Pre-election Portfolio Review

Here's my portfolio going into the election. The main holdings are: 

• GOOGL
• ILMN - talked about oncology upside here 
• FNF - I sold down in Feb as explained here, but bought back a chunk when it dropped to ~$30.
• AMZN
• PGR
• SQ+PYPL
• ASML - a small position from 2018 that doubled and turned into a material position
• TTD - this has tripled. First wrote about it last year, and here
• SHAK - bought in August
• FORM
• GH

Google and Illumina are 6-7% positions, the rest are no more than 4% each. I also have a long tail of smaller positions. 

Roughly, I'm 75% long equities, 25% cash/bonds/preferred's/yield plays. I'm also -15% short index futures, taking net equity exposure down to ~60%.

So it's a defensive posture. But probably less defensive than it looks. I'm running a barbelled portfolio where I have cash & equivalents on one hand, and highly volatile stocks on the other. 

The newer stocks in the portfolio are FORM, GH, and ILMN. For now I'll just do a few bullets points about them.

FORM (avg cost basis slightly < $29/share).

• #1 player in probe cards for semiconductor testing. Here's a nice little explanation of where probe cards fit in.
• Every new chip design needs its own probe card. This is really a consumable business so I regard it as steady revenue (at least compared to equipment makers) in a structural growth market.
• Their largest customer is Intel. Intel's troubles contributed to FORM's stock weakness this year. But FORM is gaining share at TSMC and particularly at the most advanced product lines.
• Management has a good track record of achieving its goals. The company's 2023 target calls for about $160mm FCF. Assume some interim cash flows and 17-20x EV/FCF, stock is worth close to $50 in 2-3 years.

ILMN and GH (avg cost basis ~$283/share and $97/share, respectively)

I actually had a starter position in ILMN since mid-2019, added during the downturn in February and March, and made it my biggest position in September when ILMN announced the acquisition of Grail, and stock got crushed below $270. (ILMN lost way more in market cap than what they will be paying for Grail!)

I was initially negative on Grail too, but quickly came around to it. 

Grail does pan-cancer liquid biopsy screening. The advantage of liquid biopsy is obvious. 

A few years ago, my mom did a checkup and found nodules in her lungs. It was suspected to be lung cancer. But the doctor couldn't confirm until my mom undergoes a biopsy - basically surgery to cut out a piece of her lung tissue for examination. 

My mom's fine now. But she sure would have preferred a simple blood draw! As for ongoing monitoring, blood draws will be infinitely preferable to repeated surgery.

But why Grail? Isn't there a ton of these liquid biopsy companies? 

• Yes, there's a ton of liquid biopsy companies, but only a few are 1) pan-cancer, and 2) for screening. 
• For example, I also own Guardant Health, which is one of the few companies that does pan-cancer liquid biopsy, but for cancer therapy selection instead of early screening.
• I posted a long thread here. Quick summary thesis: The pan-cancer screening market will be a natural oligopoly, where the first successful product will gain economy of scale and customer stickiness - overtime that combination will make Grail's lead insurmountable.  
• The whole field is very early innings, so I have an entire basket of these. ILMN and GH are the largest ones, but also PACB/EXAS/NTRA/NVTA.

More on Pan-Cancer Screening

Take a step back for a second. Forget the theories and just think about it. Pan-cancer screening just makes sense! Society NEEDS this.

Does it makes sense that people should have 50 screening tests for specific cancers such as colon cancer, lung cancer, breast cancer...etc? And then have insurance cover them one by one?

In practice, having these separate screenings means we don't get screened until some doctors suspect we have one of these diseases - and that's most likely AFTER we start showing symptoms. Stage 1 cancer is about 90% curable, while stage 4 cancer is only about 10% survival. Not getting screened until you're showing some symptoms is a huge disadvantage.

Pan-cancer screening solves that. You get it early, before you have any reasons to suspect you have cancer. You get it on some routine annual check up. One blood draw, 50 screens. Millions of cancer deaths prevented.

That's the holy grail of cancer screening. Someone has to drive that forward. Used to be Grail, now it's Illumina. 

The technology is here. It would be a sin of our healthcare system to not make it happen.

A (Flawed?) Ethereum Thesis

Here's a theory I cooked up earlier this month:

Ethereum as collateral means reflexive credit cycle.

just as higher home price = more lending = higher home prices;

higher ETH -> more Defi -> higher ETH. #Ethereum #DeFi

can someone punch holes into this thesis?

— mspacey (@mspacey4415) September 3, 2020

 

Quick glossary for above:

• ETH = Ethereum
• Defi = Decentralized Finance
• "reflexive credit cycle". A positive feedback loop between home prices and lending. Banks typically lend based on some loan-to-value ratio. Higher home values means banks are more willing to lend. More lending means more buying power, which increase housing prices, which then enables more lending, and the loop goes on.

For more information on reflexivity and credit cycles, Soros has a whole chapter on these dynamics in his "Alchemy of Finance". 

Anyways, when I heard that there's now a way to lend and borrow Ethereum (ETH), I immediately came up with the analogy. Ethereum prices can keep going up and up, because of this feedback loop!

Unfortunately there's 2 flaws to this thesis:

1) Can the Ethereum blockchain really scale?  The ethereum system is prone to congestion and result in high transaction fees. This is a well known critique of the ethereum ecosystem, with several solutions being worked on. But implementation risks remain.

Ethereum is the first smart-contract blockchain. It has overwhelming first mover advantage, and the vast majority of DeFi apps are built on top of Ethereum. 

Think of it like the Microsoft Windows operating system, on top of which you can have unlimited number of applications. There were other challenger operating systems that might be faster, more efficient, more secure than MS Windows, but having all the best apps / developers gave MS Windows an insurmountable network effect that outweighed its flaws.

Whenever Ethereum has scalability/congestion issues, newer blockchains will try to take apps and developers away from its ecosystem - perhaps through compatibility tactics. For example, Binance is launching BSC, "an Ethereum Virtual Machine-compatible blockchain ".

So there's a strategic chess game going on in crypto, much like there is among big tech platforms like Google and Apple. Ethereum has to solve its scalability issues to ensure its dominance.

 

2) DeFi lending is not real lending as argued here. 

and this thread below (sorry I keep linking to myself but as far as I know, no one else is talking about these things.)

i dont completely agree but hugely important article

a loan without a maturity date.. is that still a loan? https://t.co/etKO0U0Hbh

— mspacey (@mspacey4415) September 4, 2020

It get's very technical if you dig deeper. The short story is that there's no unsecured borrowing and there's no maturity date. The latter means you cannot develop a yield curve that serves as a critical reference point for pricing assets.

In short, I believe the way DeFi operations are currently set up encourages speculation and scams instead of the development of a real credit market. If I'm right, then the current "lending" in crypto is not a sustainable.

If DeFi is not sustainable, then it cannot be the necessary part of the positive feedback loop that drives ETH prices higher. 

All is not lost. Innovation and progress require several waves of boom and bust. People are driven and entrepreneurial - I'm seeing new coins and new crypto systems comes up every week.

So I'm pretty sure someone will get it right one day, and crypto will have a real credit market. The feedback loop then completes itself.

Crypto 2.0:  Crypto as Collateral

And let's not overlook how big a step forward DeFi already is. 

Here's what I posted in Reddit's r/MakerDAO forum (lightly edited to provide context here):

What attracted me to Maker is its game changing paradigm of using ethereum as collateral and issue US dollar pegged money. In doing so it accomplish 2 things:

1. ethereum replaces reserves at the Fed as monetary base. That money base is now out of government control!

2. Maker moved us from crypto 1.0 ( unrealistic dream of crypto being used as money in every day transactions) to crypto 2.0 (crypto as collateral that anchors a credit system much like Fed reserves or US Treasury bonds currently do).

This is a big step up for crypto! Serving as collateral is a more feasible and more central role than money (currently there's a multitude of fiat currencies but one ultimate collateral - US treasury bonds. It also means crypto is now a cash flow generating asset - providing theoretical foundation for valuation frameworks.

Just to elaborate. Crypto 1.0 (my own terminology for the era that ended in 2017-2018 boom/bust) envisions a crypto asset such as Bitcoin or Ethereum as money - as in when you go buy a Coke at 7-Eleven, you're supposed to pay in Bitcoin instead of US dollars. That turns out to be bunk, as crypto turns out to be too slow and too volatile for transactions. 

So Crypto 2.0 evolved to have stablecoins such as USDT, DAI, USDC...etc. All these are pegged to the USD and thus can easier be adopted as money for transactions. The original crypto assets such as Bitcoin and Ethereum then can serve as collateral that generate those stablecoins. 

This is a big step forward and in fact better mirrors the real world monetary system. (footnote 1)

Does DeFi become the new eurodollar system?

Here's another question that drew me to Ethereum:  does crypto lending/borrowing create money supply, and become the "new eurodollar"? 

In the 60/70's, foreign banks began lending in US dollars and that created USD denominated deposits ("eurodollars"). Since those banks are not subject to the same regulation as US banks, the eurodollar system inadvertently created huge new supplies of USD, and that lifted all asset markets. 

The Soros "Alchemy of Finance" book I mentioned above also discussed the impact of the eurodollar market.

DeFi, with its USD pegged stablecoins, has that same potential. 

Footnote:

1. What we know as "money" are really bank deposits ("Citibank owes you $xx, you can draw that anytime"), and is separate from the "base money" that Federal Reserve creates (which is liabilities on Fed's balance sheet, but assets on Citibank/JPM..etc's balance sheets; this "base money" is in effect collateral that backs bank deposits that you and I call "money").

On Shake Shack

I tweeted about Shake Shack (SHAK) a few weeks ago:

just bought some Shake Shack $SHAK . biggest driver of value is a) eventual store count, b) revenue per store.

they have about 300 stores now, I think that can easily double to 600.

— mspacey (@mspacey4415) August 5, 2020

Here's the gist of the thesis. Shake Shack can eventually reach 1,000 stores. At 600 stores (achievable within 3-5 years), and assume lower revenue per store for the new stores, I get to $89 a share using 20x EBITDA. That would be roughly a double in 3-5 years from my purchase price of $50.

The 20x EBITDA assumes growth runway beyond the 600 stores modeled here. That multiple may seem high but keep in mind currently it's at >25x.  In any case, it's all about growth runway and if Shake Shack can maintain its competitive position in the future (which in turn will allow them to uphold profitability).

Now, margin assumptions. As I mentioned in my tweet, Shake Shack is currently suffering from dis-economy of scale given its growth strategy. They are going after the big cities and claiming a foothold there. So if you have one store in Salt Lake City, you're setting up an entire supply chain to service that one store. 

That is obviously not optimal for margins. But things get better as you densify. The second store in the area might lead to some cannibalization, but will also allow them to leverage fixed costs. The 3rd and 4th stores will further enhance relative market positioning, as well as economy of scale... and so on. 

So as Shake Shack further penetrates the geographic areas they are already in, I expect margins to benefit.

To put things in perspective, in the affluent Bay Area (North California), Shake Shack only has 4 stores!  (San Francisco, Mateo, Palo Alto, and San Jose).

I go to the Palo Alto store, and even in the Covid-19 era there's usually a line of people waiting outside for online orders. 

Think about this for a second, Shake Shack invaded In-N-Out country - and have done pretty well!

To wrap up this section. I believe Shake Shack can easily get to 600 stores just by penetrating existing areas of operation. As they densify their operations, they can get leverage on existing infrastructure and improve margins.

A Telling Misconception

One push back I have gotten multiple times is "why would anyone buy a $10 fast food burger!?"

The answer is they don't. Shake Shack burgers are $6-7 dollars, not much more than than buying a Big Mac at McDonald's. Shake Shack burgers are made of 4 ounce patties, while Big Mac is made of two 1.6 oz patties. Then you factor in quality differences, I would say SHAK is an outright bargain.

But it's telling that people assumes Shake Shack sells $10 burgers. People hear about SHAK through friends and social media, see its nice stores (and lines out the doors), and assume it's some kind of snobby "premium" burger. 

They would be right about the premium part. Shake Shack is not your regular fast food burger, and can't be compared to such. It occupies an unique "premium fast food" position that few fast food operators can claim. 

It's the cheap glamour burger. The Michelin of fast food burgers. Founded by industry celebrity Danny Meyer.

Some people will have ideological aversion to this kind of categorization, but buzz matters. There's just some extra magic to Shake Shack beyond a quality burger at the right price. 

I was in Manhanttan through the 2000's when there's only the Madison Square Park location. I saw the buzz it generated. People regularly wait in line for an hour just for $5 burger. Even in early 2010's after they opened shacks throughout the city, the Madison Square location still has lines around the park.

As Shack Shack invades international big cities, they take that buzz with them. Below is a view of the newly opened Beijing store. I'm pretty sure people don't wait hours for Hardee's opening!

I thought one hour was long... First customer at @shakeshack in Beijing said she’s been waiting for five hours to get the hot dog 🌭.😳 $SHAK pic.twitter.com/1jNUV6b2Yn

— Eunice Yoon (@onlyyoontv) August 12, 2020

Other Puts and Takes

• Shack Shack patties have a distinct texture versus competitors such as In-N-Out or Five Guys. This is due to their proprietary blend from Pat LaFrieda and a smash-and-scrape technique.

• Declining same store sales. SHAK has a different sales pattern compared to most. Since the company enters a market with so much buzz, the stores typically start with high revenue per store, then drop off in the second year. Sales eventually stabilize, and I think will improve as they add options such as drive through and curb side pick up.

• This idea that Shake Shack might be hurt by higher mix of delivery orders (assuming those have lower margins). 
• SHAK can pick sole delivery partner as leverage (I guess that's what they do with GrubHub). 
• SHAK also has an excellent mobile app (better than McDonald's in my opinion, and I'm a big fan of MCD!). This means they won't depend on delivery partners to drive traffic.

• The real risk is if the company expand too quick and loses its quality and reputation. Other than that, I think it's a sure thing. 

• My average cost basis is slightly below $50/share. The plan was to average down and really load up if the stock ever go down to 30's. Instead, it's seen a quick run up. I will likely add a little when it reaches $60. 

PayPal's Move Into Offline Retail: Balance of Power Means Cooperation, Not Competition

I've been wondering about the payment value chain. Specifically how PayPal (and to some extent, Square) moving toward offline retail will shape the industry. Specifically, can its P2P apps aggregate consumer attention and lead to less industry power for Visa and Mastercard.

Today's consumer transaction landscape is as follows:

• Peer to peer (P2P). PayPal and Square (with PayPal app, Venmo, and Cash App). Note that P2P transactions do not have to go through Visa and Mastercard's networks.
• Business to consumer (B2C) online. 
• Visa and Mastercard  - consumers puts in their credit card info online.
• PayPal buttons.
• Business to consumer (B2C) offline
• Visa and Mastercard.
• Apple Pay and Google Pay. These wallets mostly just wraps around credit/debit cards. 
• PayPal and Square both have debit cards that consumers can put into Apple/Google Pay.

Note that PayPal already dominate P2P and have solid presence in B2C online, but weak in B2C offline.  

That's why I'm really interested in PayPal's initiatives to use QR codes. Here's a tweet back in February when I was thinking out loud:

Why aren't more physical stores letting people pay with QR codes? (Like Starbucks app). Bypass $V and $MA right? And why wouldn't $pypl and $SQ push this method to extend their reach in offline transaction?
— mspacey (@mspacey4415) February 26, 2020
 

My original thought process was something like this: 

• The P2P apps (PayPal, Venmo, Cash app) already have ability to transfer money without going through V/MA. Brick and mortar retail is the missing piece before theses apps could be used anywhere.   
• You can also store money in these PayPal/Venmo/Cash App. So these apps can technically replace banks and credit cards. 
• The more transactions go through these apps, the more leverage they have. For example, if consumers rely on Venmo for all their transactions, including at retail stores, then Venmo can threaten to steer consumers away from V/MA's networks, and extract fee concessions. 

I've since updated my thinking. Why? Because if the above hypothesis is true, Google Pay and Apple Pay will be circumvented and rendered irrelevant. 

Is that realistic? Probably not. The payment space is so big that Apple and Google are unlikely to step aside without some competitive response.

how does Apple Pay / Google Pay respond to Paypal $PYPL's ambition in brick & mortar payments? it can bypass apple / google Pay with QR codes

— mspacey (@mspacey4415) June 4, 2020

The responses could come in 2 ways - co-op and retaliation. Google Pay and Apple Pay can easily co-opt the QR code movement by adding that features as well. The wallets can also retaliate by pushing into P2P space. In fact Google Pay already has P2P features but doesn't advertise it much. It's not very smooth now, but it works.

The payment sectors has a balance of power that prevents any one player from dominating. 

So what does PayPal really get out of this QR code move? I think it mostly furthers that balance of power - as if to say "hey Google/Apple/Visa/Mastercard, if you try to cut us out of the payment profit pool, we have the means to strike back."

It's building a bunch of nuclear warheads pointing at each other. Threat of mutual destruction upholds industry economics.

In the meantime, PayPal is broadcasting that they are open to cooperation, and not looking to cut any one out.

I now think the multi-player landscape will hold and no one sub-sector or company will dominate. PayPal, Square, Apple, Google, Visa and Mastercard are frenemies that will cooperate instead of compete. They will collectively gain leverage over the banks.

With expensive growth stocks, the key is TAM and strategy. If the TAM is vast, as long as the strategy works, companies can grow into it. I think that describes both PayPal and Square. They are both long term buys.

Natera's NIPT Upside

Back in late 2017, I wrote about Natera here. I bought it but got shaken out with very little gain. The stock then almost quadrupled and I've been kicking myself from the sidelines. All I can do now is do the work and be ready when a better buying opportunity presents itself.

Natera (NTRA) is a genetic testing / diagnostic company. Current revenues mostly come from its reproductive health business which includes NIPT (Non-Invasive Prenatal Testing) as well as carrier screening. Two other promising areas where NTRA has pipelines are oncology, and organ transplants.

I will focus on reproductive health business here. 

Upside from Additional Reimbursement and Penetration

Like some other diagnostic companies, Natera's NIPT business performs a bunch of tests they don't get paid for. This is some low hanging fruit upside, as getting insurance coverage on those tests would be revenue that falls straight to the bottom line. 

NIPT patients can be segmented into high risk and average risk. The former is mostly reimbursed, while the latter that is mostly unreimbursed, and thus also suffer from low penetration. (Quick note: "high risk" and "average risk" here refers to risk of Down Syndrome and other abnormalities. So a woman above age 35 might be considered "high risk", and below that is "average risk".)

Back in 3Q19, the company estimate that it can have additional $60mm in revenue if their average risk NIPT patients get reimbursed. This is essentially another $60mm in EBIT because they already incur the costs. 

But that's not counting additional penetration in the average risk segment, which is likely to happen with reimbursement. So I went about estimating that number. 

As luck would have it, NTRA gave a virtual presentation at an UBS conference in May, and they gave out some numbers that made this estimation much easier.

Here are the relevant paragraphs from the presentation:

"...it's about 60-40 mix between average risk and high risk. And so then drilling down a little bit more into that average risk bucket, we're getting paid -- right now, we're getting paid about 35% of the time."

"Right now, that's the case for high-risk women, it's about 65% penetrated among high-risk women. It's only like 20%, 25% penetrated among average risk women."

"So contracted rates right now are in the, call it, $700 to $900 range as a general rule. And those have been very stable for the last 4-plus years since we went in network with most of the payers. In return for a huge growth in volume, I wouldn't be surprised if contracted rates eroded and then kind of got to kind of that more kind of slow single-digit heavy erosion you just alluded to"

"when I'm calculating that $60 million number, I'm actually just taking the units and I'm multiplying it by $450. Now like I said, contractor rates are much higher than that, and I actually think that -- there's no reason for them to come down all that rapidly, but I feel like that's a good, conservative long-term ASP number, presuming kind of broad reimbursement for average risk NIPT."

 

I found a couple things when I tried to tie out the numbers. First, it seems that it's actually 60/40 between high risk/average risk, not the other way around as they stated. Second, management said (shown above) that contracted rate is $700-$900 but they assumed $450 to be conservative. My calculations show that Natera is already getting paid $460 for each reimbursed test right now. 

With ASP in hand, we can work out the upside. I'm assuming volume for high risk patients remain the same while average risk volume scales up from 25% penetration to 65%. Then I assume 85% of average risk tests get reimbursed.

As seen above, Natera can get $40mm of additional revenue per quarter - from average risk NIPT tests getting more reimbursement and more penetration. 

Keep in mind I'm not assuming any upside from NTRA's microdeletion products getting reimbursed - I've seen sell side estimates that those could be worth another $50mm per year.

The $77mm quarterly revenue (bottom right of table above) annualizes to $310mm a year. 

Here's a sensitivity table I did for NTRA's reproductive health business, assuming $200 unit cost and $180mm opex (which is referenced in one of the transcripts).

 

I ran these sensitivities because management said the current contracted rate is much higher than their $450 assumption. This is contrary to my own calculations - which show they're actually already being paid at $460 rate. So the higher priced scenarios are unrealistic in my opinion. With volume growth and competition, I would expect the rate to go down, not up. 

At over $45/share, NTRA now has market cap and enterprise value of ~$3.6bn and $3.3bn, respectively. Conservatively speaking, the valuation can no longer be justified with reproductive health business alone. Not unless you want to assume a higher price than the company does, and add in another $50mm EBIT in the case microdeletion gets reimbursed. I'm not going to do that. 

At this valuation NTRA has to be successful in its oncology and transplant business. I'm quite positive on the former as Signatera looks like a potential home run.

Themes From Roku and Trade Desk Earnings

Roku and Trade Desk ("TTD") both reported earnings last week. 1Q results were strong but 2Q does not sound that great, especially for TTD which mentioned that during the last 10 days of April, "total spend improved to a negative high teens year-over-year decline."

But this post is not about near term puts and takes. I want to outline the big picture themes that stood out to me.


TV Upfronts

Both TTD and Roku talked about how failure of traditional TV "upfront" season can accelerate movement toward connected TV ("CTV").

Here's Roku in its 1Q20 call:



Here's TTD:

"Often, the majority of TV ads are sold in the upfront process. The upfronts are usually done in late April and early May, and those events are largely suspended this year."

"For advertisers, this can be liberating. I hear it from brands and agencies every day. For them, the upfronts are a bit of a burden. They're asked to commit billions of dollars to content they don't know that much about and chasing audiences that they can't measure quite as well as anywhere else. Now they have the freedom to be more deliberate, agile and data-driven in their TV ad investments."

That's an interesting point about advertisers not liking the upfront format. It reminds me of Bruce Greenwald's views of upfronts - as a scheme for media to collaborate against advertisers. 

"Behind the glitz is a highly successful, closely coordinated system to ensure the highest prices possible for advertising with the least incentive among networks to undercut one another."

"The up-front season occurs in the context of a general industry agreement on capacity developed under the guise of a public interest code of conduct to 'protect' viewers from too many advertisements...With the limited number of minutes available for sale preagreed, the tight time frames of the season make it relatively difficult for advertisers to successfully pit the networks against one another on price."

      - from "Curse of the Mogul" by Seave, Greenwald, and Knee


So traditional media is already declining, and now its implicitly anti-competitive/collaboration scheme is being exposed.

The question is what replaces the upfronts? Will there be another process that protects the bargaining power of publishers? Or does the leverage shift to ad buyers from now on?


CTV Now Exceeds Linear TV in Reach


I find it hard to believe but this is what TTD is saying. Jeff Green actually goes further and compares TTD alone to traditional TV!

"As I said, according to eMarketer, our total U.S. households with cable would fall below 82.9 million this year. Our research suggests it could be below 80 million. This year, we expect to reach well over 80 million households via CTV in the United States."

"This is an important point. The Trade Desk is the largest aggregator of CTV ad impressions across every major content provider, and that massive scale is a great leading indicator of future spend on our platform. All of this means that in 2020, The Trade Desk will likely surpass traditional TV in reach capabilities for the first time in our history. We're already seeing this shift as brands strategize on our platform."

Of course, larger reach does not mean larger monetization, but things are certainly looking bright for CTV. 

I don't like how TTD use the word "aggregator" to describe itself. It may be technically true, but broadcasting your ambition this way will likely make your clients wary and try to reign in your dominant position.

Strategic Role of Roku Channel, and CTV Fragmentation

In its quarterly letter, Roku mentioned that in the UK, the Roku Channel works on NOW TV (Sky) and Sky Q Devices.

Sky is part of Comcast which has Peacock. Peacock works on Roku. The Roku Channel works on certain Comcast devices. 

Are we going into a world where every channel works on every device, and the market for smart TV devices/software/platform gets commoditized? We now have Apple TV, Amazon Fire, Roku, Android TV (and its variants), Comcast Flex, Samsung smart TV, and it looks like XBox is getting into the game too. 

So where's the strategic point in the value chain? If CTV platforms like Roku and Apple TV become commodities, then the next point of aggregation are aggregate channels like Roku Channel, Peacock, Netflix, Hulu…etc. 

For Roku, there's a possible scenario where its importance in the value chain (and its profit potential) comes not from Roku the platform, but from Roku the Channel.

Week Ending 3/27/2020 - Bear Rally?

3/23/2020 Monday

I already sold down most of DLR and switched to DLR's preferred's last week. Turns out to be a ninja move. That stock got crushed 11% today. 

Sold a little more DLR today. I did not want to reduce overall portfolio exposure though, so I rotated that money into SBUX and GOOGL.

Even though the market is down some 30%+ (I can't even keep track anymore), there are still very few bargains out there. Some of the names are getting close though - a 10-15% leg down and I'm ready to buy them.

3/24/2020 Tuesday

Whoa, S&P 500 up 9.38% today. This must have been a vicious rally for short sellers. 

It caught me off guard too. I'm still under-exposed for some growth names (UBER, TTD, SQ) and hoping for those prices to go lower. I was just doing some work on EW last night trying to figure out growth runaway and TAM.. I was ready to buy it on a decent drop today! But the stock went up 17.6% instead! 

So this rally is kind of a bummer.

The 1929/30's Depression era comparison continue to pile up - but on the upside this time.

At least one fancy footwork I did kind of paid off. I had switched out of DLR equities into preferred's last week, just before the stock had a meltdown. Then Fed announced they will expand QE to buy corporate bonds also (I expected this but not this soon!). This should calm the credit markets and help the preferred's too.

Overall my portfolio exposure still hover around 60% equities. The moves I did the past 2 weeks are very incremental.

3/25/2020 Wednesday

Late last night congress reached a $2 trillion deal, and the market continued to rally today.

This $2 trillion won't mitigate all the damages the economy will sustain, but it buys time and minimizes the catastrophe. So it's reasonable that markets are already looking out to the other side. 

I am also looking beyond the Covid-19 induced recession. Always have. I'm just not so bullish about it.

I'm not doing much. Added a few shares of SQ. Yes it's up like 50% from the lows.. but it's still below my original purchase price before this whole crisis. So technically I'm averaging down. This is still a small position so whatevers. 

More about those preferred's. The DLR preferred's I bought has done really well but I could have done even better. 

AT&T's 4.75% Series Preferred went up 19% today! I did not buy this one. 

My thought process - as I wrote last week - was that low coupon preferred are less likely to get called so you're not going to get those huge yield-to-calls (in some cases 30-40% YTC). But I forgot low coupon securities have higher duration. 

And that's the point of this trade - own high duration stuff in advance of credit market calming (with a big assist from the Fed buying corporate bonds). 

Being a former fixed-income guy I actually thought about that dynamic but dismissed it. Lesson learned.

3/26/2020 Friday

Market seem to calm down a bit - S&P dropped only 3.4% today after a massive run up.

The more I learn about the fiscal stimulus/relief bill (CARES Act), the more impressive it looks. 

Aside from the various small business relieves, what stood out to me the most is the ~$450bn of Exchange Stabilization Fund as buffer against losses, which can be leveraged up to $4-4.5 trillion of lending by the Federal Reserve. 

The Fed balance sheet already exceeded $5 trillion, and they're talking about doing another $4.5 trillion of lending! 

So we not only have massive fiscal stimulus, but also a massive expansion of monetary base in addition to what already occurred this month. 

The scope, size, and speed of government response is truly historic. I was there in 1Q2017 when subprime blew up and can't remember the government doing anything. This time it's all hands on deck. 

Frankly I was almost looking forward to the Great Depression, but looks like that won't happen. Have I missed an once in a life time buying opportunity? Oh wells. 

Inflation Loops

Edit 1: I bought some DLR preferred at discount last week. Preferred stocks are ultra long duration instruments sensitive to changes in yield. The immediate bet is on credit spreads normalizing, but longer term it's also a bet on inflation. So that's where the below analysis is coming from.

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Consensus is that we are going to a zero interest rate forever, Japan like deflationary scenario. But here's how inflation can happen.

The inflation that markets worry about is not an one-off event, but higher prices year after year. 

For that to persist you need some sort of positive feedback loops. Here's what I think the loops are:

1) the "price increase -> wages up -> price increase" loop. Some initial supply shock raise prices (e.g. coronavirus shuts down supply chains). Higher prices lead to labor demanding higher wages (and with government and politics shifting left, labor is more likely to get higher wages). Higher wages force firms to raise prices. 

The cycle repeats itself as long as labor can raise wages and firms can pass through price increases. That requires:

• a) labor having bargaining power over firms
• Technology and automation decrease labor's bargaining power and lowers wages. Stalling technological advances can help labor here. 
• Politics can also help labor over firms.
• b) firms can raise prices because demand is not the issue, but supply is.

2) The outer loop:  The "price->wages->prices" inflation vicious circle invites government action. Government not only goes to bat for labor, but also intervenes in some heavy handed way (price controls, industrial policies..etc).  This leads to resource misallocation and output shortfalls in the product and services that people actually want. Supply side issues lead to higher prices and the vicious circle reinforces itself. 

Week Ending 3/20/2020: Watching Losses Mount

A day by day account of a tough week.

3/16/2019 Monday

Stock down 12% today!? Funny how I’m so desensitized to 5-8% moves now.

Any random stock gets hit 15% today.

I have several down 20%+ (e.g. SQ, STOR, FNF).

Square's meltdown is entirely expected, I was just too pigheaded to sell before their upcoming investor day.

STOR - the early hits had some elements of reflexivity unwind (this is growth by acquisition after all). But the new hits are due to worries about tenants renegotiating rent deferral or even rent holidays. My view is that's ok, STOR has enough liquidity to survive and thing will be back to normal in an year or so.

FNF was completely shot and I don’t quite get it.

------------------------------

I suppose this is the beginning of a new, prolonged bear market, under which stocks can be down 90% before it recovers.

The past few years I've WANTED a recession. I figured I hold more liquidity than most and can survive and take advantage of the situation. Now that the crisis is in front of me, the mental stress is almost unbearable.

I'm actually fairly calm during the trading hours. The hard part is after market closes and I go through my portfolio and count the losses. That's when it hits home.

I agonize over my own inaction. Even though I'm technically executing my plan. I upgraded my exposure in January and Feb with the idea that should a 2008 style crisis hits I will keep my stocks and ride out the losses.

Well, that crisis is here. I'm executing my plan. I'm just not sure that is the correct strategy...

Will I end up panic sell at the bottom? To fight that instinct I got a list of stocks and the prices I want to buy them at; and I will force myself into buying when those prices hit. Even if it's tiny positions.

Things are starting to looks worse than 2008 - 1929 / Great Depression is now the comp.


3/17/2019 Tuesday

Stock went up 6% today after Mnuchin and Trump talked about helicopter money.

I added 3% to my equity exposure today. 1% each to STOR/FAF(to replace the FNF I sold earlier)/BRKS. They are cheap enough and solid enough that I'm wiling to sit long term and take short term pain.

I added a little to SQ on whim after the Mnuchin speech, but will have to offload that addition tmw - here's why.

After market closes I had time to reflect. Directionally, the helicopter money approach is correct but I came to the conclusion it just be enough. The local restaurant might pay $15k a month in rent. How is $1000 going to help them stay alive when revenue goes to $0?

Some back of envelop calculation: US has $20trn GDP. Let's say 1/3 of that shuts down. And we shut down for 2 months. You got 20/3/12*2=1.1111. That’s $1 Trillion hit to GDP. But GDP doesn’t count intermediate goods, so the real amount that needs to be bailed out is probably a multiple of that.

Ideally, the government says "let's freeze time, everyone stay home, business keep their employees, we'll pay your expense". But that’s going to be an astronomical number that makes US debt/GDP go to unreasonable amounts and USD will totally lose credibility.

All we can hope for is the shutdowns flatten out the disease curve, buy us time so healthcare system doesn’t get over whelmed. Some business will go bankrupt but hopefully you save enough of them that we don’t get a permanent damage to economy that we cant bounce back from.

There is some offset here. Big companies like Facebook are already reaching out to small businesses and employees, in the form of cash grants and product credits. So maybe everyone shares some pain but no one goes under, then we bounce back?


3/18/2020 Wednesday

Another wild day. S&P down more than 5% today. Frankly, I expected worse. Stock futures were limit down the night before so I knew it was going to be ugly.

It now looks like teh fiscal package wont' be enough, and in any case it hasn't passed yet.

The situation deteriorates every minute.

Stock went down 9-10% ..(this is truly looking like 1929), before clawing back to "only" down 5%ish.

My buy limit order for TTD hit at $153 and so I added a little there. But I'm mentally ready for this thing to be down 80% from peak. That would be below <$60.

I don't know when the market will bottom, but I don't want to reduce on the way down and not have enough exposure when it roars back (and given the speed of the decline, its very possible the market recovery will be just as violent)..

So the plan is add on the way down, however incrementally.

TTD, SQ, UBER. I have small positions in these, all are potential 10 baggers if I can accumulate in the right price. Hopefully by the time market bottoms I have a decent position in each of these (and other oligopolies in structural growth markets with strong moats). Then maybe add on the way up?

It's way early to talk about recovery, but I can dream right?


3/19/2020 Thursday

A relatively calm day in the market. Markets went up but this is a very weak looking bounce.

Some of the big shorts names like Hempton, Cohodes came out yesterday and say they're no longer net short. Ackman talked about buying BX.

Yesterday, I talked about accumulating on the way down. As if to demonstrate the rightness of that logic, Uber was up 37% when I checked. Company says 80% of cost is variable, so they will be able to cut cost, survive and come out stronger.

Natera (NTRA, which I don't have) was also up about 40% today. Any glimmer of hope does wonders for beaten down stocks.

The market heat map (below) shows rotation away from defensive/yield names. the market didn't move up too much, so apparently there's no inflow to funds but managers are positioning for a risk-on rally? If so, they risk getting wipsawed and their selling will exacerbate the downward move. This can end in tears.

It's pretty hard to ignore the market, focus and do fundamental research. But i will try to do that today.

Trades

I cut some DLR as it breached MA50. I also sold EQIX. These are expensive stock that have held up but are liable to get hit. EQIX for example has <2% div yield. That makes the valuation dependent on growth, and that means acquisition - so reflexivity unwinds as stock prices go down.


3/20/2020 Friday

Spent time looking at preferred stocks today. There's a massive dislocation in the credit market. Credit spread have blown out and a bunch of preferreds are now trading at discounts to par.

It's tempting to look at Yield to Call (in some cases showing 30-40% upside) but that is not right for preferred trading at discount:

1) companies have no reason to call securities trading at discount.

2) the logic of yield to call is somewhat circular: to get the YTC you need the prefs to get called. But a company will call only when prefs trade at premium, which happens only when market yield comes down to below the preferred coupon.

So the bottom line is to look at current yield for preferred trading at discount, and compare that to the coupon to see how likely you are to get called at par.

------------------------------------
What an exhausting week. This is supposedly the worst week in the market since 1929.

I guess we are all Bayesians updating probabilities as facts emerge. Each day the economic situation look dramatically worse than before, so in retrospect it's not surprising that market took such a drastic downturn.

Some of us see the facts earlier or update probabilities earlier. I am unfortunately one of the slower ones.

Week of 3/13/2020 - Market Melt Down. A New Era?

3/12/2020

The S&P index dropped 9.5%. The market was almost 30% off its peak.

The decade long bull market is officially over.

Throughout 2019 I consciously high graded my portfolio, away from the speculative micro/nanocaps into large caps. At the same time I capped my equity exposure to 80% through most of 2019.

I came into mid-Feb with equity exposure about 65-70% of my portfolio. Then the market hit. Now I'm roughly 60% equities - I sold very marginally, the reduction is mostly because stocks went down so much that they became a smaller percentage of the mix.

What now? I've sold most of what I wanted to sell. I still have some high growth, high multiple names that are liable to take a 70% drawdown, but I've cut them down to small size and readied myself to ride out the pain. (TTD, SQ, UBER).

I even added - very marginally - to companies that I think will not only survive a recession, but will come out stronger by consolidating weaker competitors.  Examples are GOOGL, ILMN, DIS.

So, What now?

It certainly looks like a recession is unavoidable. Indeed the U.S. faces a tough trade-off  - shutting down everything to protect public health means taking economic hits.

So why have I not cut exposure to 0 or even go short?

Some of this is almost Pavlovian - every time I cut in the past 10 years stock roar back higher. It got even more absurd in the Trump era - as soon as stock goes down 10% there's a Fed cut coming.

Shorts have lost every single time because of policy responses.

So what's the normalized valuation going forward? Any low growth company that's not totally cyclical can probably fetch 20x PE. As policy response grows stronger, I wouldn't be surprised if that number goes to 25x (and with fake earning add backs too as in stock based comp).

So I'm holding, under the assumption that the economy may enter a recession, but comes back in 3-5 years - with even more system leverage.

Why The Economy Might Not Come Back

What could go wrong is if the economy just don't come back. Maybe at some point we just can't borrow our way out of a recession anymore?

The trigger could be this reflexive intersection between markets and politics - as markets go down, the chance of Trump losing re-election increases. Imagine Biden wins in November and Democrats take congress, they will likely roll back the Trump tax cuts. Immediate hit to corporate earnings!

Government is already cracking down on big tech. You layer on more regulation and taxes...

Then we can look forward to a decade of stocks going nowhere.

For now though I'm still holding to my 60% equity exposure. I may regret it one day.


3/13/2020

Stock was going nowhere until the last 30 minutes of trading. Trump spoke in a press conference, and talked about telehealth (TDOC stock went flying as he speaks). Then he brought up Google (GOOGL goes up), then Thermo Fisher, then a steady stream of CEOs.

Then he talked about waiving student loan interest, and buying oil for SPR.

Stock went on a rampage toward the close. It was hilarious! A master class by the best stock pumping president ever!

It's as if Thursday never happend.

This is why I'm afraid of shorting stuff.

10x Genomics (TXG) and the Single Cell Revolution

The so called Next Generation Sequencing ("NGS") of DNAs is actually quite primitive. Traditionally it works in bulk methods, where every cell in a sample gets lumped together. Bioinformatic analysis of sequencing outputs thus essentially operate on averages. 

This is obviously a problem as each cell can be vastly different from the next.

10x Genomics ("TXG") does single cell sequencing. Its technology partitions a group of cells into individual cells, tags them, and then feeds the single cell DNAs into NGS machines (mostly from Illumina). The outputs can then be tied back to individual cells.

Scientists can now analyze cells individually and figure out how they actually work. This is more like science!

The stock looks insanely expensive and I'm hoping valuation would come down. 

For now though, I drew some diagrams below to show what I think the potential could be.

1.  Pre-single cell era. Various assays feed into NGS machines.  

2.  Single cell era (now and intermediate term). The single cell platforms, such as 10x Genomics, comes along and increasingly act as an intermediate layer between assays and NGS. 

This is mostly for research use, but can conceivably extend into clinical / diagnostics. In this diagram I have "Foundation Dx" on the right as an example of a diagnostic application that interacts directly with NGS without single cells.

Even within research, the single cell paradigm has a long runway ahead of it.

3.  The ultimate upside for 10x Genomics, of course, is the bottom diagram, where every assay, including diagnostics, go through an intermediate layer that partitions into single cells before feeding into the NGS machines. In this scenario TXG can get a valuation as high as (or even exceed) that of Illumina's. 

We should be close to TXG's IPO lockup expiration now. Between that and the current market melt down, I'm hoping TXG's valuation can become more reasonable.

Notes on Trade Desk's 4Q19 Call

Trade Desk ("TTD") had its earnings call last week. Here are a few things that stood out to me.

On Connected TV ("CTV") trends:

1. CTV adopts header bidding style mechanism. See below:

2. Since walled gardens don’t exist in traditional TV, marketers see CTV as a chance to shift power away from the walled gardens.

3. Even live sports are adopting CTV.

Financial/Modeling Related

1. Take rates likely to come down over next few years. TTD talked about willing to give up some take rate for market share. This is likely to trigger competitive response.

2. Deleveraging on the sales/marketing costs over the next  few years as TTD add more employees to capture growth market. 

• "you should expect sales and marketing to generally grow a little faster than revenue growth over the next few years"

3. Free cash flow suffered from massive working capital drain this quarter because the gap between DSO and DPO widened. It's not clear if that’s just temporary but management says they do want to bring it down.

• I can see this cash drain being a problem as their agency clients might turn into bad credits. 
• This also implies that some of that cash on balance sheet might not be excess as it is needed for working capital buffer.

4. 2020 revenue guidance implies deceleration through the year and exiting 4Q20 at mid/high 20's revenue growth. But management insinuated some sandbagging there

• "we're more comfortable moving expectations up as we go"

Overall I think the results are solid, despite some of my cautions on financials above.

Since my September post the stock went up from ~$185 to now ~$280. It may looks expensive but that's because the company has years of profitable growth ahead - it is winning in a large TAM that's yet to be realized. 

How many companies are growing revenue 30%+ while having TTD's SaaS like margins and positive free cash flow? Not only that, the Trade Desk achieves this 30%+ revenue growth while spending a mere 20% of revenue on sales and marketing. This is a rare asset indeed.

  

I continue to hold TTD as a way to capture upside on the Connected TV theme.

Quantifying Illumina's Oncology Upside

Illumina ("ILMN") is the dominant provider of next generation sequencing (NGS) platform. The company provides an entire ecosystem of machines, consumables, software, and services. It's a bit of a razor and razorblade model, with sequencing consumables making up about 60% of revenue.

Analysts tend to worry about how many machines the company will sell this year and next year. I prefer to think in terms of end markets - after all, that is what drives instrument and consumable sales.

I will focus on oncology because I believe that will be the main contributor to the company doubling its revenue.

Oncology is not one, but three separate growth vectors. The three are 1) therapy selection, 2) monitoring, and 3) screening/testing. A couple slides from IR here give you a sense of relative market sizes.  The first is from Illumina, the second from Guardant Health.

The units are different, but we can tell that 1) all three are big markets, and 2) for now, therapy selection is the smallest but most penetrated market (and even then still very early innings); early screening is the largest but least mature market.

Let's think about how ILMN will participate in each of these markets.

1) Therapy selection. Precision medicine is revolutionizing medicine. Old medicine is a lot of trial and error - we don't really know how this drug treats this disease, but we know empirically (through clinical trials) that drug A is correlated with improvement in symptom B, so doctors prescribe it.

New medicine is different. We want to know what exactly is causing cancer. How does it impacts the specific patients in question? How will this specific patient react to this drug?

This is where DNA/RNA sequencing is required. Sequencing of patients' tumor samples allows us to move beyond some homogeneous view of cancer and into specifics of how the tumor works and how best to treat it.

That is the essence of companion diagnostics ("CDx"). CDx is in growth tornado mode and most, if not all, developers of these CDx does sequencing with Illumina machines. An example is Foundation Medicine which, through its parent Roche, has a partnership deal with Illumina to create more companion diagnostics.

Note that even companies who are skeptical of use of sequencing in early screening markets admit that sequencing makes sense for therapy selection. See below note from Exact Sciences (which uses PCR technology for screening, but think sequencing makes sense for therapy selection).

2) Monitoring. I believe the paradigm that prevails will work like Natera's Signatera (see diagram below).

Note that the process starts with sequencing of Tumor tissues. This is where Illumina's platform comes in. Natera would then use the data obtained from that step to create a personalized PCR assay, which is then used for on-going blood test monitoring (less invasive than requiring a solid tumor sample).


3)  Early Screening. I'm not convinced that sequencing will be required for this market and will (at least for now) not give credit to Illumina for this.

Screening is about testing for known diseases, for this PCR would do a cheaper and faster job. Cost of sequencing will likely come down a lot, so I think ultimately it comes down to the speed advantage of PCR.

I also get the sense that PCRs can be more distributed location wise. So instead of sending samples to some central lab for sequencing, it's faster to just have some sort of PCR at a location closer to patients.

To summarize this section, I believe Illumina's sequencing will 1) own the therapy selection market,  2) get parts of the economics in the monitoring market, and 3) get none of screening market (that's my assumption for now anyways).


Quantifying the Upside

So how do we quantify all of this for Illumina? My approach is figure out how much each of the 3 oncology vectors contribute to the company's consumables revenue right now, then scale those numbers up to some estimate of eventual market penetration.

From ILMN's 4Q19 transcript, we know that:

1) Oncology is about 20% of sequencing consumables.
2) Clinical versus research split is about 40%/60%.
3) Within oncology, therapy selection is by far the largest driver. Monitoring is nascent and screening is even earlier.
4) Oncology therapy selection is about 8% penetrated.

So if I take the $2.1bn of of sequencing consumable revenue in 2019, attribute 20% to oncology and 40% to research, that get us to $166mm of oncology clinical consumables revenue. I'll just assume all of that is therapy selection and $0 from monitoring and screening.

This $166mm is the basis of our analysis. I'm going to throw out some numbers just to demonstrating the thinking process and ball park the upside. The output is below.

Allow me to explain.

Ok, so $166mm of oncology treatment selection revenue for 2019. That market is about 8% penetrated now, where do we think it'll be in a few years? I'm assuming 60% here, so that scales up to $1,245mm of treatment/therapy selection revenue 5-10 years out (as shown in table above)

How about monitoring revenue? From the TAM presentation slides above, both Illumina and Guardant Health pegs the monitoring market at about 2.5x that of therapy selection. But remember, I think the Signatera paradigm (as explained above) will become standard, and Illumina only participates in the upfront sequencing and not the on-going monitoring.

Let's say 1/4 of the value from each monitoring treatment accrues to the sequencing platform provider - Illumina. (Plug in your own assumptions).

So my estimated monitoring revenue is the $1,245mm treatment selection revenue * 2.5 * 1/4 = $778mm.

I gave no credit to oncology screening opportunities, but that could change. Finally, for oncology research revenue I just take the present estimate of $249mm and give it a 3x to reflect the early inning nature of overall oncology market.

Layering in other assumptions for NIPT market and other sequencing consumbles, I can see Illumina's sequencing revenue go up to $7bn in a few years. The bulk of these gains come from oncology market shifting toward precision medicine and exploding upward.

Conclusions - about Valuation and Risks

The stock is around $270 at the time of this analysis. I get to about $2.5bn EBIT 5-7 years out and ILMN is thus trading at <15x EV/EBIT in years 5-7 (with interim cash flows lowering that EV). This is a decent price for what is essentially a monopoly that participate in growth markets.

The analysis here implies that Illumina's revenue will re-accelerate at some point - because the end markets will explode upwards.

Those revenues are Illumina's to lose, provided that the company retains its dominant competitive position. For now, Illumina is further entrenching its ecosystem by partnering with Roche and Qiagen to create 3rd party tests.

Risks

The only challenger on the horizon is Thermo Fisher with its Ion Torrent systems. There is also some small chance that the short-read nature of ILMN's machine could become a problem later. (Their failed deal with Pacific Biosciences would have given them strength in long-read market and remove this risk, but the deal failed).

Why Chipotle Stock (CMG) is So Expensive

I read Chipotle ("CMG")'s 10K for the first time the other day. Where have I been!

For years I have ignored the stock because of its very high multiples. I regret that very much. But better late than never.

Here I will share my notes. The 10 second summary is that Chipotle has decades of growth runway ahead of it, and it has not even started pulling some of the upside levers yet.

This is clearly a "buy every dip" stock.

Notes

• Per store revenue and margin normalization - this has been going on the past few years.
• "We are confident we can get back to volumes in the $2.5 million range, which is - those are the volumes we had just a few years ago."
• "We think we can go beyond that. The idea that digital was only 5% or 6% of sales back in 2015 when we hit these peak volumes, digital is now at 18%. It's the fastest-growing part of our business. So we have assets today that we didn't have back when we were doing $2.5 million."

• Margin expansion - increased digital sales drives operating leverage.
• "Ultimately, long-term guidance, of course for AUVs and margins to rise in concert. 
• Management has noted each incremental $100,000 in sales volumes translates into 100 basis points of restaurant margin. 
• Chipotlanes. This is CMG's mobile pick up lanes. This requires a shift in real estate strategy as most of its current real estate is not end-caps but in-line sites. The newer restaurants make good candidates for Chipotlanes though.

• US store expansion. They have about 2,600 stores, mostly in US. Management is confident that it can do 5,000 stores in U.S. I believe them.

• International presence. Almost none right now!
• They only have 39 international stores in Canada, Europe. 
• CMG has no presence in Asia! From my own anecdotal observation, Chipotle will likely be hit among East Asian countries. I have personally observed people who pretty much only eat Asian food becoming big fans of Chipotle's burrito bowl. This is because those cultures are accustomed to rice based diets, and Chipotle's burrito bowl is a familiar format. 

• Franchising. They are doing none of this and they don't need to. For now quality control is key so CMG should own the stores. Nevertheless franchising is something that can really juice ROE down the line.

• No financial leverage. This is another lever that Chipotle can pull when it matures - perhaps 30 years later!

Chipotle is basically sitting on a gold mine, it just have to not mess up! As long as the company keeps up its quality and reputation (which management is carefully doing), the market is theirs to lose. Unlike the burger/pizza/fried chicken fast food market, Chipotle's market is vast with decades of runway ahead, and CMG dominates.

FNF Diworsification (Acquisition of FGL)

On 2/7/2020, Fidelity National Financial ("FNF") announced that it is acquiring FGL Holdings (ticker "FG"), an index annuities provider.

I really do not like this deal.

The Stink of Life Insurance

In fact, I don't like anything that has a whiff of life insurance to it.

Life insurance and annuities are super long duration contracts and your P&L involves projecting out 20 years plus. That high level of of uncertainty means your financial statements are basically made up of layers and layers of assumptions (mortality/longevity, interest rates, equity index levels...etc).

This is why life insurance peers like Prudential (PRU), Metlife (MET), Lincoln (LNC) and so on all trade around 10x P/E. Don't let anyone tell you it's all about the low rates depressing investment income!

No, the very business model of life insurance and annuity is shit, period.

I would actually frown upon growth in this business, as growth would indicate the company is taking on more risk to bring in more business.

Now, I'll admit FGL's index annuities are less risky than the notorious variable annuities with guarantees. In those old GMDB/GMIB/GMDB products, policy holders invest in stock funds and the companies guarantee some minimum amount of return. These companies essentially sell a giant put option, exposing themselves to egregious losses during down markets. Index annuities, on the other hand, are newer derivative products (yes that's what it is). They are less risky because issuers essentially buy a bunch of call options on equity indices, and pass through the benefit to policy holders. Buying calls is less risky than selling puts!

A couple diagrams below show my understanding of how these products work. Notice that both the older GMxB and the new Index Annuities (FGL's products) give customers limited downside, but the latter incurs vastly better risk from insurer perspective.
 

So yes, FGL's annuities are much less risky than those notorious products of old. Still, over the life of a policy a lot of stuff can go wrong. FGL sells a derivative product with all sorts of market risks. I do not trust the financials.

Frankly, I doubt that FGL will ever shake off the stink of life insurance and the black box/ high risk stigma associated with it - even if rates go up. In other words, FGL will likely be a low multiple business forever. Even if it has high growth.


Is FNF Serious?

The first question is: is this actually a strategic acquisition, or it's just Bill Foley doing what he does - bring in some company only to spin it out later?

I told you above I hate the annuity business. So naturally, I hope it's the latter.

"Strategic acquisition" would be a big problem. As a shareholder, I don't want to see FNF deploy its abundant free cash flow toward growing a unrelated and shitty business that will never fetch a high multiple!

Unfortunately, the the 2/7/2020 conference call to discuss the acquisition seem to indicate otherwise. Management spoke of FGL as a strategic diversification and brought up examples of acquisition benefits, all of which are questionable.

As an example, they talk about FGL business smoothing out the combined company's exposure to interest rate changes. This is hogwash and they know it. FNF's refi business are already burned out from years of low rates and can't get hurt much more from higher rates. Also, it's not like FNF doesn't have its own investment operation that will benefit when rates go up!

Management also argued that FGL can benefit from FNF's bank relationship. In that very same call, FNF management actually backtracked from that assertion when challenged by analysts. The benefits will be limited to small time distributions.

I came away from the 2/7/2020 call feeling unsettled, but still hoping this is just Bill Foley playing the spin-off game.

Then came the 4Q19 earning call on 2/14/2020.

It Gets Worse!

In the 4Q19 call, FGL's CEO Chris Blunt tried to address some of my concerns above and tried to argue that FGL is not quite a life insurance business. I think he failed.

The first point:

"We are much more of a spread lender where we can reprice our liabilities on a regular basis".

This is somewhat valid and very important. It corroborates my earlier point that index annuities are less risky than the older variable annuity products.

Repricing liabilities is important because that shortens the duration, making them less sensitive to key macroeconomic factors.

That lessens the pain but doesn't make it go away. I would rather the company NOT take on these liabilities at all! (per FGL's 10K for 2018, liability duration is ~6.2 years).

The second point about improving credit quality brings back nightmares. AAA rated CDO-squared anyone? After the 2008 debacle, how anyone can still equate credit rating with actual risk is beyond me.  

Some of my other notes from the 4Q19 call:

• Talks about FGL doubling its AUM in 5 years with resource of FNF, could be 50% of FNF's overall earnings. (sounds awful!)
• Apparently FGL has ambition in pension risk transfer. (PRT = WTF!!!)
• Talks about giving Blackstone more money to manage. 
• Talks about FGL increasing investment yield without compromising on risk - by switching from BBB corporates to higher rated ABS and CMBS.

Good Fucking God!

I even get the impression Bill Foley is looking at FGL's Chris Blunt as some sort of successor. The latter is not exactly young, But it's hard not to get that impression when Foley talk about FGL growing to 50% of overall company earnings, giving Chris Blunt more money to manage, and basically let Blunt talk nonsense like chasing yield with structured products and pension risk transfer.

FNF is like "yeah it's fine, it's just a spread business". First of all, that's suspect. Unlike your traditional bank lenders with exposure to rates and credit, FGL's business have exposure to rates, credit, equity, lapse rates, and longevity/mortality. It's a spread business in the generic sense that any business is a spread business because it has revenue and cost of goods sold.

Second, even if that's true, why would I trade a steady service business (which is what title insurance actually is) leading an oligopoly, with a "spread business" that has little entry barrier?

Conclusion

I suppose one can argue "of course Foley has to talk like it's a strategic acquisition, of course that's what he says now. Just wait a couple years and he'll spin it out, just watch".

Even if that's the case, FGL is not like FNF's past acquisitions. Black Knight, Ceridian...etc, these are growth companies that has a ready market when the time comes for exit. I don't see that for FGL - it's just not a high multiple business.

After several years of holding FNF (and as my largest position the past 2 years). I will have to exit or at least cut down drastically.

Thankfully it's a long weekend now. I will have time to sleep on it.