Discovery – The Fire Sale

The Archagos fiasco forced a fire sale in companies such as Discovery (DISCA, DISCK), ViacomCBS (VIAC), GSX Techedu (GSX), Baidu (BIDU), Tencent Music (TME) and others. Forced-selling can produce distortions in the market and create buying opportunities. 

Here’s a chart from last week’s blood bath:

I decided to go quickly over the lot that got beat up. Take note that some of these shares bounced back from their lows.

ViacomCBS (-26%) – They own SpongeBob and recently got into a fight with Judge Judy, so I’m out. The shares had climbed to over $100 in recent weeks, well above the consensus analyst price target of about $60. After the past week’s fire sale, shares traded at around $45.50.

GSX Techedu Inc. (-56%) – MuddyWaters and other short-sellers are after them for fraud. I’m not touching it.

Baidu (BIDU) – The Chinese google. Baidu was part of a group of Chinese stocks that got unloaded. There might be something good there but we are not done with the Chinese government’s interference and the recent SEC action.

Tencent Music (-37%) – This one is intriguing and will require further reading. My hunch tells me that in the long-run it could be a winner but again, because of the CCP’s meddling into big Chinese tech and the SEC I’m staying out for now. 

Discovery (-27%) – My favorite from the fire sale. I bought some. When somebody (Archegos) is dumping shares of a good company at bargain prices, I’m a buyer. When somebody is in a desperate situation, and needs to sell, the buyer is in a good position. Discovery is the one that I’ve looked at on and off over the years. I’m not saying it’s the best one of the group, it’s simply the one I’m more familiar with. It always looked too expensive and they have some headwinds to deal with. The selloff forced me to look at it again. Plus the fact that I was already familiar with the company helped me pull the trigger. DISCA is trading around $41-$42 and is down from $77.27 on March 19, 2020.

Keep in mind this is not a full valuation exercise. I didn’t include the Advance/Newhouse preferred shares. This post is just a quick way for me to chop down some notes on the company.

Discovery didn’t fall off a cliff because of some bad news related to the company. It’s victim of a massive sell-off of shares related to the collapse of a hedge fund. Archegos Capital Management received a margin call and was forced to flood the market of shares.

Discovery themselves put out a press release on Friday during trading hours:

Discovery (Nasdaq: DISCA, DISCB, DISCK) today announced that today’s trading activity is not the result of insider transactions or transactions by Advance/Newhouse Programming Partnership or its affiliates.

The Company issued its outlook for the first quarter of 2021 on February 22, 2021 and provided additional guidance at the Deutsche Bank TMT Conference on March 8, 2021, and is comfortable reaffirming its outlook and the additional guidance. The Company is confident in and pleased with the execution of its strategy, both with respect to its traditional business and the direct to consumer roll out. It looks forward to releasing first-quarter results and hosting its quarterly investor call on May 10, 2021.

Source: 2020 Proxy

We know that the largest shareholder, Advance/Newhouse Programming, is not the seller and it’s reasonable to think it’s not John Malone. Vanguard and BlackRock are ETFs. So we had one guy, through a couple banks, dumping blocks of shares at whatever price to cover his debt. Along the way this probably triggered algorithms to sell too, which further fueled the downward spiral. 

Discovery has three classes of common stock:

• Series A has one vote per share
• Series B has 10 votes per shares
• Series C has no votes.

Discovery is in an out-of-favor industry (cord-cutting), but is able to produce quality content for significantly less than other media companies and has a large subscriber base. Do not underestimate the creator of the 90 Day Fiancé. They bought Scripp (HGTV, Food Network) in 2018 for $15b and the Discovery has been a strong performer over the last couple years.John Malone also owns a good chunk of it and controls a good block of the voting power. If shares don’t rebound, it could be an interesting acquisition target. 

Discovery+ seems to be a hit. It has surpassed 11 million total paying direct-to-consumer subscribers globally and is on pace to be at 12 million by the end of the month. With cord cutting, Discovery+ is the future of the company. There’s an old saying: Adapt or die. Well if you don’t adapt to the digital world you die. 

Streaming is shaping up to be a tough business. The competition is heating up. It will be a war on price and content. Netflix has a first-mover advantage, Disney has content, great brands, sports and families, Amazon has AWS to pump money into Prime, Apple is a juggernaut with 40%+ of the device in people’s hands. AT&T’s HBO has premium content and will be fine. As for CBS/Paramount+, NBC Peacock and the rest I don’t know. Discovery might be a modest success. They have a loyal following with women in above-average-income households. Discovery boasts 3 of the top 4 women’s networks. They also have a good international presence. The trick is trying to find a  balance between growing streaming and not cannibalizing the cable cash cow too much.

However, the economics of streaming require significant scale to turn a profit. We are in the early innings of the streaming era. Disney’s streaming is not profitable yet and I think Netflix recently just turned free cash flow positive. The problem I see with the streamers is they are now on the content & technology treadmill. They need to spend a massive amount on content and technology every year to stay in the game. Discovery has the advantage of creating less expensive content. Where most of the streaming media business has gravitated toward scripted series and movies, Discovery has settled on the unscripted, home, food and travel shows that garnered large audiences but had relatively little high-profile competition in terms of content. Producing Property Brothers, Gold Rush, and the 90 Day Fiance doesn’t break the bank. And they have Shark Week.

Discovery has been a strong buyer of its own shares over the years. In 2020 they repurchased $965M of DISCK stock at an average price of $23.18. Given where the stock trades today this has been highly accretive. Share buybacks are a great idea if the market is failing to recognize the value of a current stock. If shares languish the future buybacks will be highly beneficials.  They also spend some FCF on reimbursing debt.

Discovery uses a metric called adjusted OIBDA – operating income before depreciation and amortization.It’s similar to EBITDA, except with OIBDA, the calculation is started with GAAP net operating income. In EBITDA, the calculation is started with GAAP net income. OIBDA is used to give a clearer picture of the profitability in continuing business activities without taking into consideration the effects of capitalization and tax structure.

Discovery’s market cap after the selloff is approximately $18.5 billion, with trailing free cash flow of $2.34 billion. I’m guessing FCF will be between $2.5b and $3b in the future. To stay on the conservative side, and I’m working with $2.3b. This works out to a FCF yield of 12.6%, or only 7.9x FCF on equity. This is cheap, despite the future opportunity ahead and the quality of the company. Decent companies these days are trading at sub 5% FCF yield. If you were a private acquirer, how much would pay for the whole company? Disney bought Fox for 13x EV/EBITDA. Comcast bought Sky around 16x EBITDA. Discovery could probably attract similar multiples in the event of a sale. The value of the firm is currently $31b, it would have to command a 30%-50% premium to compensate for the selloff and the take-over premium. The market is pitching you a fat pitch.

Now I know that, for the sake of time and simplicity, my FCF calculations are flawed. They are not based on a fully diluted basis. I didn’t include the full conversion of the convertible preferred owned by the Advance/Newhouse interests. So the real FCF per share should be lower. In a take over scenario I would have to use fully diluted numbers. In my head I know what’s going on, but please if you are serious about investing in this company make sure you include them. These back of the napkin numbers are to give me ballpark range.

Discovery is the one of the largest global media providers with over 2 billion cumulative subscribers in over 220 countries. When you buy Discovery, you get a piece of Discovery, TLC, Animal Planet, HGTV and Food Network.

Discovery prints money and has an interesting cost profile. If the price stays low it will be bought out for its great content. Meanwhile share buybacks and debt reimbursement will benefit equity holders.

I didn’t buy this stock to hold forever. It’s more of a trade. I’m buying shares from a good company from a desperate seller. I will probably resell when the mood shifts or when it hits a reasonable valuation. A 12.x FCF (8% fcf yield) multiple would imply a stock price of $57.62, which is 38.8% higher than post bloodbath price of $41.5 a share. Considering the shares peaked at $77, it’s a reasonable outcome.

Anthony ‘Tony’ Deden and Nick Sleep Links

*March 29, 2021 Update: I added another podcast link. I didn’t realized the Anthony Deden did a 2nd part with Grant William a couple years later. The first part was when Grant Williams was with Real Vision, and the 2nd part is on his own podcast

I added some links to the Investment Resources page. Once in a while I add something I like that I think deserves to be shared.

Below are new links from two investors that I like:

Anthony ‘Tony’ Deden from Edelweiss Holdings

• Anthony Deden | Grant Williams | Real Vision (Youtube)
• Edelweiss Journal
• Remarks by Tony Deden at the Grant’s Fall Conference (PDF)
• 40 ‘invaluable’ investing lessons from Tony Deden (PDF)
• New update: The Grant William Podcast #2

and

Nick Sleep from Nomad Investment Partnership

• All the Nomad letters (PDF)

Interest Rates, Inflation & Economic Confidence

With the vaccin being rolled-out and the economy gradually reopening we have seen rates rise higher. The benchmark 10-year Treasury currently yields ~1.7%. That is still low by historical standards, but higher than it started the year or what we have seen in 2020 (~0.50%). As a result we have seen the high flying Nasdaq correct 10% and the rest of the market bounce around. 

The next big debate is: Is inflation coming back? Are interest rates going up? Rates have been ticking upward. There’s a risk of inflation. Monetary supply has been expanding. We’re seeing commodity prices go up. Take oil prices. Last year oil prices dropped in negative territory and a barrel today is back to $60. But oil is always a wild card. There’s certainly inflationary pressure in other parts of the economy. Fixing my deck got more expensive. A treated 2x4x10 piece of lumber at my local lumber yard went from $4 to $15 in one year. I will never look at a piece of wood the same way. 

Commodity prices play a major role in the cost of living and our behavior as well. They make up the basic input costs to run our lives. Practically everything we consume has a commodity associated with it. How much of the rise will be transferred from suppliers to the consumer? Take tissue paper. The price of wood pulp plays a direct role in the cost to make a roll of toilet paper. Pulp prices are going up and that should contribute to higher prices for tissue paper products. 

The Fed has spoken last week and reiterated their new mandate to let inflation go above the traditional 2% target. They project a 2.4% bump in inflation for the year and then it will retreat. Put me in the skeptical category. The Fed also expects the GDP to grow 6.4% for 2021. Mild inflation is not to be feared. Indeed it’s in part changes in the market’s expectations of inflation that drive bond yields down in recessions and up in recoveries.

The government is not backing down from stimulus, the Fed is keeping rates close to 0%, and consumers are sitting on piles of cash waiting to be unleashed. Lockdowns have given rise to pent-up demand. The ramifications of such actions will be felt in the real economy. They will be felt in the markets too.

Higher Rates: Good or Bad?

Depends what you own. Bonds and equities compete for investor’s capital.

Before digging deeper into that let’s rewind a bit. To better understand the price of money, we need to distinguish short-term rates and long-term rates.Short-term rates are dictated by the central bank, the Federal Reserve in the U.S., which is responsible for monetary policy. By fixing short-term rates that banks can borrow at, it pretty much controls short-term rates. The current Fed fund rate is 0.25%. This is the interest rate at which banks lend money to each other, usually on an overnight basis. The thinking goes that low rates discourage savings and encourage investments which boost the economy.

Normally we should expect rates to rise over time due to the growing economy. The idea is to prevent the economy from overheating which could result in higher inflation. Most of the world’s central banks have a 2% inflation target.

Long-term (5yr-30yr) rates are generally set by the market. Numerous factors come into consideration but the state of the economy, future prospects, inflation, and balance sheet affect rates. For example the 10-yr US T-Bill yields 1.7% at the moment and the 10-year Turkish government bond yields 19%. Well a 19% yield looks really nice but you might want to think twice before reaching for this juicy income. The higher Turkish yield gives you an idea of what the market thinks of the Turkish economy – that it doesn’t have the same creditworthiness as the U.S. Inflation is raging (above 15%), the lira is collapsing, you have political risk with President Recep Erdogan, and you don’t have institutional credibility.

The recent rise in U.S. rates is in part due to better economic prospects, rising inflation, and the U.S. balance sheet. Rates also reflect confidence in the government. The U.S. government has to issue a lot of bonds to finance itself with an ever growing deficit. A February auction went poorly. There’s no plan to reduce the deficit or to tackle the national debt around $28 trillion (127% debt to GDP ratio). Now is there a demand for these bonds flooding the market? Well yes but at the right price. Nobody wanted to buy them at 0.5%, so you need to raise the price.

Having said that long-term markets are generally set by the market, that has changed somewhat in the last couple years. Long-term rates are manipulated by central banks buying long-term bonds to bring the rates down. They are often the biggest buyer and we have seen their balance sheet expanding. It’s another way to stimulate the economy but long-term effects are unknown. Among other things it screws up price discovery mechanisms, the market’s natural ability to auto-correct (invisible hand), and capital allocation decisions. Here’s a question no one seems to be asking: What will happen when they decide to unload their balance sheet?

In the U.S. the 10-yr T-Bill forms the foundation for the price of all other assets. It’s used as a benchmark for other interest rates and is thus a barometer of risk appetite in markets and of economic confidence more broadly. And it’s global benchmark. The sharp rise in T-bill yields from the start of the year was matched by yields on bonds in other places. Bond prices move in the opposite direction to confidence; bond yields go in the same direction as confidence. When the economic outlook is bleak, as it was in March last year, yields fall sharply as investors rush to the safety of bonds. As the outlook brightens, bond prices start to fall and yields start to rise again. Bond prices are thus countercyclical most of the time. This feature makes them very attractive diversifiers for equities, the prices of which are more procyclical, moving up and down in tandem with the economic cycle.

In Canada we rely a lot on the 5-year Government bond because we have 5-year mortgages. Because government bonds are the foundation for all other pricing, higher rates will be felt in mortgages, loans and credit cards.

Back to what I would own in a higher rate environment:

I wouldn’t own bonds. Bond prices fall when rates go up. Bonds promise fixed cash payments in the future. Those cash flows are worth less when inflation unexpectedly rises. And I never understood the desire to own bonds that paid less than 1 % (negative real rates). Investors are buying them for the capital gains that came with lower rates, not the coupon. It’s a weird world — Buying bonds for capital gains, not the coupon (and investors buy stocks for the coupon).

There’s a camp that says when rates go up you should be invested in equities. But not for all stocks. With the recent rise in yield, we have seen high flying tech stocks take a beating.

Higher interest rates have hurt high growth stocks like Tesla more than others. For starters, higher interest rates make it more expensive to finance growth. Second, high growth companies generate most of their cash flow far in the future. Higher rates make the promise of future cash a little less attractive, relatively speaking, than higher yield from bonds in the present day.

Net Present Value formula. Take a cash flow and divide it by the discount rate.

If you have ever looked at a discounted cash flow model (DCF), a tool used to price assets based on projected cash flow and its risk, you know how sensitive it is to a discount rate. The value of an asset is the sum of all its future cash flow discounted to the present. That’s the formula in the graph above. Take a cash flow, let’s say $100,000, apply a 5% rate, you get  $95,238$ (1/1.05). Now apply a 10% rate (100,000/1.10), the value of your cash flow falls to $90,909. Also, to compound the effect, the further a cash is projected, the more sensitive it is to a change in rate. That’s why a 30-year old bond is more affected by a rise in rate than a 5-year bond. The projected income in the late years is whacked which affects the value of your bond.

If you are a start-up, your valuation is probably based on future cash flow estimates, and in a DCF model the terminal value carries most of the value. A slight rise in the discount rate and you can see the value drop like a rock. This explains why the Dow held up better than the Nasdaq during the recent rise in rates.

Now that I’ve told you what I wouldn’t own in a higher rate environment (bonds and unprofitable high flyers), I would focus on high-quality companies with growing income that are trading at a reasonable price. Because their business model is already proven, profits are reliable and not based on future projections that are subject to get beat up if rates are rising. Balance sheet quality is also important. A highly indebted company will see its cash flow pinched by higher rates. A company with a healthy balance sheet will retain more profit for shareholders and will be able to finance at a better rate if needed. 

In a rising rate environment, equities might get beat up in the short-term, but in the long term a rise in rate might signal a stronger economy that might support higher earnings and a higher stock price.Also equities have generally outpaced inflation over the long haul. 

Higher rates might bring a correction in the growth stocks everybody is talking about. The cool hot stocks will get cold. I would keep a list of these high quality growth companies that are at insane prices and wait for them to correct. A rising rate environment presents an opportunity to buy them at a cheaper price.

NFT – Fad, Fraud or Innovation?

The First 5000 Days by Beeple sold for a record-breaking $69.3 million at a Christie’s online auction.

Regular readers know that I’ve been keeping an eye on cryptocurrencies and the blockchain. It’s a fascinating space even thought I don’t have any investments in cryptos at the moment (I did but my exchange got blown up in a massive fraud). I’m sure you have heard about non-fungible tokens (NFT) by now, the current flavor of the month in business news. I read about NFTs in the past (cryptokitties) and it seemed to be nothing more of than a nerd sub-culture of a sub-culture. I was quite skeptical and it didn’t seem important enough to invest the time.

Then the Beeple sale happened.

Last week a purely digital work of art, The First 5000 Days, by Beeple sold for a record-breaking $69.3 million (42329.453 Ether) at a Christie’s online auction. The bidding opened at $100. According to Christie’s, during the last few minutes of bidding, a total of 33 active bidders from 11 countries competed for the piece, with 22 million visitors tuning into the auction. This is the third-most valuable piece ever sold by a living artist.

Once you start reading about blockchain and cryptos, it doesn’t take long to fall really deep into the rabbit hole. I get it, there’s a lot to digest. It’s an intersection between philosophy, finance and technology. Not the easiest subjects to grasp. Just the lingo makes your head spin. Blockchain, cryptos, NFTs, DeFi (decentralized finance), record breaking digital art sale by an artist named Beeple that was bought by a NFT fund named Metapurse run by a guy named Metakovan. This is all real or I think it is. For the past year I’ve wake up wondering if I’m in the real world or if I’m in some kind of bad Matrix prank just waiting to snap out of it.

Right now, I can’t tell the difference between what is a fraud, a fad, or a innovation that’s here to stay. Are we in the first inning or second of NFTs? Will this become the standard in 10-15 years? Is this the tip of a $1 trillion plus industry? Or is this another ridiculous speculative mania that will spectacularly crash?

Distressed Investing

“How did you go bankrupt?”

Two ways. Gradually, then suddenly.”

― Ernest Hemingway, The Sun Also Rises

Distressed securities is a niche space. It’s a big contrarian playground. It’s an area filled with mispriced assets. When companies become distressed, they go through restructurings. If you like reading long complicated legal documents then there’s an investing space just for you. Besides lawyers, investors willing to do the work can profit from bankrupt companies. Investing in distressed securities is the practice of trying to find inefficiently priced securities in companies that are restructuring and going through significant change. Because it’s a complicated, risky, and messy space, lots of investors shy away. The inefficiency and lack of investors creates opportunities for the investor willing to get their hands dirty.

First a little background on bankruptcy. Up until the mid-19th century defaulters were treated harshly. Defaulters were thrown into debtor’s prison called the Schuldturm—the prison tower that was the destination, in the past, for those who couldn’t pay their debts. The word “bankrupt” derives from banco rotto, the practice in medieval Italy of smashing the benches that merchants sold their goods from if they did not pay their debts. Unless you deal with the mafia, which has inherited some of the old Italian ways if you don’t honor your debt, today’s bankruptcy proceedings are less violent. 

Euphoria

We live in strange times. I don’t know if this is just me, but right now with everything that’s going, and all the changes, I can’t differentiate what is a fad or a revolution.