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$DG and $WMT
It has been a wild ride since the start of the pandemic.

I'll publish a complete update on $DG on Tuesday morning (Monday is a holiday in the U.S.), but one quick thought: I'm pretty surprised to see them reiterate the FY22 EPS guide (I think the market is as well, which is why shares are up 10%+ premarket). We saw significant P&L pressure on both GM's and SG&A this Q (with EBIT -18% YoY), which leaves a lot of work over the remainder of the year to get to DD EPS growth (53rd week helps).

On the other hand, $DG looks well positioned IMO to navigate through this period (relative to retail peers; I'll need to update $WMT, $DLTR, and $FIVE as well). As shown above, they lagged by a wide margin throughout FY21, largely due to business mix. Based on commentary from Walmart and Target, I think we'll see some of that reverse going forward. (A lot of the general merchandise categories that $DG has a small / no presence in are rolling over.)

As always, it's important to keep short-term results in the proper context (assuming you're a long-term investor, as I am). The underlying TSR algorithm for $DG remains in tact, and pOpshelf, Mexico, etc., are important additions to the thesis (optionality). FWIW, the equity traded at ~17x forward in advance of the Q1 results.

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Looking forward to it, I had noticed that Dollar General rocketed this morning, more so than the broader market.

Anything in particular during the call you felt that catalysed that? Not that it ultimately matters, but.
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“A New World of Travel”?
In Q1 FY22, the global leader in alternative travel accommodations reported the strongest quarter in the company’s history, with Nights & Experiences (N&E) booked through Airbnb crossing 100 million for the first time (+59% YoY); this reflects strength in LatAm, North America, and EMEA, offset by weakness in APAC due to subdued cross-border travel. As shown below, trailing twelve month (TTM) N&E booked were 338 million, an all-time record for Airbnb. Guidance calls for another quarter of more than 100 million N&E booked in Q2, with the TTM figure climbing to ~361 million; at current ADR’s, that’s an annual GBV of >$60 billion, up ~2x from FY18.

On top of 26% growth in N&E booked versus pre-pandemic levels (Q1 FY19), GBV and revenues both grew by >70%. That outcome is largely reflective of a nearly 40% increase in average daily rates (ADR’s), with the cost of an average night climbing from $122 in Q1 FY19 to $168 in Q1 FY22. (As noted in the letter, revenues and EBITDA are “highly sensitive” to ADR’s.)

The company reported mid-teens adjusted EBITDA margins in the first quarter, attributable to a combination of underlying business strength and the heighted cost discipline that I’ve written about previously (on a dollar basis, adjusted EBITDA in Q1 FY22 improved by nearly $500 million versus Q1 FY19). TTM adjusted EBIT margins were ~13%, a significant improvement relative to all prior reporting periods (this is my preferred metric of profitability for ABNB, which accounts for SBC and D&A). From my perspective, the financial results reported over the past 12-18 months clearly show the underlying attractiveness of Airbnb’s business. (And the balance sheet remains very strong as well, with ~$3 billion of net cash at quarter end.)

Long-Term Stays

Management remains convinced that the pandemic, most notably due to the widespread adoption of remote work, has led to “a new world of travel”.

CEO Brian Chesky: “Millions of people are now more flexible about where they live and work. As a result, they’re spreading out to thousands of towns and cities, staying for weeks, months, or even entire seasons at a time. Through our adaptability and relentless innovation, we’ve been able to quickly respond to this changing world of travel. Now, two years into the pandemic, Airbnb is substantially stronger than ever before.”

As I’ve written previously, Airbnb’s customer value proposition and its differentiation from industry peers (hotels) is most evident on long-term stays; its competitive position improves as average stays lengthen (“the longer guests stay, the more we believe they value the amenities and convenience of staying in a home”). This use case became increasingly popular during the pandemic, with the shift in Airbnb’s business mix continuing to show in the Q1 results (the mix of 28+ day stays is still ~50% higher than it was in 2019). $ABNB

This is a preview of Monday's post (Airbnb: "A New World of Travel"?). To read the remainder of this post, please subscribe to the TSOH Investment Research service.

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Not an investor, but have read a lot of yours (and others) writings on the name. As an observer, it is quite fascinating to "trend watch" as Airbnb does its thing.

What are your thoughts on the cyclicality of their business versus the regular hotel & leisure industry?
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Peloton: "What's Next?"
In “The Magic Happens on the Screen”, I wrote the following:

“Is there some way to tweak the equation, both in terms of the dollar amount spent over the product’s useful life and the mix between upfront and recurring monthly costs, that results in a more attractive customer value proposition and a sustainable long-term business model for Peloton? I suspect that CEO Barry McCarthy and the team are working through this as we speak.”

On May 10th, Peloton reported quarterly results for Q3 FY22 – and in McCarthy’s first opportunity to directly communicate with the company’s shareholders, “Mr. No Bullshit” lived up to his reputation. The primary takeaway? While Peloton clearly faces a number of significant short-term headwinds, the reimaging of the company’s business model has begun.
Starting with the financials, the connected fitness (CF) base continues to grow, ending Q3 at ~2.96 million subs (~6x larger than pre-pandemic).

However, the pace of CF sub growth has slowed significantly. Based on the Q4 guide, Peloton will add 650,000 net CF subs throughout FY22, compared to a peak TTM contribution in Q4 FY21 of 1.24 million net CF subs. As shown below, this has led to a large deceleration in the YoY growth rate (it’s been cut in half over the past six months, with the Q4 guide implying YoY CF sub growth of less than 30%). As with many companies, it’s now apparent that the pandemic was a one-time, and temporary, boost for Peloton – and the hangover presents real challenges. (“Management’s view was that there was a paradigm shift… It was a false narrative.”)

The slowdown in CF sub growth aligns with the significant decline in new hardware sales, with Connected Fitness product revenues down 42% YoY to $594 million. Meanwhile, the company ended the quarter with $1.41 billion in inventories, up 50% YoY. Simply put, Peloton has been blindsided by a huge decline in customer demand (and as a reminder, the price of the core Bike offering has been reduced by ~35% since September 2020); this has put a lot of strain on the company’s financial position, with FCF of -$747 million in the third quarter. (“We have too much [inventory] for the current run rate of the business.. it has consumed an enormous amount of cash.”) That said, management believes this is ultimately a timing issue (“the obsolescence risk is negligible”); if that proves accurate, it will provide a much needed tailwind in the coming year (“Our goal is to restore positive FCF in FY23”).

But first, the company has to make it through FY22. As McCarthy noted in the letter, Peloton is “thinly capitalized for a business of our scale.” In response, they issued $750 million of five-year term debt, which should provide sufficient oxygen to manage the business through the remainder of the year. (McCarthy: “With the money we raised in the term loan, I'm very confident we've got plenty of capital, regardless of what happens in the economy, full stop. To the extent that there are concerns amongst investors about our ability to do that, I don't share them.”) It’s also worth noting, as reported by the WSJ, that Peloton has considered selling 15% - 20% of the company to a minority investor; needless to say, liquidity concerns only add to the stress for a company that already faces many difficult decisions.

This is a preview of Thursday's post (Peloton: "What's Next?"). To read the remainder of this post, please subscribe to the TSOH Investment Research service.

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I have read a lot of biased and/or after-the-fact post mortems of Peloton, but this one was great. You always seem to bring an objective edge to your reports, thanks for sharing :)
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"The Magic Happens On The Screen" ($PTON Deep Dive)
This morning, I removed the paywall on my $PTON deep dive.

Tomorrow, TSOH subscribers will receive an update on Peloton.

On February 8th, Peloton announced that co-founder and CEO John Foley, who had led the company since its founding back in 2012, was stepping down (the company also announced plans to “right-size the organization”, which will lead to a workforce reduction of ~2,800 employees). Foley’s replacement, 68-year old Barry McCarthy, is well known in the investment community; he was the CFO at Netflix from 1999 – 2010 and the CFO at Spotify from 2015 – 2020. McCarthy’s hiring is the primary reason why I decided to look at Peloton. As I’ll discuss in today’s write-up, I believe McCarthy was a great hire for Peloton, particularly given his experience at Netflix in the 2000’s.

(The “shotgun marriage” was well received by the market, with the stock climbing from ~$25 per share to ~$39 per share in a week; it has since given back a lot of those gains, and currently trades at ~$28 per share - more than 80% below its December 2020 highs. Also note that Foley’s exit came just 24 hours after Blackwells Capital published a deck lambasting the CEO.)

A week after he was hired, McCarthy was interviewed by the FT.

In that discussion, there were two key points that stood out to me.

First, he doesn’t want Peloton to be sold (which likely puts to rest, at least in the short-term, speculation about a deal with Amazon or Nike): “If I thought it was likely that the business was going to be acquired in the foreseeable future, I can’t imagine it would be a rational act to move across the country. There are lots of other things I could do with my time that are [more] lucrative than hanging out with a business that’s about to be sold.”

Second, he believes strategic changes are required: McCarthy said his growth strategy would focus on content, explaining that “where the magic lives” is on Peloton’s digital screens, not its connected bikes or treadmills. Expanding the digital community and enhancing content could make Peloton ‘a very fast-growing business with very high margins’. His playbook will include developing ‘product line extensions’ so customers could own multiple machines… ‘An entirely different pricing structure’ could replace the $39 monthly subscription… McCarthy declined to comment on specific launches but emphasized Peloton was ‘a connected fitness company, not a bike company’.”

Following a roller coaster ride for the business (and the stock price) over the past 24 months, Peloton is at an inflection point; as McCarthy wrote in his first email to employees, “Now that the reset button has been pushed, the challenge ahead of us is this... do we squander the opportunity in front of us or do we engineer the great comeback story of the post-Covid era?”


Peloton ended Q2 FY22 with ~2.8 million Connected Fitness (CF) subscribers, a roughly 4x increase in 24 months. I don’t think it’s an overstatement to say that Peloton is loved by its core customers, with U.S. NPS scores in the high-80’s. With a $39 per month fee for ongoing access to the company’s digital content and instructors / classes, the CF sub base generates ~$1.3 billion in run rate revenues, with monthly churn below 1%.

As shown below, the number of workouts per average subscription ramped during COVID, climbing ~2x to a peak of 26 workouts per month. But that tailwind is fading: as the world reopened, average workouts per subscription fell ~35%. (As disclosed in the 10-K, the average subscription covers 2.2 members; that implies an average of seven monthly workouts per member.)

In addition to the CF subscribers, the company has ~900k subscribers who pay ~$13 a month to access Peloton’s digital content without the company’s hardware (run rate revenues of ~$140 million). As noted on the Q3 FY21 call, the Digital to CF upgrade path has been a nice source of growth for Peloton over the past year (“Over 20% of our Digital subscribers ultimately upgrade to CF… We can think of no better way to introduce fitness-minded consumers to the amazing quality, breadth and depth of our content offering.”). However, growth has stalled for the digital sub base; following a rapid ascent over 15 months, digital subs have been flat since Q3 FY21.

In total, Peloton generated $4.1 billion in TTM revenues in Q2 FY22 – roughly 10x higher than at year-end FY18 (FY22 guidance calls for revenues of ~$3.8 billion). While the business “ran off the rails”, it’s still worth noting that this company put up impressive growth over the past few years.

McCarthy’s Vision

Peloton has lived through a handful of high profile issues in the past year, most notably a delayed response to safety concerns for the Tread+ (after calling the CSPC’s warnings “inaccurate and misleading”) and a $1 billion stock offering just 12 days after CFO Jill Woodworth assured the market it did not need outside funding (“we don't see the need for any additional capital”).

Not to be flippant, but I don’t think these events had a meaningful impact on brand perception among customers; for that reason, our time is best spent focusing on the future, not the past. Which brings us to McCarthy’s vision for Peloton. Luckily, interviews with the FT and the NYT have provided a lot of color on the opportunities that he sees; in addition, his work at Netflix and Spotify may offer some insight into how he will run Peloton. At a high level, these are the three key points I’ve taken from the interviews and from thinking about McCarthy’s prior executive experience:

1) McCarthy is primarily focused on the software / content opportunity. When asked about his long-term vision for Peloton, McCarthy replied:

The magic doesn’t happen in the sheet metal. It needs to be good enough, but it’s not sufficient. If it’s just NordicTrack, you’re not winning. The magic happens on the screen… It’s the music, it’s the instructors, it’s all the social aspects that we have only just begun to develop - and that’s where we’re going to spend our money. Today, it’s a closed platform - but it could be an open platform... Could it be running an app store?”

While “the magic happens on the screen”, I think Peloton’s hardware still matters; what truly differentiates the Peloton experience is the integration of hardware and software. In addition, product line extensions provide the opportunity to expand the TAM (“Mr. Foley said he expects the Tread to eventually outsell bikes as the market for treadmills is 3x bigger than for stationary bikes [over the last two decades in the U.S., ~5 million treadmills sold per year and ~1.6 million stationary bikes sold per year]… We believe there are 35 million American households with a treadmill in their basement”). So, while the end goal is to grow the sub base, which demands even larger investments into the stuff that happens behind the screen (classes / instructors, software, etc.), it will be interesting to see what that means in terms of McCarthy’s focus (as it relates to CF growth versus digital growth).

2) The company is going to test different pricing strategies. In August 2021, for the second time in less than a year, Peloton announced that it was reducing the cost of its core bike offering by another 20%; as a result, the cost of the core Peloton bike is now at $1,495 – a third lower than what it cost in mid-2020. (Note that the company introduced a $250 delivery and setup fee in January 2022, meaning that the effective price for the bike is $1,745 – still more than 20% below the mid-2020 price.) But it doesn’t sound like the August 2021 price cut is the end of the line. When McCarthy was asked about the potential need for additional capital; this was his response:

“The answer is maybe… Regardless of what the strategy is, you need a capital structure to support it. So if it becomes this enormously capital-intensive business because you’re giving away a $2,000 bike and then recouping it over time, you can absolutely raise capital around it. It would be some combination of debt and equity - mostly debt like we used at Netflix, because the bigger the subscriber base gets, the more predictable the revenue stream gets. And the more predictable the revenue stream gets, the more leverage you can put on it.”

As management wrote in the Q4 FY21 shareholder letter, “We know price remains a barrier and are pleased to offer our most popular product at an attractive everyday price point. We are also introducing a longer 43-month 0% financing term option for Bike+ and Tread across all regions.” Despite a 20%+ (all-in) price cut on the bike and attractive financing terms, it sounds like McCarthy believes there’s still work to be done on pricing.

3) McCarthy will look to a well-worn playbook. In a 2019 WSJ interview, while still at Spotify, McCarthy was asked how the long-term strategy at the company compared to Netflix. This was his reply (bold added for emphasis):

For more than a decade, the Netflix strategy was low price, at the expense of margin, to drive increased share of market and faster growth. We’re pursuing a similar strategy. I often get the question, why don’t you increase the price? And many record labels feel like we’re undervaluing their music. It’s very similar to the feedback we got from studios at Netflix. The investment in new content to drive growth for Netflix was in streaming content on top of the DVD content. For Spotify, the investment is in podcasts. Original podcasting content for Spotify comes with a fixed cost, just like the streaming investment for Netflix came with a fixed cost, and over time, as it became a large percentage of the business, it shifted the Netflix cost structure from variable to fixed. That had some profound implications for the evolution of that business model.”

The strategy at Netflix and Spotify was: (1) low prices, at the expense of margin, to drive global subscriber growth and high market share; (2) as the business scales, find a fixed cost lever; (3) rely on that combination of scale, fixed cost leverage, and a point of differentiation to sustain that dominant market position, with “profound implications” for the business model.

Much like at Spotify and Netflix, it will take many years for this long-term vision to result in consistent and meaningful profitability / FCF, particularly if McCarthy acts as aggressively as I suspect he’d like to (in pursuit of unit / subscriber growth). As McCarthy said on Spotify’s podcast strategy, “What you’ll see first is an investment in content and growth in engagement, and monetization will follow.” I expect to see a similar approach at Peloton.

Betting on Management

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

I took that Warren Buffett quote as gospel as a young investor. But over time, I’ve come to a more nuanced view: truly great managers have a knack for finding and building attractive businesses. An instructive example is Jeff Bezos: if Amazon never moved beyond its roots (first-party e-commerce, let alone a narrow category focus), it would be a small fraction of its current size. But along the way, Amazon built a wonderful business that caters to the needs of third-party sellers (fulfillment, advertising, etc.); in addition, they discovered a massive new market opportunity in AWS by commercializing their internal tech capabilities.

McCarthy’s experience at Netflix and Spotify follows a similar storyline. Without vision and execution, those are completely different companies than what we see today (and that assumes they’d still be in business). That outcome was largely due to management, culture, and a willingness to make bold bets, not business reputation. (Unsurprisingly, McCarthy agrees: “The thing I learned early in my career is that being a successful investor is all about picking the right guy or gal, because as an outsider you never know enough to really make an informed decision; you’re almost entirely dependent on the abilities of the people you’ve invested behind.”)

How does that relate to Peloton? It’s not apparent to me that this is destined to be a “good business” or a “bad business”. Instead, when we look back in ten years, I think the outcome will largely be dependent upon management’s strategic decision-making and internal execution.

Product Market Fit

As McCarthy told the NYT, “I know from my experience that product market fit is the hardest thing on the planet to find. And once you find it, it’s almost impossible to screw it up no matter how hard you try.” Customer data supports this conclusion, particularly among the CF subs. But how deep does this love run? How big can Peloton’s subscriber base become?

On the digital subs, I believe they’ll remain a secondary consideration (lead generation for CF). The true Peloton experience comes from the integration of hardware and software. (“Foley first considered developing just a software platform, but he discovered that by being vertically integrated they’d be able to deliver a dramatically better experience for consumers.”) In addition, I’d note that many use cases for a standalone fitness app, like yoga or strength, do not offer the measurement / gamification / social component that’s a big value add for the bike and Tread (“the motivating power of a community and integrated metrics that push riders to be their best”).

If you agree with that conclusion, the focus is expanding the TAM for the integrated offering (CF subs); how can Peloton serve the broader fitness market, the ~200 million people around the world with a gym membership, as opposed to 5-10 million high-end, “serious about fitness” customers?

But Peloton was already moving in this direction. “Greater [hardware] affordability” was a key part of the long-term plan for reaching 100 million subscribers (“Our aim is to break down barriers to purchase and broaden our reach, and we have implemented strategies along the way to achieve both of these goals”). As noted above, they’ve already cut the bike price by $500, inclusive of the $250 delivery and setup fee. In addition, they offer 0% financing, which means you can buy a Peloton bike for less than $50 per month with no money down (excluding the $39 per month for a CF sub).

Is current product (hardware) pricing a major deterrent for somebody who is comfortable paying $39 per month for access to instructor-led bike rides? Would their willingness to buy change if the upfront cost was reduced (another) ~$500 with the monthly subscription increased ~$10?

Or is the TAM for a stationary bike that has an all-in cost over the first 36 months of more than $3,000 simply a lot smaller than the ~200 million people around the world with a gym membership (“90 million of those are in our four current markets: the U.S., U.K., Canada and Germany”). As a point of comparison, note that Planet Fitness just reported that 9.7 million people currently pay for their Black Card membership, which costs $22.99 per month (over a three year period, that’s still an all-in cost of less than $1,000).


Given that Peloton’s “special sauce” is the relationship with instructors and the gamification / social aspect of workout streaks and leaderboards, McCarthy’s vision – “expanding the digital community and enhancing content” – seems appropriate. Getting “the product” in the hands (on the feet?) of a wider customer base is a huge opportunity for Peloton. In addition, they’ve clearly establish brand / product differentiation in the marketplace; it’s the reason why Peloton has been able to sell millions of bikes while charging ~2x more than competitors.

But how do they get to 10 million CF subs, let alone 100 million?

With “high NPS and low churn”, reducing the CF subscription fee might be a tough pill to swallow, especially in the short-term (and that assumes it would have a meaningful impact on bike / treadmill purchases, which isn’t a given). If that’s off the table, we’re left with lower hardware pricing… a continuation of Peloton’s recent strategy. (“The company said in a confidential presentation dated January 10th that demand for its connected fitness equipment has faced a “significant reduction” around the world due to shoppers’ price sensitivity and amplified competitor activity.”) That doesn’t seem to fit McCarthy’s vision of an “entirely different pricing structure”. Is there some way to tweak the equation, both in terms of the dollar amount spent over the product’s useful life and the mix between upfront and recurring monthly costs, that results in a more attractive customer value proposition and a sustainable long-term business model for Peloton? I suspect McCarthy and the team are working through this as we speak (“I think there’s enormous opportunity for us to flex the business model and dramatically increase the TAM by lowering the cost of entry and playing around with the relationship between monthly recurring revenue and the upfront revenue.”)

At the end of the day, Peloton has a better mouse trap than competitors who just sell “dumb” hardware. Subscription revenues result in much higher lifetime gross profits per customer relationship; in combination with scale and (some much needed) operating efficiency, this should give Peloton the ability to price more aggressively, while still maintaining differentiation and high NPS scores. (“We are at a critical inflection point in our business. These are the early days of a significant transformation of our operating model to achieve a better balance of growth and efficiency.”)

Finally, I think McCarthy has an ability to see what matters and to clearly communicate his ideas, which will be important internally (with employees) and externally (with investors) given that this situation will require buy-in from key stakeholders (see McCarthy’s comment on Netflix’s funding / capital structure). He will need that trust if he announces a radical change, such as an “entirely different pricing structure”. This comment, which McCarthy made back in 2010 while at Netflix, is worth thinking about (as shown above, Peloton’s subscription business now has gross margins in the mid-60’s):

We’ve been playing a market share game… When we attached streaming to the service, we didn't increase the cost. We just increased the benefits, and, in effect, lowered the margins to what amounts to a price cut in order to continue to drive fast growth and penetrate the consumer marketplace and build the brand and scale, anticipating that there would be competition… Over the long run we will be a more profitable business with very large share and relatively low margins than we would be with relatively small share and high margins.”

As a long-term, concentrated investor who started looking at this company a few weeks ago, patience seems warranted; importantly, I suspect it won’t be long before we see notable changes at Peloton. (McCarthy: “In the months ahead, you can expect to hear from me about our strategy and the choices we’re planning to drive our success.”) Looking forward, my focus as an analyst is to further understand how pricing and business model tweaks can potentially help to attract tens of millions of CF subscribers over time.

To reiterate, I think McCarthy is a great fit for this role given what he lived through at Netflix (the economics of DVD distribution, pricing strategy in competition with Blockbuster, and the early days of video streaming); if that’s proven correct, I believe Peloton will capitalize on a massive long-term market opportunity. I’ll leave the new CEO with the last word:

It’s a religion. If we can’t figure out what to do with that, then shame on us.”

NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. The TSOH Investment Research Service is not acting as your financial advisor or in any fiduciary capacity.
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"Just Keep Swimming"
(Recent Disney Posts: Q1 FY22, Q4 FY21, Q3 FY21, Theatrical + IP)

In Q2 FY22, Disney+ reached ~138 million global paid subscribers (+33% YoY); inclusive of Hulu SVOD and ESPN+, Disney’s DTC services have more than 200 million paid subs. As these numbers suggest, and the charts below show, Disney has gained a lot of ground on the industry leader, cementing its position as a top player in the global VOD business. (That said, Netflix’s run rate DTC revenues are still ~120% higher than Disney’s.)

In addition, as management reiterated on the call, they believe Disney+ will have 230 million to 260 million subscribers by FY24 (implies another ~80% subscriber growth from here); that outcome, if achieved, would likely put the Disney+ global sub base on par with Netflix. (“Disney+ isn’t even five years old yet; it's still a toddler. There’s lots of growth to come on Disney+.”)

In terms of the financial profile for Disney’s DTC services, I’m encouraged by the trends that we’re seeing (and I remain fully convinced that these will be incredibly profitable and valuable businesses over the long run).

The “streaming is a bad business” drumbeat has grown louder over the past 6-12 months, but I’m of the opinion that this conclusion will prove a misguided half-truth in the fullness of time for those who achieve global scale, notably Disney and Netflix (industry reshuffling will contribute to that outcome – and amidst a period of heightened concern about the long-term economics of the business, particularly for the subscale players, I think it’s likely that this day is near). For example, consider the progression for Disney’s DTC run rate revenues and run rate programming & production costs since early FY20.

As you can see, DTC run rate revenues (including Hulu Live) increased by ~120% over the past two and a half years, from ~$8.7 billion to ~$19.2 billion. Over the same period, run rate DTC programming & production expenses increased ~85%, from ~$7.7 billion to ~$14.3 billion. The net result is that the gap between Disney’s DTC revenues and DTC content costs has increased from ~$1 billion to ~$5 billion (run rate) since Q1 FY20.

To read the remainder of this post, please subscribe to the TSOH Investment Research service_

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Spotify: The Power Question
“The product-market fit and power questions are different questions; one doesn’t necessarily answer the other… When you have a business model that gets you to product-market fit, there may be a power opportunity embedded in that and there may not be. Those are two very different problems. One is the problem of capitalizing on an inherent potential for power; the other is trying to figure out what you’re going to do to get power in something that currently doesn’t have it. That’s a very hard problem; it’s a second invent that’s every bit as hard as the product-market fit invent.

On April 27th, $SPOT reported its Q1 FY22 financial results. At a high level, I think the company’s recent performance has been largely as expected. For example, the world’s leading audio streaming service continues to report strong user growth, with 419 million monthly active users (MAU’s) as of Q1 FY22; the company has added 202 million net MAU’s over the past 36 months, roughly comparable to its total user base at the end of 2018 (207 million MAU’s). This reflects continued growth of ad-supported and premium subscribers, with both user bases up >3x over the past five years. On the user acquisition front, Spotify is winning. (TTM MAU growth in Rest of World in Q1 FY22 was ~25 million, the strongest print in the company’s history; it took some time, but the Stream On markets are now moving the needle.)

The problem is that the company is struggling to show continued progress in its business / financial model, which had led to a >70% decline for the stock from the February 2021 highs, Those issues can be succinctly captured by looking at a single financial metric: gross margins. (As a reminder, this topic has been a key focal point of mine from day one.)

A short history lesson can help us to frame today’s investor concerns.

In March 2018, when Spotify hosted its first Investor Day (prior to the direct listing), former CFO Barry McCarthy shared the following long-term targets.

At that time (FY17), Spotify had ~21% gross margins. In FY21, the company reported ~26% gross margins – an improvement of >100 basis points per year, on average, since FY17. The problem is that the entirety of this improvement occurred in the first twelve months; from Q4 FY18 to Q1 FY22, Spotify’s TTM gross margins increased by ~30 basis points (cumulatively).

One notable point on this topic, as McCarthy discussed in early 2019, is that the >1,000 basis point gross margin lift from YE FY16 – YE FY18 was largely due to label negotiations that were completed prior to the direct listing:

“When I joined the business had a 15% gross margin, but this just wasn't sustainable at that level. So the last round of label negotiations was about elevating the margins to a point where at least the business was self-sustaining. And it was in the economic self-interest of the record labels to allow the margin to increase because streaming has been the single source of renewed revenue growth to labels. So, what was good for Spotify was good for the labels; that's why the margin increased. On a go-forward basis, is that going to happen again? No, it’s not going to happen again. It's not in their economic interest to allow it to happen again.”

In terms of the go-forward improvement in gross margins, McCarthy focused on three key items: (1) the two-sided marketplace in the music business; (2) mix shift to non-music audio content like podcasts; and (3) global scale.

“So, how is it that margin improves? The only way the margin improves is if we provide [labels and artists] with some value-added services that don't exist today that makes their business more profitable, and we benefit as well for doing it… One element on this is the two-sided marketplace, and it's based around understanding the likes and dislikes of your user base, and then creating tools and promotional vehicles for labels that allows them to grow listenership for their artists in ways that don't exist today… Secondly, you change the cost structure of the business. We did that at Netflix, very successful. It was a variable-cost model; we shifted it to fixed. When we shifted it to fixed in the form of upfront investments in streaming content that monetized well, it created enormous operating leverage. So, think podcasts, exclusivity, and extensions of podcasts-like content. Now it changes the working capital attributes of the business. You invest upfront, and over time, you'll reap the benefits of the content you've invested in, provided that your audience engages with the content… At the end of the day, gross margin flows to whoever owns demand creation. If you can shift demand, margin will flow to you… The third category is scaling the business. When we launch in new markets, typically, we run losses for many years. Among the reasons we run losses is that labels extract a toll tax from us in the form of upfront guarantees in order for us to obtain licenses to launch. Over time, we grow into the cost of those licenses, and eventually, those markets shift from gross margin negative to gross margin positive.”

As discussed at the outset, global scale isn’t the issue. The company has maintained its strong leadership position in the industry and will likely have more than half a billion users around the world by the end of 2023.

So, that leaves us with the two-sided marketplace in the music business and non-music audio content, most notably podcasting. Let’s take a closer look at each of those buckets to see how they’ve performed in the past few years, in addition to their long-term contribution to Spotify’s business model.

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Meta: “Appropriately Calibrated”
In “Meta: A Precarious Position”, I concluded with the following:

“A thoughtful discussion on Meta must now address concerns around FoA user growth and engagement (most notably for the blue app), a competitive threat from TikTok, the impact of IDFA and regulatory headwinds on revenue growth, the massive expense ramp (which will continue into FY22), and the ~$10 billion of annual losses at FRL (with very little that we can tangibly point to as the output from that investment). That’s a lot to work through. And when you finish that exercise, I think you inevitably conclude that this bet requires a lot of trust in Zuck and the team (that’s always the case, but this is at another level). Given their impressive track record, I think they’ve clearly earned that trust; however, their actions of late are quickly putting that to the test (to paraphrase Buffett, it took 17 years for Zuck to build a reputation with investors and six months to ruin it).”

That change in perception and lack of trust, most notably as it related to the belief / concern that Zuck was willing to spend an ever-growing sum at FRL, led to a market cap decline following Meta’s Q4 FY21 earnings of ~$250 billion, the largest one-day drop for a company in stock market history.

But right out of the gates on the Q1 FY22 call, it was apparent that management - and specifically Zuck - had come to appreciate the importance of addressing this issue more directly and transparently for shareholders (sorry for the long excerpt, but this is an important topic):

“I think it's useful to level-set on our business trajectory over the last few years. After the start of Covid, the acceleration of e-commerce led to outsized revenue growth, but we're now seeing that trend back off. However, based on the strong revenue growth we saw in 2021, we kicked off a number of multi-year projects to accelerate some longer term investments, especially in our AI infrastructure, business platform, and FRL… But with our current business growth levels, we're now planning to slow the pace of some of our investments… On FoA, I’m confident we can return to better revenue growth rates over time and sustain high operating margins. In FRL, we're making large investments to deliver the next platform that I believe will be incredibly important both for our mission and business - comparable in value to the leading mobile platforms today. I recognize it's expensive to build this - it's something that's never been built before and it's a new paradigm for computing and social connection. Over the next several years our goal from a financial perspective is to generate sufficient operating income growth from FoA to fund the growth of investments in FRL while still growing our overall profitability. That's not going to happen in 2022 given the revenue headwinds, but longer term that is our goal and expectation.”

This commentary has put some much needed guardrails around FRL (which, by the way, still generated an operating loss of ~$3 billion in the quarter). In addition, it was encouraging to see management express some optimism on the long-term trajectory for FoA, which is facing its own headwinds.

As I noted recently in a post about Disney, the interplay between Mr. Market’s views on a company’s long-term prospects / strategic vision and how management chooses to react to that signal can be an interesting dynamic. There are times when management should rightly disregard the short-term worries of the stock market and plow forward. On the other hand, there are also circumstances where I believe Mr. Market’s skepticism should be viewed as a sign to management that an alternative approach should be considered.

With Meta, the market (rightly) expressed concerns about FRL, most notably the scale of investment given management’s own admission that the segment was unlikely to be a material driver of the business at any point in the current decade. With the Q1 commentary, we now have a clearer understanding of how these investments are likely to evolve over the coming years (“the goal is to continue growing operating profits and to fund FRL through that growth of the FoA business”). Management took Mr. Market’s skepticism as a valid reason to consider an alternative approach, primarily in terms of how they communicate their long-term vision with shareholders; in my opinion, it was a much needed change and an important step in the right direction.

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$FB - Communicating With Shareholders
In April, I posted an article titled "Disruption & The "Right" Owners". The focus of the post was the difficulties that Jeff Bewkes faced during his tenure as the CEO of Time Warner, most notably his inability to respond to a new business model (SVOD, as pioneered by Netflix).

This was the key quote from Bewkes, as retold in Tinderbox:

I met with our big institutional owners and asked if they would support flatter earnings growth... moving HBO faster to the global Netflix model. None of them thought the Turner networks could make that crossing... Our biggest shareholders didn't want us cutting our earnings.”

As I noted, that conclusion had major implications:

"If you take this at face value (not revisionists history), what Bewkes is saying here is quite interesting. Even after identifying the right long-term trends and the bets that needed to be made, his shareholders and the risk of short-term stock price weakness effectively tied his hands. Said differently, as early as 2013 or 2014, Bewkes already knew that he didn’t have the ability to effectively compete with Netflix given the constraints that Time Warner faced. Despite the fact that the game was still in its early innings, Time Warner was already positioned to lose (the company’s DTC service, HBO Max, launched in the U.S. six years later, in May 2020)."

I was reminded of this write-up as I reviewed Meta's (Facebook's) Q1 FY22 results.

On the company's conference call, it was apparent that management - and specifically CEO Mark Zuckerberg - had come to appreciate the importance of addressing their metaverse (FRL) investments more directly and transparently. Said differently, they did a much better job of addressing some of the key questions / long-term assumptions that helped contribute to the ~$250 billion market cap decline after the Q4 FY21 earnings.

I won't repost the entire call here, but it's worth reviewing. You'll see how management is intelligently balancing their long-term strategic objectives with necessary disclosures / guidance to give shareholders some much needed clarity on how to think about investments that are unlikely to have a payoff for another 10+ years (and at a time when the core business faces short-term headwinds). This can be a tough balance to strike, but I'm of the belief that FB management is now in a much better position to manage the short-term and long-term needs / objectives of the business.

Just looking at Facebook on the surface, regardless of which of the dozens of metrics I might look at, a dozen separate valuations, whether it’s vs industry peers or vs unrelated companies, they are an absolutely dominant business, period. So many people are over thinking $FB (in my slightly humble opinion) raking in $30 billion a quarter with 2.5 billion daily active users and owns 4/10 most downloaded apps; yet people complain that their growth “slowed down”
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Microsoft: "Taking Share" $MSFT
Amidst a period of heightened angst among market participants, Microsoft reported strong Q3 FY22 financial results that reminded Mr. Market why the tech giant has been one of the best performing mega cap stocks over the past decade. The highlight for the quarter, as has been the case for much of the past five-plus years, was astounding results in the company’s cloud businesses: In Q3, Microsoft Cloud run rate revenues reached ~$94 billion (+35% YoY in constant currencies) – up >5x from the year-end FY17 run rate, and higher than Microsoft’s total revenues in FY16 (~$92 billion).

In addition, Cloud gross margins in the third quarter reached 70% - a cumulative increase of ~1,200 basis points over the past four years.

As CEO Satya Nadella noted on the Q3 conference call, these stellar results - another quarter of 30%+ top-line growth on a nearly $100 billion Cloud revenue base – are reflective of Microsoft’s massive long-term opportunity (TAM): “Going forward, digital technology will be the key input that powers the world’s economic output. Across the tech stack, we’re expanding our opportunity and taking share… Leading organizations of every size and in every industry trust the Microsoft cloud.”

Today, the Cloud businesses account for just under 50% of Microsoft’s total revenues. Said differently, even if the remaining businesses at the company are unable to grow (they can and they will), the contribution from the 30%+ revenue growth in the Cloud businesses alone is enough to drive double digit topline growth. This has quickly become the driving force of Microsoft’s business – and it has led to revenue growth rates for the company that seemed unimaginable five years ago. (In addition, as the cloud businesses have scaled, corporate EBIT margins expanded by >1,000 basis points.)



The Cloud results were inclusive of another strong quarter for Azure (Microsoft’s hyperscale global cloud platform), where constant currency revenue growth accelerated slightly to +49%. (“We are seeing larger, more strategic Azure commitments from industry leaders… The number of $100 million+ Azure deals more than doubled year-over-year.”) Based on the YTD results and the Q4 commentary, I estimate Azure will exit FY22 with run rate revenues of ~$50 billion while growing 40%+ YoY (said differently, Azure is likely to generate more than $15 billion in incremental revenues in FY23).

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Has Twitter Truly Changed?
Given the recent developments at $TWTR, I've decided to remove the paywall on my December 2021 post, "Has Twitter Truly Changed?" As I wrote at that time, "I’d rather a company be forthright with investors, even if it means pulling guidance, as opposed to stubbornly clinging to an unrealistic goal." I think it's an open question whether sticking with the unrealistic mDAU targets put the company in a tough position once they faced an outside bidder (it's hard to say "this offer is insufficient" while simultaneously telling investors "we can't hit our numbers"). Hopefully we get some great reporting on this story! The entire post is reprinted below.

In “Twitter: An Audacious Goal” (05/21/2021), I wrote the following:

Has Twitter truly changed? The Analyst Day event started with CEO Jack Dorsey explaining that he agrees with Twitter’s critics – “we agree we’ve been slow… we agree we haven’t been innovative… we agree many people don't trust us”. The problem I have with the “we’re better now” story is that many of the people in the C-Suite have been there for years. For example, Dorsey returned as CEO in 2015, and Ned Segal joined as CFO two years later (2017). The same is true for the Chief Technology Officer (Parag Agrawal) and the Head of Consumer Product (Kayvon Beykpour), who assumed their current roles in 2017 and 2018, respectively. A fair retort may be that change doesn’t happen overnight – for example, it takes years of effort to complete an “architecture rebuild” (it sounds like those efforts are still ongoing). All I’m saying is that I’m more skeptical than the bulls that this management team has suddenly seen the light, especially since they’ve had their hands on the steering wheel for many years. (The fact that Elliott Management was trying to push Dorsey out early last year speaks to this reality.)”

On to today’s update.

What’s Changed

Since May, a number of important developments have occurred at Twitter.

First, the stock has continued to struggle. At Wednesday’s close (~$44 per share), Twitter’s stock price has declined by 20%+ since mid-May; over the same period, the S&P 500 has increased double digits. Since the February 2021 Investor Day, which was initially met with a positive response by Mr. Market, the stock has declined by ~40%.

Second, that “audacious goal” (at least 315 million monetizable daily active users, or mDAU’s, by yearend FY23), has become an even tougher hill to climb. Based on guidance, the company is likely to end FY21 with roughly 221 million mDAU’s; if so, they’ll need to add 94 million mDAU’s over the next 24 months to reach their FY23 target. As shown below, the pace of trailing 24-month (T24M) net mDAU’s has held in the mid-60’s (millions) over the past six quarters, with help from the surge in engagement throughout 2020 as a result of the pandemic. In order to reach the FY23 target, the pace of T24M net adds will need to climb another ~40% in the face of much tougher comps as the strong FY20 net adds roll off. Simply put, based on current trends, I don’t think there’s reason to believe Twitter will come close to reaching the mDAU target (more on this in a moment).

Third, and most importantly, the company announced on November 29th that Jack Dorsey’s (second) run as CEO had come to an end; whether he resigned or was fired depends on who you ask (“the framework for his departure - including identifying his designated replacement - had been in place for more than a year”). Dorsey will be replaced by 37 year old Parag Agrawal (he will be the youngest CEO of any company in the S&P 500), who has been employed at Twitter for the past decade and has been its CTO since 2017. I’d note that the press release from the company was not made available until 10:40am ET (during market hours), which would seem to indicate that the news was leaked before the company was ready to act.

In addition, Twitter announced that Bret Taylor would become Independent Chair of the Board of Directors. Interestingly, on November 30th, the day after the Twitter changes were announced, Taylor was named co-CEO at Salesforce (he’s been COO at Salesforce for the past two years). This has led to some speculate that Taylor parlayed the developments at Twitter into a promotion at Salesforce (Marc Benioff may have been keen to keep him as opposed to seeing him named Twitter’s CEO). To top this all off, remember that Salesforce considered making a bid for Twitter back in 2016.

Financial Targets and Trust

Near the end of the press release, Twitter noted that “There are no changes to the Company's previously shared outlook for the fourth quarter and full year 2021, or its 2023 goals.” In addition to the unchanged financial targets, management has been clear that there is no plan for a shift in their strategic vision (CFO Ned Segal, at an investor conference on December 2nd, 2021: “We're not changing our strategy. We still want to get the rest of the world to use Twitter. We want to do a better job monetizing our service. We think we have the right strategy in place in order to do that. It's Parag's job to build on top of the really strong foundation that Jack has led us to, but to allow us to move faster and execute even better against it.”).

Not to beat a dead horse, but I find it particularly difficult to accept the reiterated FY23 mDAU guidance. I think Elliot Turner of RGA Investment Advisors hit the nail on the head when he said the following on the “This Week In Intelligent Investing” podcast (starts at the 36th minute):

“The mDAU target became increasingly challenging… If you look objectively at the company, people by and large think that Twitter is in a much better place than when they started the year, but the stock is down a lot. And I think it’s because they effectively tied their fates to this mDAU target… just about every question is about mDAU’s; a million different iterations of ‘How are you possibly going to achieve this?’ And it keeps the company from talking about things that are actually working, that are actually going well.”

I think Turner is spot on. This has become a distraction for the company and it is having a real impact on investor sentiment (trust); in fact, you’d be hard pressed to find a single bull who believes they’ll hit the mDAU guidance (I’ve asked). That’s pretty striking; I’d argue it demands some explanation.

I think this disconnect probably speaks to the events of the past 24 months, which likely played a role in Dorsey’s exit. Based on press reports, the main reason Twitter introduced the FY23 revenue and mDAU targets was to appease an activist investor, which saved Dorsey from a fight for his job. But as the mDAU target has become increasingly unlikely, investors have started to lose faith in management. It’s a reaction I understand: I’d rather a company be forthright with investors, even if it means pulling guidance, as opposed to stubbornly clinging to an unrealistic goal.

By the way, if we assume management still believes they can still hit those FY23 targets, it would behoove them to clearly detail how. The reason why “every question is about mDAU’s” is because management has not done a good enough job to date explaining how they can get there. This answer, from Segal at the December 2nd investor conference, simply doesn’t cut it: “When we think about our DAU goals, whether it's in the U.S. and other more developed markets for us like Japan, the U.K. and others or some of the emerging markets where we've seen real strength in DAU recently like the Middle East, the Philippines, Indonesia, Brazil, we still see lots of opportunity to grow our audience across those markets and others.”

This is a big sticking point for me. Honest and transparent communication with investors is important (to be fair, I think Agrawal did a much better job at this during his first investor conference on December 7th). In the past, this is the kind of thing I’d try and compensate for by adding some arbitrary risk premium to my hurdle rate. But these days, I think the best solution to a lack of trust isn’t a higher return requirement; it’s to move on to another idea until the underlying problems have been addressed.


The Investor Day was pitched as a reset / coming clean moment for Twitter.

Ten months later, Dorsey is gone and the financial targets are in question.

I don’t want to overemphasize a single point, but I get the sense management is uncomfortable in being forthright with its investors (maybe Segal is worried about losing his job as well). In the interim, they’re losing credibility with the investment community, which may explain why the stock has continued its poor performance despite the reiteration of the FY23 guidance.

In summary, while I appreciate that we may be nearing a point of peak uncertainty / pessimism, which is generally a good time to be bullish, my investment process demands that I see a path for Twitter to become a high-quality business, run by individuals with a long-term time horizon, integrity, and managerial skill. At this point, I don’t think I can honestly make that assertion; for that reason, I have no plans to buy Twitter at this time.

That said, I still believe this situation is worth keeping a close eye on.

The C-Suite changes may be a key step in Twitter’s evolution. And further reshuffling is already underway: days after Agrawal was promoted, the company issued an 8-K outlining changes to its org structure (“cross-functional leaders who have complete ownership of all the resources required to deliver on the goals that they have… and to be held accountable to the outcomes delivered for our customers and for our shareholders”), along with the resignation of its Engineering Lead and its Design & Research Lead. These are crumbs, but I think it’s a good start (Agrawal’s comments at the previously mentioned investor conference were also encouraging).

The end of an era presents the opportunity for a new beginning.

If I believe that effective change is underway, I’ll likely buy Twitter.

NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. The TSOH Investment Research Service is not acting as your financial advisor or in any fiduciary capacity.

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Great write-up Alex, and secondly, I can't lie but there is a sense of relief washing over me, now that I will likely no longer be a TWTR shareholder.

After taking a position in Feb 2020, I thought my thesis had come years early after their analyst day paved the path to 300M+ mDAUs, and a 2x of revenue. Product velocity seemed to ramp up, and then by the middle of 2021, it all just stopped, and became typical old Twitter. I had planned to give them a little more time after the Jack exit, but with Elon doing his thing, I think I am content with taking $54/$55 per share, and moving on.

Not married to the business, I made okay returns, time for the next opportunity.
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