- CEO Anthony Geisler
But I don’t want to make it seem like everything is rosy at the company right now. While these charts look great, the stock did come off its after-hours pop for what I believe could be a function of a few reasons.
* The company did miss EPS estimates and while topline growth was still great, investors could have interpreted the earnings miss as a sign of taking longer to get to GAAP profitability.
* Investors were expecting better free cash flow (ex-SBC) from the prior quarter (which was down) despite it doing better YoY.
* Shares outstanding have ballooned and insiders are selling even though the CEO is on a share plan and the PE fund that owned XPOF prior to being public has been gradually selling its stake.
Regardless, XPOF has really proven why the rally it’s had since last summer is justified. They continue to execute expansionary efforts, not just domestically but also abroad, improving the revenue that each studio makes which directly decreases the payback period for franchisees and shows that not all fitness companies are built the same.
Despite the price action on earnings day, this one is still looking like a winner.
Peloton Interactive (PTON)
God, where do I even start? How about my thoughts when earnings came out?
I don’t try to be an a*****e when it comes to Peloton, it just comes naturally since it’s just too easy to not be one. There were far too many people that wanted to really believe that connected fitness was here to stay. The stages of denial for Peloton went from
* They’ll bounce back! People love their bikes! to,
* Okay well someone will come around to buy them. Probably Amazon! to,
* They just need to slow the cash burn so they can focus on growth again!
All of these were jacked up on hopium despite the last one being the most realistic.
At the end of October last year, I shared my thoughts on the company and why I thought expectations were overblown. You can check it out below if you’d like.
Despite my warnings and consistent negative tweets, the stock is actually now down ~13% YTD despite the short squeeze that happened at the beginning of the year. The same short squeeze that took me for a ride.
But how bad were earnings? Well, in my opinion, pretty bad. Let’s dive in.
Connected Fitness Subs & Growth
Connected fitness subscribers are people who own a Peloton product, such as its Bike or Tread, and pay a monthly fee for access to live and on-demand workout classes.
CF Subs are the bread and butter of the company. It’s what many bulls have been leaching onto as if were the last lifeboat on the Titanic that will get them to safety.
They’re not wrong, the subscription gross margin hovers around the ~68% range, though this was a contraction of (40bps) YoY but a +20bps QoQ.
If the company can get more connected fitness subs, then they can get better operational leverage through this channel stream to really get sticky, recurring revenue.
However, this is the issue that I have with it. It heavily relies on customers’ access to get the bikes. This is why the company has cut prices, brought back S&H charges, introduced lower-priced offerings, and even brought on a new program launched last year that gives people the ability to rent the bike instead of outright purchasing it upfront.
While this may have helped during last year’s “throw everything out but the bathroom sink”, I don’t believe that it can last much longer.
While subscription revenue is increasing at (1st image), connected fitness product revenue is decreasing which means the growth factor of getting new CF subs in the door is going to be tough.
This was actually confirmed in guidance when McCarthy said
“This upcoming quarter will be among our most challenging from a growth perspective.”
and gave new guidance of 3.08 million to 3.09 million CF subs. It’s actually marked the first time that Peloton has guided for a decline in CF subs.
The reason this is important, besides the obvious is that even though the company added ~74k CF subs, the number of members on the Peloton platform actually didn’t change at all and remained at 6.7 million.
We’ll see how this bodes well with many Americans traveling this summer and probably doing many things other than wanting to stay home and workout.
Cash & Free Cash Flow
What’s good though is PTON’s cash balance and burn rate. In Q2’23, PTON ended with $871 million in cash and cash equivalents and an undrawn $500 million revolver.
Good because if they needed it they can certainly use it if needed. Fast forward to the most recent ER, cash and cash equivalents are now $873.6 million with an amended $400 million revolver.
Free cash flow burn has materially decelerated, mainly from the over $1.7 billion in restructuring charges the company endured in 2022, and even though SBC made up ~$250 million in add-backs to adjusted EBITDA.
Interpret that how you want but that sucks. I’m not trying to find reasons to hate the stock, there are plenty of them just by scratching the surface but what Barry has accomplished so far to stem the bleeding is pretty amazing.
I made a joke last year about when the market would bottom and how it was tied to Peloton.
Given that it’s gone as low as $6.62, perhaps the market bottom isn’t that far off.
Hell, even the bond has come off the recent start-of-the-year highs.
Until then, I’ve already closed my short and should it get cheap enough for a buyout target, I could change and go long purely off of a speculative trade.
I think the whole thing is radioactive and really wouldn’t touch it in the short term with all the macro stuff going on and the fact that they had to recall 2.2 million bikes due to a defect which I think is a laughable joke.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech
Disclaimer: I/we (“Cedar Grove Capital”) currently do not have a stock, option, or similar derivative position in Xponential Fitness (XPOF) or Peloton Interactive (PTON) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
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Hello everyone, thanks for making it back to part II of my two-part notes on the Microsoft $MSFT and Activision $ATVI deal. If you missed part I, you can find it below.
In part II, I’m going to be sharing my updated thoughts on the issues with the deal going through, the probability of the deal happening, the trade structure that I’m personally thinking of, and then what happens if the deal falls through.
So with that, let’s take a look at the current deal probability that the market believes.
As of right now, the deal's probability of closing is at ~68%. Given that the expected probability has dropped to just under 20% in November, there have been quite a few changes that have occurred since then.
But what’s the main theme of why the FTC wants to block this merger is because of one thing. Competition.
The Federal Trade Commission is seeking to block technology giant Microsoft Corp. from acquiring leading video game developer Activision Blizzard, Inc. and its blockbuster gaming franchises such as Call of Duty, alleging that the $69 billion deal, Microsoft’s largest ever and the largest ever in the video gaming industry, would enable Microsoft to suppress competitors to its Xbox gaming consoles and its rapidly growing subscription content and cloud-gaming business.
It’s always been about competition since Microsoft owns Xbox, one of the gaming consoles that compete against Sony’s PS5, Nintendo’s Switch, etc.
The FTC’s complaint believes that Microsoft will take Activisions' slew of games (Overwatch, Diablo, Call of Duty, World of Warcraft, etc) and leverage its power against its rivals to either withhold them against its competitors or to squeeze them for a better deal.
A squeeze in my mind that resembles how Apple’s ecosystem is so airtight that it charges a 30% take rate on payments made through the app.
But the FTC’s claims I feel are personally b******t because a lot of the games that you see above heavily rely on their ability to appeal to the masses. Without the reach that they currently have, their sales would be a fraction of what they currently are.
The theme here? You can’t bite the hand that feeds you.
So let’s talk about the issues at hand with this deal.
Microsoft could release exclusive only titles + have a monopoly
With Microsoft having already acquired Bethesda in 2021 for $7.5 billion, the scope for Xbox to push consumers to Xbox Series X|S for Bethesda titles already exists. If you want to play the AAA Bethesda title Starfield you have to own an Xbox Series X|S.
Xbox could use Activision/Blizzard exclusivity to monopolize some of gaming's most popular franchises, forcing you to own an Xbox Series X|S as competitors may not be able to sell specific Activision/Blizzard titles.
However, Xbox already releases most of its exclusive games on both PC and Xbox, so the idea that the deal would make Activision/Blizzard titles solely available on Xbox Series X|S is unlikely to be true.
But this notion of having exclusive titles isn’t anything new. In fact, PlayStation is a culprit itself, for instance, PlayStation acquired Bungie for $3.7 billion in 2022 and added PlayStation-exclusive content to Destiny 2 as an example.
What’s funny is that Brad Smith, President of Microsoft, said back in December that just shows how unbalanced the exclusivity currently is.
“PlayStation has 286 exclusive games, compared with Xbox’s 59, so the administrative law judge is going to have to decide whether going from 59 to 60 is such a danger to competition that he should stop this from moving forward.”
He even goes on to add that
“If you look at the global market, Sony has 70% of that market, and we have 30%. So the first thing a judge is going to have to decide is whether the FTC lawsuit is a case that will promote competition or is it really instead of case that will protect the largest competitor from competition.”
So while exclusivity may worry you, the deal may look to avoid restricting gamers and, even if Xbox were to make specific games exclusive, follows current trends within the gaming industry.
-
Fund Performance
In Q1 2023, Cedar Grove Capital Management, LLC (“Cedar Grove Capital” or the Fund” or “CGC”) returned -10.1% gross return compared to 7.5% for the S&P 500, 16.8% for the S&P Consumer Discretionary ETF XLY, -17.2% for the Cannabis ETF, and 3.0% for the Russell 2000.
Q1 Market Commentary
Q1 had an interesting start to the year as buyers that took advantage of tax loss harvesting looked to restart their positions. Heavily shorted companies were squeezed and holders looking to quickly cover their positions only added fuel to the fire.
However, the narrative that inflation was quickly coming down, and a soft landing would be achieved created a false sense of reality as more poor economic data kept coming in on the contrary.
What is interesting to note however is that the market rally since the start of the year is not a broad-based one.
Only a handful of companies in the S&P 500 have contributed to its increase this quarter. This lack of a broader uptick in companies leads us to believe that this rally is one of the last breaths upwards that we’ll see this year before the rest of the index begins to deteriorate below the October lows as earnings get repriced.
Given the recent bank failures, continued layoffs, slowdown in consumer spending and delinquencies all continue to have me worried about what’s to come.
With the 10Y/3M yield curve the most inverted ever, it’s hard not to see just how much havoc the Fed raising rates is doing to asset prices.
As we signaled the alarm back in September about the deteriorating state of the consumer, in our opinion it seems to be materializing at a faster clip since the start of the year.
J.P. Morgan believes that consumer excess savings will be all spent up by the summer of 2023. This means that much of the cash on hand that was still fueling the economic growth in the services sector will most likely come to a halt soon.
This tracks against end-of-year 2020 earnings call commentary when speaking on demand.
To further add to this “weak demand”, signs of credit card data spending have been decelerating since the start of the year according to Barclays.
Long story short, I think the bad news is good news narrative is slowly starting to mean less and less and we’re quickly approaching that bad news is indeed bad news.
Have a look at the market was pricing rate cuts as more information was coming out.
The expectations flip flop more often than a piece of hair in the wind. However, the problem with presumed rate cuts, while much of the market would initially cheer for a pause or a cut, is what that actually signifies.
The Fed has never cut rates because the economy is fine, rather, they have cut rates to spur economic activity mainly due to a recession. Look at the chart below when analyzing rate cuts and market bottoms.
In each of the last 7 Bear markets, the S&P 500 did not bottom until AFTER the Fed began cutting rates. On average, the market bottomed 11 months after the first rate cuts.
And then if we look at the past when lending standards have been tightening, there are only a few instances where a soft landing has been achieved. More often though, a hard landing has taken place.
Given that I continue to believe, and find support for, a slowing of the economy, I believe we are indeed in for a hard landing and the portfolio still reflects that expectation even after a wild Q1.
Positions
Portfolio Commentary
Given we entered into 2023 with a net short position, the market rebound in January and into February took us by surprise. While we believed it would be short-lived, we did need to trim positions to stay within appropriate risk ranges.
Notable Updates
We’ve officially re-entered into cannabis positions via Green Thumb Industries (GTBIF) which despite the price, has been an operational favorite of ours. We also entered into Urban-Gro (UGRO) as a continued play on vertical farming products/services considering it still has a healthy cash balance and a small promissory note to be paid in full by the end of this year.
While we have gone long some positions, they’re currently only starter positions and will look to build them out throughout the year. Some of these positions you might have seen on our last update as short but that was more a factor of price rather than business fundamentals.
We do believe that there’s still value in the names, hence why we flipped. RH (RH) being a notable one.
Other tech names that we were not short prior to EoY ‘22 have become overextended in our opinion which leaves room for us. Our biggest short position to reflect this thought is in Nvidia (NVDA) where we believe reality has been completely disconnected from the price which has mainly been driven by Ai hype.
At 60x fwd earnings, it’s still nearly double the historical average prior to COVID despite deteriorating macro conditions and a supply chain glut of chips.
Tesla (TSLA) is another notable short that we initiated as we’re in the camp of price cuts not being as advantageous to overall volume as everyone believes. Given the last update on deliveries, it seems that the price cuts are indeed not moving in favor of the expectations that Elon and other analysts have set out.
Wall Street was expecting Tesla to report deliveries around 432,000 vehicles for the quarter. Total deliveries only numbered 422,875.
While also moving in and out on our short book, we’ve taken an active long position in the Microsoft (MSFT) and Activision (ATVI) trade as we believe that the weight holding back the deal has become virtually null. The big announcement out of the UK towards the end of March coincided with us publishing our part 1 on the deal which you can read below.
Besides the 1 arbitrage trade we have engaged in during Q1, there are other special situation opportunities that we have been doing work on, and should they be of interest, we’ll initiate a position.
While we do not like trading in and out (learnings from Q2’22), the volatility in weak names does create opportunity and we will continue to nibble should they present themselves.
Closing Portfolio Remarks
2023 will be a stock pickers market and we believe that there is still more pain to come. While timing will be incredibly difficult, we’ve already begun building out positions in names we believe will deliver long-term value.
CGC aims to deploy the rest of our remaining capital (which has been sitting on the sidelines) during Q2.
There are plenty of asymmetric trades that have been on our radar and are just looking for the right time to begin.
If you’d like to receive our monthly position updates or premium notebook content, you can enjoy a trial below.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Hi there, welcome to another post by Cedar Grove Capital Management and our first post sharing our thoughts on a recent earnings release.
Posts like this will generally go to paid subs but this one will be completely free and the following earnings recap will be partially free with all others after being paywalled.
If you enjoyed today’s post, please hit the heart button and if you have any feedback, comment below.
Earnings Recap
Last week, RH $RH released its Q4’22 and FY’22 earnings and they weren’t the most spectacular.
Looking at GAAP figures, net revenue, operating margin, and net income were all down y/y.
Bright spot was on gross margin which was up 110bps from last year. Cash was down a massive ~$660M from a year ago while leverage remained mostly elevated (more on this later).
I could keep going down the list but that’s boring but the takeaway is that hey, things were down.
Looking at their outlook, however, RH sees $2.9B - $3.1B in sales with an operating margin of 15%-17% which includes 150 bps of drag due to international expansion.
On the earnings call, the company also foresees elevated capital expenditures from its historical range hitting anywhere from $275M to $325M.
But was everything so bad? Well, RH is faced with what I believe to be an inflection point and you as an investor need to understand what’s going on if you plan to stick around or jump ship.
Background Context
Back in late 2021, I first posted my take on RH and believed that it could hit $750/share. Just a few months after making that call, the price came within a stone’s throw away from it before s**t ended up hitting the fan at the end of November.
In early 2022, I reiterated that I thought RH was cheap and that there was plenty of higher-income spenders out there that would somewhat isolate the company from a slowdown in the economy and RH still had plenty going for it.
It was, and is to this day, one of our most read, heard, and shared articles. You can read it below if you’d like.
With that though, macro took over and things really started to deteriorate for basically everything consumer discretionary as the spending shift really went towards experiences.
Even with our enthusiasm for RH, and the complete beat-down the stock got in 2022, that doesn’t mean that the future isn’t bright despite what the recent earnings were.
This is basically how I interpreted the most recent earnings.
Are You Going For The Ride?
Nothing new was really said in terms of how the business was expected to do. If any of you remember correctly, Gary has been calling for the shitstorm of the year to take place in 2022 (which for the most part has) and hasn’t downplayed any of it.
The market front ran all the macro and the constant commentary he was giving about the business, the economy, the housing market, and its ability to navigate.
Again, nothing new, which is why the stock has been whipped sawed left and right in the hopes of a rebound in discretionary spending.
Throughout the earnings call, Gary kept reiterating the long-term vision of what he wanted RH to be when analysts were asking him questions.
“Our strategy to elevate the design and quality of our products is central to our strategy of positioning RH as the first fully integrated luxury home brand in the world.”
RH was a traditional showroom furniture and housewares company a long time ago and then slowly transitioned from its legacy galleries into bigger, more modern galleries that made the overall experience better. This included having restaurants in the space so customers/clients can make it a destination while they shop and splurge.
This has proven fruitful over the last decade as EBITDA margins have grown >2,000 bps since the Great Financial Crisis.
But this was not the end of the vision for Gary. He wants to not just be domestic but also an international one. We are bullish on this plan since the European market is highly fragmented and its wealthy demo appreciates fine quality.
This was part of our initial thesis considering that RoW was basically a large amount of untapped whitespace for the company. The first is the RH England estate which sits on 73 acres and will have 3 full-service restaurants. Later openings in Brussels, Madrid, and Munich over the next 18 months and Paris, London, and Sydney in 2024/2025.
International expansion is not where investors need to get wary. No. The real part, which is why I labeled it the inflection point for investors, is what else Gary wants to expand to in order to complete this ultra-high-end luxury experience for the very wealthy.
In the past 12 months, the company launched RH Contemporary, new galleries (stores) such as RH San Francisco, fine-dining restaurants in multiple galleries, the first RH Guesthouse hotel venture, and charter jet, and yacht services. RH also purchased 857 acres of Napa Valley land to build a resort and winery.
But the company also wants to get in on creating where its customers live. In the works is RH Residences, which would build fully furnished luxury homes, condominiums, and apartments with “integrated services” for “time-starved consumers.”
All this obviously isn’t cheap and can be a really slow investment before anyone actually sees a return from this. Hence, why RH’s capex guidance for 2023 was a ~71% increase from FY’22 at the midpoint and historically above trend ($275M - $325M).
You really have to believe that his vision, one for catering to the very wealthy, will pan out not in the next year, but in the next 5 years as not only the economy gets better but that customers actually want to be catered to in this type of way.
Personally, I do believe there is a market to be made if RH is able to act on it fast enough but also strategically to not burn through capital before cash flow completely s***s the bed.
I mean, there are reasons why getaways can cost upwards of $13,000/night and have people book and trends support that as well.
HNW individuals will also be spending more. A survey of Virtuoso travellers revealed that 74 per cent agree that “creating a travel experience that best fits my expectations is more important than price,” with plans to increase the average spend of US$20,700 per person in 2021 by 34 per cent, to US$27,800 per person in 2023.
This is why even though there’s execution risk, the underlying RH business can still thrive while supporting the next evolution of RH in the decade.
What Keeps The Price Up
So if you are a macro bear (I am) then what’s to keep this stock from taking a nose dive harder than a rock off a cliff? There are a few things that I believe can help keep the price within range without it totally capitulating. All else being equal.
1) Expectations
Gary was one of the first CEOs to come out in 2022 to sound the alarm. Making comparisons to Bear Stearns and referencing the movie “The Big Short”. He has not sugar-coated anything or led investors to believe anything other than his thoughts on housing taking a crap, the economy slowing, and that everyone needs to brace themselves or succumb to a reality check real quick.
If we connect this to price action, the price of RH stock has reflected the negative sentiment from Gary and also the broader market since the start of 2022. Trading within range once it bottomed out.
2) Share Repurchases
In October 2021, the company took out over $2B in debt at LIBOR +250 maturing in October of 2028. This debt was raised to fund future aforementioned growth plans as well as fuel buybacks.
Since peaking in 2016, DSO has decreased by ~37% and the current program still has plenty of authorization left.
During fiscal 2022, the Board of Directors authorized an additional $2.0 billion for the purchase of shares of our outstanding common stock, increasing the total authorized size of the share repurchase program to $2.45 billion. We repurchased approximately 3.7 million shares of our common stock during fiscal 2022 pursuant to our share repurchase program at an average price of approximately $269 per share, for an aggregate repurchase amount of approximately $1.0 billion leaving a remaining amount of $1.45 billion outstanding and available under our share repurchase program at the end of fiscal 2022.
To remind you, the current market cap of RH at the time of writing this was $5.37B. Having an authorization of $1.45B, even spread out over the next ~2 years could still mean the company buys back ~27% of the company. Not an insignificant amount.
While I don’t hold management share guides in stone, it’s interesting to see what they think when they do publish.
3) Real Recognizes Real
Lastly, luxury is here to stay. It has for centuries and it will not be going anywhere anytime soon. With that though, if RH does get hammered if the economy goes to s**t, it could make for a VERY interesting acquisition target.
Similar to how LVMH bought Tiffany’s right before the pandemic (they contested but it went through), a marriage between LVMH (or another major fashion house) could see some massive synergies with what Gary is trying to build.
Take a look at their portfolio below to see what I mean.
Takeaways
The road ahead is going to be a bumpy one. No one is suggesting otherwise nor should anyone think otherwise. It will get worse before it gets better but the vision makes sense, and if executed well, can really pay off for a long-term investment.
The question is, are you willing to go for that ride?
As of right now, I know I am.
Lastly, for those of you that don’t know, I do run another newsletter for our private side of the business through Cedar Grove Capital Holdings. This newsletter is all SMB-related topics that I’ve gone through or wanted to share in case you're interested. See the example below.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech
Disclaimer: I/we (“Cedar Grove Capital”) currently do have a stock, option, or similar derivative position in RH (RH) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
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Hey folks, thanks for joining me again for another post by Cedar Grove Capital Management. Today I’m revisiting the Microsoft $MSFT and Activision $ATVI deal that we originally wrote about in April of 2022.
If you’re interested in our thoughts and our trade structure, you can have a look below.
As far as the update goes, I think to better understand the real risks here, we first have to go back in time and relook at a deal that has recently faced immense scrutiny that the FTC allowed it to go through over a decade ago.
This deal is important because it shows just how many warning signs there were but also the side effects of not knowing what the future really holds.
This post is part one of a two-part post on the deal. If you’re interested in catching the next one when it comes out, please subscribe below, it is free at the basic level.
With that, let’s dive in.
Live Nation 🫱🏼🫲🏽 TicketMaster
In 2009, Live Nation and TicketMaster agreed to a $2.5 billion merger that many at the argued could reignite the ticket sale industry for live performances or it was nothing more than just delaying the inevitable.
Granted, this merger was announced during peak great financial crisis and many were still struggling to get back on their feet. Hell, the market bottomed just a few months later.
Typically, FTC isn’t as scrutinous (but not always) on vertical mergers as horizontal ones. Vertical integrations are usually mergers of non-competing companies where one's product is a necessary component or complement of the others. Such mergers can achieve procompetitive efficiency benefits.
Vertical integration can lower transaction costs, lead to synergistic improvements in design, production and distribution of the final output product and thus enhance competition. Consequently, most vertical arrangements raise few competitive concerns.
However, that is not always the case and if we’re looking at the anti-competitive nature of this particular deal, it almost seems like an obvious merger that needed to be blocked but somehow made its way through.
Both Ticketmaster and Live Nation enjoy monopoly-like dominance in their fields, but they achieved those positions by different means: Ticketmaster through technological innovation, like Microsoft, and Live Nation through consolidation, like Standard Oil.
But what were the possible net benefits that were allegedly supposed to come from the deal?
1) The Movie Theater Model
For those of you that aren’t familiar, the movie theater model is quite simple. Movie theaters don’t make much money on the actual sale of the movie tickets themselves but rather on what they charge you once you get in there. That includes popcorn, drinks, snacks, and any clothing associated with the movies.
This similar approach was proposed by Glenn Peoples who was a senior analyst at Billboard.com back in 2009.
There are seats that aren't being filled at a lot of concerts, and so some of the prices are going to go down so they can get people in there so they can get their parking money, so they can get their beer money, so they can get their merchandise money. And on the other side of it, the good seats, the in demand seats by people who really place the most value on these events, well, they're going to be paying more.
The logic here is that the “surge” pricing of in-demand tickets can help people come in for the not-so-nice seats (more ticket sales) and also get more stuff once they’re there.
A win/win/win/win (Live Nation / venue / artist / fan). The fan is included because they, in theory, get the seats they want at the price they’re comfortable with.
2) Scalpers
The other problem that plagued the industry was scalpers. These were the guys that sniped tickets when they went on sale only to list them on the secondary market to make a quick profit.
The thought was that Ticketmaster was limited by artists and venues who want to keep prices low to sell more tickets. But that helps create a thriving secondary market for the most popular concerts.
A thriving secondary market that Ticketmaster had through TicketsNow which actually landed them in the hot seat in 2009. More on this in the next section.
The new Live Nation might be able to squeeze some of those middlemen out. Congressman Brad Sherman said that would be good for artists.
The highest prices are when you have to pay scalpers. And I believe that these changes will make sure that when you buy a ticket the majority of that money is going to the band you're a fan of rather than ticket resellers.
But let’s look at the clear reasons why the deal should not have gotten approved.
Why The Deal Needed to Die
1) "This deal is not in the best interest of fans"
Michael Hershfield, the co-founder and CEO of LiveStub -- a secondary ticketing company much of whose business would disappear if Live Nation and Ticketmaster merged said that,
"This deal would mean that Live Nation would have direct access to Ticketmaster's ticketing solution, including its resale marketplace TicketsNow. Live Nation could potentially harness Ticketsnow and begin to offer performers the opportunity to list tickets on the resale system without ever listing in the primary market."
This was all too true when TicketMaster sold tickets to a Bruce Springsteen show through TicketsNow, rather than through its primary ticketing system.
Springsteen complained about his fans being subject to a "bait and switch." When they went to Ticketmaster.com to purchase tickets at their $95 face price, many were directed to TicketsNow (secondary market) where the tickets were priced as high as $2,000.
Congress was not too fond of this play by the company and the FTC ended up fining them as a result.
2) The Fan Pays More
Even leaving aside the idea that these two live music behemoths would no longer have to compete with each other for venues and tours, the more immediate threat to fans is that tickets could be sold by auction rather than at a single price.
While the combined company might take the opportunity to ditch the"convenience" fees that are detested by fans -- or at least internalize the fees (which are divided between Ticketmaster, the promoter, and sometimes the performing artist and other parties) -- the idea of bypassing the primary ticketing market entirely and introducing them directly into the Ticketsnow auction system could give prospective audience members with more cash to burn a big edge over impecunious fans -- even if those other fans are quicker on the draw when it comes to buying tickets.
In other words, thickness of wallet -- and not quickness of response -- would become the salient factor when trying to buy tickets for hot shows.
If you read the above right, then it basically insinuates that ticket inequality would now exist since there isn’t a fixed price system anymore.
3) Ownership Drives Fees
Congressman Schumer, in a signed letter to Attorney General Eric Holder, estimated Ticketmaster’s share of the ticket sales market at 65% while Live Nation was at 15%.
Combined, you’re looking at a market share of ~80%. Having ownership to that degree allows the company to give itself an edge when charging fees.
These fees make it difficult for consumers to know the true value of concert tickets. Primary ticketing companies — the box office or ticket booth at the venue itself, say — impose fees that, on average, amount to 27% of the original ticket price.
Secondary ticketing companies, such as the eBay subsidiary StubHub, charge an average of 31% of the ticket price.
Because Live Nation controls a significant portion of both markets, the extra fees give the company an enormous competitive edge.
But how did the deal get done?
FTC Cuts A Deal
After nearly a year of scrutiny, the Justice Department filed a proposed settlement that would allow the companies to merge — if certain conditions are met.
The settlement required some concessions that were supposed to create more competition in the ticketing business that Ticketmaster currently dominates.
Ticketmaster was required to license its primary ticketing software to Anschutz Entertainment Group (AEG), the second-largest concert promoter and operator of major venues.
Within five years, AEG could either buy the software, create its own or partner with another competitor.
In truth, as I mentioned in the beginning, vertical integration is less frowned upon in the eyes of the FTC.
“The Justice Department had a very weak hand. This is vertical integration, which our antitrust laws generally allow. They were able to successfully negotiate for significant concessions.” - U.S. Representative Brad Sherman of California
This is key because back then, the financial crisis was just turning a corner. The FTC was less hard on mergers in general in an effort to spur growth and market activity in a very dormant market environment and this was allowed to happen.
When you really don’t look into all the details too much, or don’t apply enough weight to them, you get a behemoth that survives the financial crisis and comes out much stronger than the FTC could have imagined.
That is what’s important here when we look at the MSFT/ATVI merger.
Takeaways For MSFT Merger
* It’s not just about what the market conditions are now (declining sales, performance, shows), it’s what they could be down the road.
* Really dig deep into where the “leverage” lies and who it lies with. This will be important in part II.
* Go hard with the worst-case scenarios and let the companies dig themselves out of them to prove it’s not as bad as it is.
* Concessions should never be lenient if the gut reaction is this is a bad deal.
That’s it for part I to set the stage for what I’ll be sharing in my notes for part II. I always felt case studies are a great way to use historical events to help understand and predict the future. I’m sure that Lina at the FTC has also been doing the same.
If you’re interested in joining our premium community, you can enjoy a free trial below.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
HoldCo Twitter: @cedargrovech
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
Hey everyone, welcome back to another article by Cedar Grove Capital Management.
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Introduction
Back in September, we published our thoughts on the consumer and what led us to liquidate our positions due to what we believed was not a light at the end of the tunnel but in fact, another train.
Since it’s been three months since we posted that piece, we thought it would be best to send out another update on our thoughts while touching on different market segments this time.
In this post, we’ll be sharing our thoughts on
* State of small businesses in America
* Homeownership and how asset prices have destroyed the future
* Used car market and what that means
* Consumer savings rates not seen since before ‘08
* The dinner table is still costly
With that, let’s begin.
Small businesses, the backbone of America
According to the U.S. Small Business Association (SBA), small businesses of 500 employees or fewer make up 99.9% of all U.S. businesses and 99.7% of firms with paid employees.
These range anywhere from your local mom-and-pop place around the corner or that small local/regional company.
Of the new jobs created between 1995 and 2020, small businesses accounted for 62%—12.7 million compared to 7.9 million by large enterprises. A 2019 SBA report found that small businesses accounted for 44% of U.S. economic activity.
Without small businesses, the American economy and workforce would be a pretty wild landscape to imagine.
In fact, in 2021, there were 5.4 million new business applications. That’s 23% higher than 2020’s record.
So, small businesses are important, and lots of people have wanted to start them recently. Hell, we just bought one ourselves.
But if we’re looking at the economy, we need to see how small businesses are viewing it themselves.
Recession Scaries & Inflation Pain
To find out how inflation is affecting small businesses, in June, Digital.com surveyed 1,000 owners and co-owners of small businesses with 500 or fewer employees. The results show that inflation – and rumblings of a recession – present a serious threat to the survival of the majority of small businesses.
Key Survey Findings
* 65% of small businesses say it’s ‘very likely’ or ‘likely’ they’ll permanently close if inflation continues at its current rate
* The prospect of a recession has 95% of small business owners ‘very’ or ‘somewhat’ concerned
* Businesses that are in danger of closing are more likely to have already been impacted by declines in revenue and customers, pandemic-related shutdowns, and supply-chain issues
* 38% of small businesses facing closure plan to lay off employees to stay afloat
“Small businesses have struggled to survive two years of COVID lockdowns. Many of those that made it through are likely to be low on the resources and energy required to now survive the highest levels of inflation in 40 years.” - marketing consultant Dennis Consorte
Additionally, the ongoing economic impact of inflation has led to the threat of a recession.
Small business owners are taking note of this as well, with 60% of all small business owners saying they’re ‘very concerned’ about a possible recession in 2022. Thirty-five percent are ‘somewhat concerned.’ Only 5% of small business owners say they’re ‘not at all concerned’ about a recession.
Referring to the increase in business applications picture from above, inflation might be about to make that boom go bust. Sixty-two percent of businesses founded since 2020 will ‘likely’ or ‘very likely’ close down without relief from inflation.
Businesses founded just before the pandemic, between 2017 and 2019, are even more likely to be struggling. Seventy-three percent of these businesses say closure is likely.
Even the majority of well-established businesses are being threatened by inflation. Fifty-seven percent of businesses founded between 2007 and 2011, and 55% of businesses founded before 2007 say permanent closure is ‘likely’ or ‘very likely’ if inflation doesn’t ease up.
To add to worrying statistics, more than 40% of U.S. small business owners say they couldn’t pay rent on time or in full for the month of November, the highest this year.
Analyzing trends in rent delinquency rates, this is up ~4 percentage points from October (37%) and 10 percentage points from September (30%).
A survey of 4,789 small business owners by Alignable was conducted between Oct. 15 and Oct. 27. The findings partly reflect how inflation is affecting small businesses. More than half say their rent is at least 10% higher than it was six months ago, and one in seven say rents have increased at least 20%.
About 49% of restaurants were unable to pay their rent this month, up from 36% in September, while 37% of real estate agents couldn’t pay their rent, up from 27% last month, reflecting the fallout from a slowdown in home sales as higher mortgage rates chill the housing market.
Takeaways
* Small business owners are genuinely concerned about inflation and its effect on their businesses
* Many are concerned about a recession and the very likelihood of their business closing
* The pace of small businesses not being able to afford rent is at its highest point this year
Now let’s move on to home ownership.
Poorer Than Before
With COVID shooting the median existing-home sales price to a peak of $413,800 in June of this year. Since then, prices have come down ~10%, and are looking to continue that way.
However, with mortgage rates pushing past 7% recently and settling at a national average of 6.6%. This has led to existing home sales plunging over the last year.
November clocked in a 28.4% y/y decline in existing home sales, which was the worst since February 2008.
But this isn’t what I’m concerned about. New home sales only affect those that are taking on new loans at much higher rates than before but as you can see from above, no one is lining up to do that.
In fact, nearly a quarter of Americans had clinched a mortgage rate of less or equal to 3%, according to data from the Federal Housing Finance Agency, as of the end of June. Only 7.2% of homeowners have a rate higher than 6%.
This means that while many Americans paid a lot more for a house, their mortgage payments are still very much under control due to them locking in low rates.
But here is what I am concerned about. The asset prices of homes are tumbling. As I mentioned above, prices are already down ~10%, but why am I worried about that?
I’m worried about the equity wipe of homeowners that overpaid, which was basically everyone.
What do I mean by this? Well, let’s look at the example below.
For easy numbers, we’re looking at a home that was valued at $500k in 2020, and sold for 50% more in 2021 (more common than you think). With a 20% down payment for a 30-year FRM, that means that you’re putting up $150k in cash (excluding fees, etc) for the home and the mortgage is $600k.
Now that prices are coming back down to reality, the overpriced home you paid for is worth 20% less, at $600k.
You’ve been making payments for ~1 year but the value has taken such a hit that your equity is virtually wiped. Meaning, that $150k you put down to obtain the house in the first place is down to ~$12k after making nearly one year of payments.
This means that you’ve basically paid $150k to only own ~$12k worth of a home in just one year. Not ~$12k in incremental equity, but ~$12k in total equity.
Terrible return.
This means three things though.
* Unlocking equity from your home via a HELOC/home equity loan is not possible because you basically have no equity left in the home currently
* If you had a HELOC or home equity loan, your line of credit from your lender might freeze or reduce your line of credit but you’ll still be on the hook for the payments regardless
* Assuming a 2.5% annual appreciation rate, it would take another 10 years after the 2022 drop to get back to the value that you initially paid for it
My concerns with this are that it will tie people up with little to no equity in their homes for years to come which doesn’t allow homeowners to tap their equity to fuel other economic growth with said funds.
Additionally, you can’t sell either without taking a massive loss due to the underlying price of the asset crumbling.
You’re basically held hostage to your home but instead of like in 2008, your mortgage payment is not making you go underwater and into foreclosure.
An expensive and not financially rewarding purchase if you ask me.
Used Car Market Collapsing
Remember during the pandemic when you could sell your old used car for basically double what it was worth? Yea. Those days are long over.
The Manheim used car index has cratered this year as supply chains for chips have eased which has allowed those on the waitlist for new cars to finally get theirs.
While it surprisingly ticked up last month, that’s more a function of people finally pulling the trigger and swapping out their cars before it’s too late for something slightly newer.
But, here’s the real kicker, the market for getting a new/used car is severely under pressure with rates.
Looking at the below chart will show you what the average used car loan rates are on a state-by-state basis.
According to Edmunds, the average interest paid over the life of a car loan hit an ALL-TIME record in November.
New car loan: $8,436 in interest
Used car loan: $10,204 in interest
In October, I was lucky enough to lock in a used car rate at 4.54% on a 5-year term. Mind you, I have an 820 credit score and yet people were still saying I paid too much.
That’s laughable at this point considering the average is now double that.
But not only do you have supply chains easing, rates going up, and people coming to the realization that their used cars are no longer assets but once again liabilities, this puts consumers in a very peculiar spot.
Consumers NEED cars for daily life like commuting to work, family things, etc. Waiting to get a car because prices were too high has backfired since now that prices are down, rates are up and that means people are falling behind on payments.
This is causing delinquencies to start climbing at a faster clip not seen since pre-2008.
Another notch on the belt of what’s holding the consumer down.
Overextended
This is one that we touched base on back in our September post but back then it was 30bp higher than what it is today.
While it stands at 2.4% right now, it was 2.2% back in October which was the second lowest rate on record only being beaten by July in 2005.
What’s interesting to call out here is the trend. Moving from a 2.2% rate to a 2.4% rate suggests to us that consumers are starting to wake up to the fact that they cannot keep up their spending habits as they have been.
The fact that there was a decent savings rate uptick in virtually nothing but declines since 2021, a slowdown in retail sales, and an increase in BNPL all confirm this hypothesis in our opinion.
Time will tell just how quickly rates continue to change if they change at all and whatever disposable income is left is not used towards just maintaining an already stretched lifestyle.
The Dinner Table Looking A Little Slim
Have you noticed that food costs have continued to go up? Perhaps you’ve already made changes to your weekly grocery store run in order to not spend as much.
Well, according to Bankrate’s Nov. 23 analysis of the cost of holiday essentials, six of 10 of the most inflated prices were for food, including turkey, bakery items, eggs, flour, and prepared mixes.
Let’s take a look at the most recent holiday that just happened, Thanksgiving.
The overall average cost of a "classic" Thanksgiving dinner for 10 people, which includes things like a 16-pound turkey and a dozen dinner rolls, is $64.05. That’s almost $11 or 20% higher than the average for 2021.
How about the upcoming Christmas dinner? Well, ham is up 7.8% year over year, frozen and refrigerated bakery products are up 19.4%, and eggs are up 49.1%.
To pick at eggs real quick, look at Cal-Maine foods.
This company literally does nothing but sell eggs. A company that sells eggs has beaten your tech-heavy, innovation-driving story-type stocks. Eggs…
Because of the rising costs of food, more and more consumers are trading down to private labels in an effort to find value.
About 78% of Americans currently purchase in-store brand products, 61% are buying more private-label pantry items, and 58% are buying more private-label household merchandise.
So with prices still going up for our everyday food, and consumers already buying more private-label products just goes to show why we’re concerned about where discretionary funds will eventually be shifted to.
Concluding Thoughts
While we do not want the underlying consumer to be feeling the pressure that they have been, the data as we are interpreting it, all points to nothing but more pain ahead.
One of the easiest ways you can check the pulse of the consumer, aside from the data, is to look and see if you’ve changed anything. If your friends or family have. Odds are you know someone who’s suffering from something from the above. Whether it be trying to get a new/used car, having the price of their home drop, etc.
Our concern is that the market, and many investors, are not seeing the forest for the trees and are too dependent on inflation data and what the FED may or may not do.
That is all short-term thinking and the exact reason why we sat out market volatility for a few months before finding it appropriate again to start new positions.
While this isn’t 2008 with a main point of failure (housing), the consumer is getting hit from all angles and time will continue to show how an earnings recession is coming and quite frankly, has already come.
Thanks for reading everyone and I hope you and your family have a wonderful Christmas holiday!
Until next time,
Paul Cerro | Cedar Grove Capital Management
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
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Cannabis has been quite the whirlwind over the last few years. Many investors know the pain of holding onto the hopes of a change in governmental policy that would immediately change the cannabis market.
These changes specifically revolve around SAFE banking and the effect of what 280E would have on each of U.S. cannabis’ financial statements. I wrote about this late last year in the post below.
YTD, U.S. cannabis is getting crushed and anyone that’s held onto these names listed below has truly felt pain. Considering the underlying fundamentals of these companies are actually solid for the most part, it has been quite frustrating to see the price action deteriorate.
Not even cannabis ancillary players have been spared and in most instances which are arguably better since they have uplistings and access to bigger pools of liquidity. Many of them have actually deteriorated worse than the pure-play multi-state operators.
What is most interesting to note is what’s actually happened in the last 3 months. When all hope was lost, a forgotton friend came out of nowhere and made a special announcement. President Biden made an announcement on October 6th saying that he would pardon all prior federal offenses of marijuana possession, urged governors to do the same, and then asked the attorney general to look into how the drug is scheduled.
Stocks rallied on the news to the tune of an average of ~41% that day. It seemed that the long waiting for policy reform was finally coming.
🎉 BIG WIN. 🎉
Not.
I tweeted about my thoughts on this since I’ve been around this block a few times myself.
While there obviously was a chance that I could have been wrong, I was confident that this was nothing more than headline moves with nothing really substantial behind it.
To prove this, NBC news even reported just how little substance in the grand scheme of things his announcement was when it came to pardons.
A senior administration official said that over 6,500 U.S. citizens were convicted of simple possession of marijuana under federal law from 1992 to 2021 and that thousands more were convicted under a Washington, D.C., code. No one is in federal prison solely for simple possession of marijuana, and most marijuana possession convictions occur at the state level, the official said.
This basically means that the federal pardon, while helping some, was quite minuscule considering most offenses were at the state level.
To put things in perspective, out of 350,149 cannabis arrests in 2019, about 91 percent were for possession.
Despite the news, this was the first catalyst that set off what would be a spectacular rally in cannabis stocks. The next were inclusions of cannabis reform in certain bills that would also benefit the entire industry. This was essentially one of the switches that would help ignite the cannabis bull market which I spoke about on the megabrands podcast over the summer.
However this would not be the case, and what was a spectacular rise in names up until that point had a dramatic fall.
This fall from grace has almost essentially wiped out most, if not all gains since the pre-White House announcement over two months ago.
Cedar Grove Capital Management decided to sit out this entire time because of just how loosely these moves were being held together on the mere speculation of reform.
When policy drives the narrative, prices can fluctuate on a dime, as you saw above.
Don’t get me wrong though, I am still bullish on the overall cannabis industry and still think it’s THE most undervalued sector of the entire market but there are little to no more catalysts to push it higher for the time being.
There’s still speculation out there that something will get passed in the lame-duck session but call me skeptical. For now, there doesn’t seem to be a solid reason to hold a long position in any names until more substance arises.
The time will come and we’ll see what the 2023 year has in store for cannabis. Hopefully, it’s a good year.
For those of you that have made it this far, take the poll below to see what your fellow cannabis investors think.
Until next time,
Paul Cerro | Cedar Grove Capital Management
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
Disclaimer: All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe -
If you like today’s post, please be sure to hit the heart button, comment with any feedback, and share it with friends if you find it useful.
For those of you that may or may not know, I’ve said one or two negative things about Peloton (PTON) in the past.
Okay, so I’ve been pretty pessimistic about Peloton, but how could you not be? The stock has performed so poorly that PTON is down >68% from its IPO day closing price back in 2019!
Once one of the best-performing darlings during COVID, this company has fallen off the poor management tree and hit every branch on the way down. Who would have guessed that bikes with TVs on them wouldn’t be worth an almost ~$50 billion market cap when you only have a few billion in sales?
💥SHOCKED💥
Besides the obviously poor decisions by management and internal strategy teams, many bagholders were hoping for a bottom to form or even a saving grace from a buyout. I even wrote about the potential Amazon buyout rumor in February and how there was no chance it would happen.
With so much turmoil at the company, what didn’t help reassure investors was the mass exodus of executives, including co-founder John Foley himself. Let’s take a recap of who has left just in the last two months.
September
* John Foley - Co-founder, ex-CEO
* Dara Treseder - Head of Marketing
* Kevin Cornils - Chief Commercial Officer
* Hisao Kushi - Chief Legal Officer
October
* Shari Eaton - Chief People Officer
How encouraging. Anyways, today’s post isn’t about pulling PTON through more shards of glass and reminding all the bagholders why they should have seen this coming. No, today is about their turnaround plan, what I think it could be worth, and what the worst-case scenario is should McCarthy (new-ish CEO) fail.
So, let’s dive in.
“Everything But The Kitchen Sink”
Barry McCarthy was brought on earlier this year as the new CEO (replacing Co-founder John Foley), to turn around the company. McCarthy is a seasoned veteran with large companies being the CFO of both Spotify and Netflix.
Nice.
In relation to Peloton, with any sinking ship taking on too much water, you need to plug up the holes. Only then can you actually start removing the water and hopefully sail on to greener pastures.
How big are PTON’s holes? Well, pretty big.
If we look at the company’s LTM FCF, their most recent quarter showed a cash burn run-rate of -$2.4 billion. This is less than the over -$2.6 billion reported one-quarter prior. Mind you, their sales alone were ~$3.6 billion in the LTM. Crazy how that even happened.
One obvious place that they were spending way too much money on was, people.
Bloated Workforce
SG&A margin was over 51% of sales in the LTM. Being too heavy with human capital, once PTON made the February announcement that they were bringing on McCarthy, they also made the announcement of laying off ~2,800 employees.
On top of the announced layoffs, they also said that they were reducing the number of warehouses it owns and operates and expanding delivery agreements with third-party providers, and winding down its first US factory plant in Ohio.
The company believed that this round of changes would save the company >$800 million in annualized costs. This was just the start. In July, Peloton said it would cut about 500 Taiwan-based manufacturing jobs. A month later, it announced plans to cut 530 employees from its North American delivery workforce and 250 customer-service positions in North America. Most recently, PTON cut about 500 jobs, roughly 12% of its remaining workforce in the last round of cost-cutting measures to turn the company around.
This fourth round of job cuts left Peloton with roughly 3,800 employees globally, less than half the number of people the company employed at its peak last year. It also has eliminated about 600 more jobs since June than previously disclosed through retail store closings, attrition, and other moves.
In-House → Out-of-House
Additionally, aside from cutting its workforce, Peloton decided it would cease all in-house production of its bikes and treadmills and move manufacturing to partners in an effort to simplify its operations and reduce costs.
Given how the company prided itself on wanting to own the whole system end-to-end (E2E), this change was surprising but not that surprising.
While there’s no direct callout for how much the cost savings of this change would be, it can’t hurt the company’s burn rate.
SALE! SALE! SALE!
One of the biggest issues that Peloton was facing was that as the economy reopened and it was becoming more evident that consumers were favoring out-of-home (OOH) activities. This meant that any company that grew exponentially during COVID because of limitations of being able to leave the house were having major issues with inventory.
This led to PTON having their inventory ballon triple digits while revenue was dropping off a cliff.
To add insult to injury, I even did some channel checks on second-hand equipment. While this level of diligence is imperfect, in my mind, it put forth the idea that some PTON users were over their bikes and wanted to get rid of them.
In the NYC region of FB marketplace, the list kept going on and on for residents selling their bikes, some at even half the price of a new one. I understand that correlation ≠ causation but this definitely should have been on people’s radar.
Consequently, to improve cash flow and move inventory, PTON took it upon itself to lower prices. While this did somewhat help, it’s apparent that it didn’t do enough and most likely diluted brand premium and pissing off customers.
All these cost-cutting steps, while painful, were necessary to help stem the bleeding.
McCarthy said the company has drastically reduced the amount of cash it is burning through by cutting jobs, outsourcing all manufacturing and reducing costly unsold inventory, and isn’t at risk of running low on funds. Peloton went through more than $1.7 billion in cash in the past three quarters combined, ending June with $1.25 billion in cash reserves and a $500 million credit line.
If you remember what I mentioned previously, current run-rate post-cost-savings don’t leave too much time to right the ship before cash reserves start getting low and break covenants.
Those covenants can be tripped in two ways.
“requires us to maintain a total level of liquidity of not less than $250.0 million and maintain a minimum total four-quarter revenue level of $3.0 billion (which are replaced with a covenant to maintain a minimum debt to adjusted EBITDA ratio upon our meeting a specified adjusted EBITDA threshold).”
Again, not too much wiggle room even on the revenue side of things if they don’t want to break covenants.
The Numerator
So while there’s only so much that a company can do to stop the bleeding (all the above), what you can also work on is growing revenue. After all, it’s all one big equation anyways.
Historically, Peloton wanted to keep a premium brand image and control the supply of its goods. That’s why it only sold its equipment online and in its own retail stores while not allowing its content to be placed on other equipment. This was the whole point of its connected fitness offering.
However, with the absolute need to grow revenue, they’ve changed this up in the name of survival. Here’s a list of changes that Barry has done so far.
* Fitness as a service (FaaS) - renting out the bike and content for a monthly fee
* Launch of the Peloton Rower - what a dumb idea.
* Growing the Peloton digital app with paid tiered services
* Freemium model where users can get access to their library on the go and upgrade
* Selling equipment at other retailers like Dick's Sporting Goods
* Putting bikes in Hilton hotels
* Selling select products on Amazon
Basically, a lot of things which is why bond investors seem to feel a little better about the state of the company given how PTON’s recent bond offering is trading. Recent price of $0.72 on the dollar vs a low of $0.62 in July shows that reinforcement in sentiment.
But what Barry and management don’t know is if any of these initiatives are actually going to work. In hindsight, a lot of these ideas might be dumb but given the situation that they’re in, they need to try anything and everything before time runs out.
“There comes a point in time when we’ve either been successful or we have not,” Mr. McCarthy said in an interview, saying that point will be in about six months, or a little over a year since he took over as CEO.
Tick tock. Tick tock.
What I Think It’s Worth
One of the biggest points that everyone fought me on was how profitable PTON’s connected fitness (CF) portion of the business is. They aren’t wrong since in the most recent year they generated ~$1.4 billion in sales with a 71.3% contribution margin. Impressive, but this part of the business used to be straightforward but isn’t anymore.
You see, you had ~3 million subscribers paying $39/month (recently increased to $44/month), and that number seemed to keep growing. However, over the last two quarters (Q3-Q4), the number of CF subscribers only jumped by ~4,000.
In essence, the most profitable part of the business is barely growing if at all anymore. When you look at the chart above, growth seems to be not an option at the moment and analysts have called for the next Q to have flat growth. I’m skeptical that number will hold at that level given commentary from PTON.
With the US market for connected fitness down an estimated 51% YTD and our market share up an estimated 17% YTD, we expect the market for connected fitness to remain challenging for the foreseeable future in FY23.
Before this year’s change of strategy, the way to value PTON was much easier to understand. You could model out CF subs, digital subs, and hardware. However, with all the changes going on, it’s incredibly difficult to model that out.
How do you count hardware sales through Amazon or Dick’s Sporting Goods? How do you factor in conversion from Hilton rewards members after they’ve stayed at one of their hotels? How do you model out its FaaS offering? Its conversion post-free 2/3 month trials?
It’s hard to and to even try is foolish and more a guessing game than anything. So below is how I’m thinking about it.
Revenue Forecast
If we’re looking to model what we can, I’ve taken into account CF subs, digital, and hardware. I don’t know who in their right mind would think this company grows into a recession when you have product starting costs at $3,195 (Rower) and $3,495 (Tread).
It’s just not going to work out. Additionally, when you factor in the price hike from $39/mo to $44/mo for CF subs, you can notice the drop in total CF subs between Q3’22 and Q4’22 of just 4,000 net additions.
Adding fuel to fire, there are many Peloton members that are no longer using the bike yet still paying the monthly membership. Those fringe users are likely to cut the cord in the coming months and years ahead, especially as monthly sub prices are increased by the company. This is also exacerbated by the fact that the company is handing out free 1/2/3 month trials like they’re candy.
As I’ve said it no less than 1,000 times but gyms and studios are back in a very big way and that’s where the money is going at least in the near term.
My above revenue for FY’23 of $2.86 billion is drastically lower than FY’22 of $3.58 billion and FY’21 revenue of $4.02 billion. As I said, high-priced hardware going into a recession off of fitness transition to in-person doesn’t make for beneficial tailwinds.
SaaS Multiples
Once high-flying SaaS companies were trading at over 14x median sales during COVID. Once the economy started to turn, many wondered where the floor was, and here comes Thoma Bravo with his buyouts suggesting the floor was in.
JOKES.
SaaS multiples have completely collapsed and while there are multiple versions of what type of SaaS to count for (enterprise, cloud, etc), it’s easier to just use the blended median to get to an answer.
SaaS valuations have officially collapsed. We’re back to pre-2016 levels. Of the 123 SaaS companies we follow, the average public SaaS business is trading at 7.5x revenue while the median is 6.3x.
The other concern about using the above info is that the median SaaS business had trailing twelve-month revenue of $483mm, EBITDA of -$35mm, but positive operating cash flow of $35mm thanks to up-front collections on annual contracts.
So long as you’re growing cash efficiently (the median annual growth rate is 25%), investors will overlook negative EBITDA especially if the business is cash flow positive after working capital changes.
While Peloton has significantly more sales, it has terrible EBITDA and cash flow, not to mention that debt overhang, low morale, new employee stock options, etc. Basically, everything is working against them.
Valuation
Right now, PTON is being valued at $3.84 billion enterprise value. If we take the Q2’22 median multiple of ~6x on its revenue, which isn’t correct given that its connected fitness arm only grows with the hardware, you get ~$17 billion EV.
There is no way that will happen. Let me repeat myself. A zero percent chance that will happen.
If we look at what the street is giving $PTON , right now it stands at 1.3x NTM EV/sales. Again, I think that’s aggressive. The problem with getting the multiple lift that many argue it should get is the fact of just how bad it’s burning cash.
With so much uncertainty with the company, I think many investors are trying to invest in a turnaround because any inkling of positive news moves PTON up faster than tweens toward the Jonas Brothers.
In the current situation with bleeding cash and a slowing economy, I think 1x NTM EV/sales seems appropriate and even then it’s leaning towards the generous side.
NTM EV/Sales: 1x
FY’23E Sales: $2.855 billion
Debt: $2.37 billion
Cash: $1.25 billion
Market Cap: $1.73 billion
FDS: ~328 million (RIP all PTON employees with strikes above now)
Price: $5.29
That’s why I said that I didn’t think the market bottoms until PTON goes under $5. We got kinda close already when it touched $6.66 (lol) but no dice yet.
But here’s the thing, what if Barry can get to BE cash flow? A Long shot but if he does, that can help with the sentiment from its investors and a case to be made about a future turnaround.
Still, with declining expected sales and a 2x multiple on hopes and dreams, that gets you to ~$14/share.
“We’re Still Sinking”
If Barry can’t get Peloton to breakeven FCF, the odds of the company’s viability are quite low and don’t leave many options for them. By the end of 1H’23, if FCF can’t be reined in and growth can’t be kick-started again, I’d imagine their cash position is drastically reduced and their debt burden might start to wane down on them.
But what happens? Do you file for bankruptcy? Wind things down? Sell? Realistically, I don’t think they would file for Chapter 11 since I bet there’s some more they can do to just “exist” but I think they would sell. But who to?
I have a hard time believing that PE would touch this company given the FCF problems it has. Even transformative PE shops would have a hard time fixing this trash pile better than what the company was already doing on its own so that’s why I strike them out.
However, I DO think that a strategic would buy them. It would have to be someone that’s big enough to absorb the losses while it figures out how to engrain them in their overall plan, AND can leverage an existing base or platform to kick start it up again.
But, with that being said, I don’t think that current shareholders would get the saving grace that they believe they will. Because the company has so many issues, because it will most likely be in desperation, and because its base might already be in the current PTON demographic, a strategic wouldn’t pay top dollar for the company.
If we’re talking about obvious suitors, I’ve compiled a list below.
Large strategics with demographic overlap
* Amazon - could roll into Prime
* Apple - could roll into Apple Fitness+
* Google - potentially a hardware play with Android?
Others with overlap
* Lululemon
* Nike
* Adidas?
Honestly, these are the only ones that I can think of and even then, they aren’t going to be paying much for the company. Maybe in a firesale but my bet would be Amazon if any. As I mentioned in the embedded post about a takeover at the beginning of this article, Apple prides itself on being able to build its own stuff and I find it hard to believe that they would buy it. The last big hardware acquisition I can remember them doing was Beats audio and that just ended up propelling them into the headwear space after that with the pods.
Closing Thoughts
Peloton will forever be a case study taught in universities of its terrible management decisions but if Barry can get it going again, it will also be taught as one of the best turnarounds investors have seen in this century.
High-level though, this turnaround is not an obvious one and sooooo many things can still go wrong. Considering that we’re most likely entering a recession and consumer discretionary spending is already being dialed in, the company will have more hurdles to deal with besides terrible management and operations.
I would treat this trade like someone would about crypto. Only risk what you’re willing to lose if it went to zero because it very well might.
Personally, I’m waiting for it to go much lower before I think about betting on a turnaround. Until then, given the level of volatility in the market and the name itself, going short at these lows seems far too risky.
Until next time,
Paul Cerro | Cedar Grove Capital
Personal Twitter: @paulcerro
Fund Twitter: @cedargrovecm
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Disclaimer: I/we (“Cedar Grove Capital”) currently do not have a stock, option, or similar derivative position in Peloton Interactive (PTON) at the time of writing this article.
All information provided herein by Cedar Grove Capital Management, LLC (“Cedar Grove Capital”) is for informational purposes only and does not constitute investment advice or an offer or solicitation to buy or sell an interest in a private fund or any other security. An offer or solicitation of an investment in a private fund will only be made to accredited investors pursuant to a private placement memorandum and associated documents.
Cedar Grove Capital may change its views about or its investment positions in any of the securities mentioned in this document at any time, for any reason or no reason. Cedar Grove Capital may buy, sell, or otherwise change the form or substance of any of its investments. Cedar Grove Capital disclaims any obligation to notify the market of any such changes.
The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of Cedar Grove Capital. The information in this material is only current as of the date indicated and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Cedar Grove Capital which are subject to change and which Cedar Grove Capital does not undertake to update. Due to, among other things, the volatile nature of the markets, and an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment.
This is a public episode. If you’d like to discuss this with other subscribers or get access to bonus episodes, visit www.cedargrovecm.com/subscribe - もっと表示する
