As discussed in Monday’s update, Mr. Market reacted to Meta’s rising AI investments / capital expenditures (CapEx) with some uneasiness. Microsoft is working through similar developments, with FY24e CapEx likely to exceed $50 billion – nearly 3x higher than its FY19 spend. But the market responded more optimistically to the Microsoft news, with the stock climbing a few points following the Q3 FY24 results. In my view, that reaction reflected a clearer understanding from investors on the opportunities that Microsoft is pursuing, along with their strong starting hand (seeing the path to an attractive ROI).

With that said, this period isn’t without risk for Microsoft. As CEO Satya Nadella noted in a recent keynote, they are going all-in on AI: “We’ve taken this platform shift and etched it into every layer of our tech stack… People ask, ‘What’s the AI product?’ The answer is everything; the infrastructure, the data layer, the tools, everything.” We are in the early innings of this platform shift, with the winners and the losers to be determined in due time. For now, as you can see in the graphs below, shareholders are being asked to accept significant investment risk. When we look back in five or ten years, Microsoft’s results will have been greatly impacted by the output from this CapEx ramp.

In the late 1990’s, Rodney Sacks and Hilton Schlosberg were searching for Hansen Natural’s next leg of growth. They had purchased the company in 1992 for $14.5 million, but Hansen Natural was still looking for “a real point of differentiation” in ready to drink (RTD) beverages. Their most recent attempt was an energy drink, Hansen’s Energy, that hit the U.S. market in 1997 (after focusing on Europe for a decade, Red Bull also entered the U.S. market in 1997). That effort ultimately paved the way for the April 2002 launch of Monster Energy Drinks, which Hansen sold in 16-ounce cans for roughly the same price as the 8.4-ounce Red Bull offering. (A strategy reminiscent of Pepsi’s “twice as much for a nickel” advertising campaign from the 1930’s.)

From a business perspective, the beast had been unleashed: by 2012, annual revenues had crossed $2 billion - up >20x from a decade earlier (Hansen Natural would change its name to Monster Beverage in 2012).

This success didn’t go unnoticed; as discussed in the Celsius write-up, Monster’s distribution in the early 2010’s was handled by a combination of Coca-Cola’s network and Anheuser-Busch wholesalers. That lasted until a momentous 2014 announcement: through a strategic partnership, Coca-Cola would contribute its energy drink brands (NOS, Full Throttle, etc.) and pay $2.15 billion in exchange for a 16.7% equity stake in Monster, which would be the beverage giant’s “exclusive energy play” (as a result of subsequent share repurchases, Coca-Cola’s stake is now up to 19.6%). In addition, the Coca-Cola system would become Monster’s global distribution partner; as Sacks said in 2017, “The key for us was International distribution… To truly be an International brand, we needed a distribution partner with their reach.”

Tomorrow marks the three-year anniversary of the TSOH Investment Research Service. At the launch in April 2021, I planned on giving TSOH a year to find its footing. It has only become a sustainable venture because of people like yourself, for which I’m incredibly grateful. Thank you for your continued support. I work to produce the highest quality output that I’m capable of, and I hope TSOH has proven well worth your time and money.

I’d also like to thank Francisco Olivera of Arevilo Capital Management, who has greatly contributed to TSOH behind the scenes since launch. Francisco and I met years ago because of our mutual interest in business and investing, and we’ve learned a lot together over time. Here’s one notable example: after an unnecessarily long delay, we finally pushed each other to appreciate the enviable moat Netflix had dug in the media business (as they say, better late than never!). More importantly, I have also learned a lot from Francisco about what it means to be a great friend and a great dad. Thank you Francisco.

On to the update.

Strong 2023 results continued into early 2024, with the TSOH portfolio +19% in Q1 (full results below). I shared some thoughts on judging performance in the Q4 2023 update, so I’ll keep today’s comments brief: I’ve spent 15+ years slowly building the foundation of my investment approach. Today, I have a clear view of the type of investor I’m trying to be, and I think portfolio changes made in recent years have pushed me further in the right direction. Hopefully this recent performance is an early indication of what’s to come over the long run. (As a reminder, TSOH has been my sole professional endeavor since launching in 2021; I intend on keeping it that way for many years to come.)

As it relates to my most recent investment activity, the decision to trim NFLX, META, and MSFT wasn’t made lightly (particularly MSFT, where the position dates to early 2011 and has rarely been tinkered with). Over the years, a frequent topic of my investment philosophy discussions has been the balance between owning great businesses while remaining cognizant of valuations and long-term expected returns. The latest discussion was “Valuation and Long-Term Investing”, which hopefully provided clarity on how I thought through the most recent changes. Speaking more broadly, I’ll be curious to see what Mr. Market has in store for us throughout the rest of 2024. While I’m happy with the collection of businesses I currently own and their weightings, I will be ready to take further action if I believe Mr. Market is forcing my hand.

Here’s the current TSOH portfolio:

From “Back To The Basics” (December 2023):

“Dollar General has clearly struggled in recent quarters. That would not have been a major concern for me if those pressures were solely macro related (that’s life when you own a business). What was difficult to say, particularly given outsized results at Walmart and Family Dollar, was the source and magnitude of the headwinds. As I wrote in June, I believed that Jeff Owen (who became CEO in late 2022) had work in front of him to prove that he was the right person for the job. In October, the board concluded that he wasn’t, with Todd Vasos returning effective immediately. In my view, the Q3 call did a good job of showing why this change was needed. My read is that Vasos has a good grasp on what ails Dollar General, both externally (macroeconomic / competitive) and internally… That was an important step back in the right direction… With some assurances on the issues that DG must navigate, which I believe will prove fixable, along with further clarity on the macro and competitive situation, my conclusion is that ~$127 per share is an attractive price. For that reason, I have decided to add to my DG position.”

DG’s Q4 FY23 results and FY24 guidance were another step in the right direction: while we’re a long way off from historic levels of profitability, with FY24e operating margins ~300 basis points below the FY15 – FY19 average, the competitive concerns that I’ve previously discussed are being addressed. (And, as I’ll discuss today, Dollar Tree management is responding decisively to Family Dollar’s ongoing struggles, as I suspected they would).

From “Positioned To Capitalize” (June 2023): “If you share my view that live sports will ultimately play a prominent role in the content slate for a few of the leading DTC services / streamers, you can start to appreciate why the WWE and the UFC are attractive properties - particularly given the flexibility of their format / scheduling, the size and demographics of their audience, and the price tag of their rights relative to other sports. As overall content budgets at major media companies are being thoroughly scrutinized, my view is that sports rights are one area where spending will continue to rise (the latest example is Peacock’s ~$110 million deal for a single NFL playoff game).

As it relates to the leading player in streaming, Netflix, I’d note that they have had significant success with sports docuseries like ‘Drive To Survive’ and ‘Full Swing’… I think the introduction of the ad-supported / AVOD tier will eventually lead Netflix to conclude that they should be in live sports.”

On January 23rd, the global leader in DTC video streaming took a major step forward in their distribution of “live sports entertainment”: Netflix announced a 10-year, ~$5.2 billion deal for “Raw”, WWE’s flagship weekly program. I won’t rehash the ground covered in the most recent Netflix update (“Reaping The Rewards”), other than to reiterate that I think this is a good fit for Netflix given the flexibility of WWE’s format / scheduling, the size and demographics of its audience, and the structure / price for “Raw” relative to other (global) sports.

I also think this is an intelligent deal for the WWE / TKO. As a reminder, here’s what Netflix co-CEO Ted Sarandos said after the deal was announced: “We believe that the WWE has historically been under-distributed outside of North America, and this is a global deal. We can help them and they can help us to build that fandom around the world.” TKO CEO Ari Emanuel shared a similar conclusion: “This strengthens the WWE brand on a global basis.”

In “Letting Winners Run”, I wrote about Robert Kirby’s coffee can portfolio, a true “buy and hold” approach to investing. As discussed in that write-up, my investment philosophy isn’t too far removed from that way of thinking, with the caveat that I’m not completely unflustered by optimistic valuations. (If we put “never sell” on one end of the spectrum and “every asset has a price” at the other, I’d say I lean 70% or 80% towards the first approach.) Today, I want to provide a clearer understanding of how I think about and quantify value. In doing so, I hope to share my take on the “more nuanced understanding of value” that Steve Romick spoke about in “The Evolution Of A Value Investor”.

As a reminder, my starting point for security selection is business quality (the first filter). On portfolio construction, I operate with a structural allocation of ~100% equities, with portfolio decisions based on relative considerations and opportunity costs (with additional consideration for portfolio construction desires), not an absolute hurdle rate or a minimum discount to intrinsic value.

Returning to individual security selection, my goal is to find high-quality companies with honest and able managers positioned to generate attractive business results over time. As I think about the quantitative assessment of value – determining the relative attractiveness of those companies that pass the first filter – my primary valuation metric is a five-year forward multiple of normalized EPS / FCF. I’ve settled on that metric because it keeps me focused on where the business is going - the movie versus the snapshot - without going too far afield on future predictions. It is similar to the approach employed by Bill Nygren: “For almost all businesses, our crystal ball goes dark after seven years, so we assume all businesses trade at similar P/E's after seven years. With an estimate of fair value seven years in the future, we discount that back at an appropriate discount rate… Whether that results in a near infinite or a negative P/E on current earnings is not of concern to us.” (You can read more about his approach in this interview with John Rotonti.)

Here’s the five-year forward P/E on my estimate of 2028e normalized EPS for each of the 11 companies I own, along with their current portfolio weights:

On February 7th, The Walt Disney Company reported its Q1 FY24 results.

It was a solid start to the year, with continued strength at Experiences and an ~$850 million reduction in DTC losses leading to >20% YoY earnings growth. A similar outcome is expected to hold for the remainder of the year, with FY24e EPS of ~$4.6 per share (up ~22%). In addition, Disney is on track for ~$8 billion of FY24e free cash flow, with management looking to ramp capital returns (including repurchases, which have been paused since late FY18).

Overall, I think thesis laid out in “The Turning Point” (August 2023) is coming to fruition. In particular, I was encouraged by the results at Disney+ UCAN in the quarter, with paid subscribers down ~1% YoY on ~37% ARPU growth. (“These DTC pricing actions, if well received, will go a long way towards paving the path to resurging profitability within the video businesses… That outcome would be a critically important signal for the future of Disney.”)

But the road ahead still looks bumpy. In my opinion, that is most evident when analyzing the company’s strategy for live video, and particularly U.S. sports rights. The latest examples are the new sports bundle with Warner Bros. Discovery and Fox, launching fall 2024, as well as the ESPN DTC offering, launching fall 2025. These actions are another step in the direction of revealing the accounting mirage that I wrote about in “Improve The Bottom Line” (November 2023). Said differently, the company’s P&L remains heavily exposed to the distribution of live sports rights; sitting idly by in the face of sustained pressure on U.S. linear pay-TV volumes isn’t a sufficient answer.

That brings us to the focus of today’s post: as CEO Bob Iger noted on the Q1 call, Disney wants to transition ESPN “into the preeminent digital sports platform, reaching as many sports fans as possible and giving them more ways to access the programming they love in whatever way best suits their needs”. What does that mean for Disney’s long-term DTC strategy, as well as its future earnings power? And as it relates to the business and the stock, is this a sign that The Walt Disney Company is finally rounding the corner?

_As I wrote in “Phase Change” (February 2023), a turning point emerged at the end of 2022: “This is a clear indication that the actions being taken will meaningfully impact profitability; given that FOA generated >$45 billion of FY22 operating income, or ~3x higher than run rate FRL losses, you can appreciate why this is a very big deal for Meta.”

_

From “Tinder’s Melting Ice Cube?” (November 2023): “What’s clear is that the investment community continues to harbor serious questions / doubts about management’s strategic vision. Above all, Mr. Market is very concerned about the trade-off between Payers and RPP, particularly at Tinder; do RPP lifts justify the Payer declines? Is the second variable even an active choice?”

Match’s Q4 FY23 results did not provide an answer to that question. Total payers declined by 5% YoY (comparable to the Q3 FY23 decline), with an outsized impact from Tinder (-8%) and the Americas region (-12%). Those volume pressures continue to be outweighed by pricing, with revenue per payer, or RPP, up 17% YoY in Q4 FY23 (led by Americas, with RPP +26%).

For the year, Match’s revenues increased 6% to $3.4 billion. The business generated more than $800 million of free cash flow (~$2.8 per share), with $550 million allocated to buybacks. In addition, the board authorized another $1.0 billion repurchase program, with management committing to return at least 50% of ~$1.1 billion in FY24e FCF to shareholders (by comparison, the market cap is ~$10 billion). If management holds to that capital allocation framework, and if the business is able to maintain its current trajectory on profitability, more than $3 billion is likely to be returned to owners through repurchases over the next five years (or >30% of today’s market cap).

That valuation suggests Mr. Market continues to be cautious on the trade-off between volumes and rates that we saw in 2023, and which will continue into 2024. This is the key question to answer on the investment. For that reason, it is the topic that I’ll focus my attention on in today’s write-up.