Welcome to Episode 41 of The Transcript Podcast.
This is a special episode of a recording of a Twitter Spaces conversation we held on Friday, 19th November with two special guests, Sam Ro and Alex Morris. In this episode, we discuss the key themes that we took note of in Q3 2021.
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Show Notes:
00:00:00: Introduction
00:01:54: The impact of Inflation
00:09:56: All about Inventory and nagging supply chain issues
00:19:26: Trends in the labor market
00:24:45: Tech Companies in Q3
00:28:32: The Metaverse
00:36:38: Opportunities and Challenges in Streaming
00:41:21: What Surprised you the most in Q3?
00:51:02: What to look out for in Q4
00:56:29: Conclusion
Episode Transcript:
Introduction
[00:00:00] Mokaya: Welcome to our Twitter space today. I'm Erick Mokaya, I'm based in Sweden and I'm the author of The Transcript, a weekly newsletter where we cover the key quotes from earnings calls. Today we are very privileged to have guests, Sam Ro and Alex. I've known them for a while and would allow them to introduce themselves. So maybe I'll start with Sam. Sam, I know you've made a major move this past quarter, maybe you can tell us a little bit more about who you are and what you do. Then, Alex will do that after you. Welcome, sir.
[00:00:28] Sam: Sure. Thanks, Erick. Thanks for having me again for this call. I am the writer of Tker. It's a newsletter on Substack that focuses on the news and data that inform longer-term themes in the markets and the economy. I started that just over a month ago in the middle of October. Before that, I was the writer of the XES markets newsletter. Before that, I was at Yahoo Finance where I co-wrote the Morning Brief newsletter. If you want to go back to ancient history, I was at Business Insider for a while, where I led the team’s coverage of markets. I’m glad to be here. If anybody is interested in Tker and what I'm doing, the links and URLs are all on my Twitter profile.
[00:01:13] Alex: Perfect. I hope everybody's having a good day so far. My name is Alex Morris. I run the TSOH investment research service. In a nutshell, it's everything that I used to do in my former life as an Equity Research Analyst. I just made it completely available to everybody who subscribes to the service. It's deep dives on individual companies, updates on the companies that I currently own, and names on the watch list. Every once in a while, some investment philosophy-type discussions and then disclosure of any changes before I make them along with the rationale for those changes. I've been doing that for the past seven months now. It's a lot more work than a real job ever was, but I've greatly enjoyed it so far. Thanks for having me as part of this Space.
The impact of Inflation
[00:01:54] Mokaya: Alex's favorite companies include Facebook and we're going to explore a little bit of the key themes he saw during this quarter. Sam, I know of a generalist, you especially look at the key macro themes and you write a lot about them. So I guess I'll start with you Sam, maybe the first thing that we'll talk about is inflation, what you saw there this quarter, as many companies talked about that. I know the Fed keeps saying that inflation is transitory, but do you think the companies agree with that from what you read from the earnings calls?
[00:02:22] Sam: Yeah, I mean the whole ‘inflation is transitory' is a pretty loaded question. So I'll come back to that in just a second. But on the matter of inflation, I think we've seen a lot of the charts where they aggregate the number of times inflation has been mentioned on the earnings calls. I believe if it wasn't a record, it was right up there for Q3 similar to Q2. I think it was probably the case in Q1 as well as businesses were guiding what the rest of the year was gonna look like. But yeah, I think it's very unambiguous that the prices for a lot of goods and labor, all of it is going up. Both companies’ and consumers’ cash levels are in good shape but again, something that we saw this quarter and it was something that happened last quarter was, as much as all the execs and companies have been screaming about rising costs because of inflation, they were able to deliver record-high profit margins and it's a combination of things: efficiencies, bringing in technology to streamline things and then, of course, raising the prices of the goods and services that these companies sell. So I think that was pretty interesting this quarter, the degree to which companies were saying that their customers were able to absorb these higher prices. I guess to a certain degree, that's not too surprising when you do see some of the macro data, especially with the big companies. Companies are in much better financial shape than they were pre-pandemic. Cash levels are higher, et cetera, et cetera.
Both companies’ and consumers’ cash levels are in good shape but again, something that we saw this quarter and it was something that happened last quarter was, as much as all the execs and companies have been screaming about rising costs because of inflation, they were able to deliver record-high profit margins and it's a combination of things
And then of course with the consumers, there are quite a few economists who've tried to measure this, but this concept of excess savings, the additional amount of savings above-trend that consumers saved during the pandemic because they didn't go on vacation last year or they weren't going to restaurants last year. Then not to mention government stimulus checks and financial aid and all that stuff. Consumers’ balance sheets are in a lot better shape than they were pre-pandemic and they're also just sitting on a lot of cash. I think what we've seen in the last quarter and it might spill into the next quarter as well, is as much as inflation and rising prices is sort of undesirable, all the customers of these businesses that we're following are willing to pay because they need those goods and services and the equipment for their businesses to run. So I thought that was a really interesting dynamic and that can't go on forever. Eventually, people tap out those excess savings on corporate leverage and financial conditions become a lot tighter. For the time being, at least businesses seemed to have a good grasp on what their customers can handle in terms of price increases. That's been interesting to watch. There's a lot of inflation in the system but the customers have been able to take those prices.
[00:05:42] Mokaya: Alright. I want to ask Alex, maybe you can comment on that. Also, in addition to what Satya Nadella was saying about digital technology being a deflationary force in an inflationary economy. From the companies that you follow yourself, have you seen them raise prices, and how are the consumers responding to that, Alex?
"Digital technology is a deflationary force in an inflationary economy...I mean in an inflationary environment, the first place any business should go to is how to really ensure that they're able to get productivity gains and even dealing with constraints." - Microsoft CEO Satya Nadella
[00:06:01] Alex: I think what Sam said is a really important point, which is a lot of the focus has been on the supply side of the equation, which we know things about the ports and some companies have quantified that like Dollar Tree on their most recent call when they talked about how this was a meaningful hit to their business. I ran the math to try to estimate what they were talking about and what I got to was something like 200 or 300 bits as a percentage of revenues was the incremental cost that they were looking at, which when you run a business on an annualized basis, or with mid to high single-digit, even margins, that's a very massive hit. We've heard about that side a lot. I think to Sam's point, the demand side is what's interesting to me. We talked about this last time, but I just think we've seen it continue. I look at some of the retailers that I follow... Walmart's 2-year stacked comps were up 16% in this quarter, still right around all-time highs. That number historically has been more like low to mid-single digits if you look back over the past five years or so it’s meaningfully above trend and Walmart, at the end of the day, is a huge part of their mix is consumables and groceries. It's not people going out and just spending money on discretionary purchases. It's something that people have to have. When you look at other retailers like Home Depot or Target where maybe that purchases are a little bit more selective and you see comps are even stronger. I think in the case of both of those companies the two-year stack was up north at 30%. So you're seeing massive demand on that side of the equation and impacts on supply play into that as well. I think what we've seen this quarter was more clarity out of companies like Walmart and Costco and the like that are what I kind of view as the very well-run best in class retailers. It's interesting to see how effectively they make decisions and find ways to work around these challenges. I think it was on the Target call that they made the point that a few years ago, we were having a similar conversation about tariffs and it just stuck out to me that this is just a reality of running a business. There are always these short-term headwinds of one kind or another, might be tariffs, it might be cost inflation, or supply chain issues tomorrow it'll be something else. So I just think it's interesting to see the companies that can really think long-term and can navigate their way through.
So you're seeing massive demand on that side of the equation and impacts on supply play into that as well. I think what we've seen this quarter was more clarity out of companies like Walmart and Costco and the like that are what I kind of view as the very well-run best in class retailers. It's interesting to see how effectively they make decisions and find ways to work around these challenges.
[00:08:22] Mokaya: In addition, that speaks a lot about the pricing power some of these retailers can actually raise prices and yet the consumers are not in any way kind of reducing the demand for some of their products that they have. Is that something that you'd speak about most of the retailers? I know there are a couple of companies that have struggled to keep up in terms of prices. They can’t raise prices as much as possible and they're kind of two types: some can raise prices and then they don't have a lot of margin pressure, then some can raise prices in that regard. Do you see some companies being affected one way or the other with inflation?
[00:08:55] Alex: Yeah, it's kind of interesting I might even just flip that. Doug McMillon, who's Walmart CEO made an interesting comment on the call. He said, fighting inflation is in our DNA. Some won't love that fight and so do we. We have a lot of variables to manage, deliver everyday low prices to customers, and simultaneously strong financial results for our shareholders and we're using that. I think these companies are constantly fighting with navigating the cost of running their business and ensuring that they deliver a good product to customers at the end of the day at a very compelling price point. And if they don't do that all the time, they won't stay in business. So this is just a different version of what they're constantly facing. Now you have some things like right now, Costco called out on their call, we still have limitations on certain things, whether it's toilet paper, bottled water or the like, but they can also react to those things as they mentioned, we had the financial ability to bring things in early or to order really, to mitigate future delays. We have the balance sheet to hold a little bit of excess inventory in the short term and we need to. It's part of the entire long-term business model financing strategy of these businesses.
All About Inventory and Nagging Supply Chain Issues
[00:09:56] Sam: If I can just add something there. I think Alex nailed it in that this quarter we learned a whole lot about execution. Last quarter and this was just sort of the mix of the companies, I feel like in the second quarter we were hearing a lot of the early concerns about supply chain issues and ability to procure goods and maintain inventory and stuff. Whereas with this quarter there were a lot more earnings calls where the CFOs and the executives were talking about the plan that they put into place to execute so that they could have inventory to sell. When you hear about Walmart and Target and Home Depot's 2-year stack comp sales growth it's one thing to see that as a reflection of consumer demand, but what's also really impressive about that was that all of these stores were able to secure the inventory to sell to their customers. I thought that was super interesting about this past quarter is, while inventories and supply chains are still a big issue and the census data will tell you that inventory levels are still pretty deflated, it seems like there's a higher degree of confidence, especially with some of these best in class retailers, that they are figuring out a way to work through the supply chain issues so that they do have inventory for the holiday season and the coming quarter.
I thought that was super interesting about this past quarter is, while inventories and supply chains are still a big issue and the census data will tell you that inventory levels are still pretty deflated, it seems like there's a higher degree of confidence, especially with some of these best in class retailers, that they are figuring out a way to work through the supply chain issues so that they do have inventory for the holiday season and the coming quarter.
[00:11:23] Alex: Yeah, I think I just wanted to add to that point. There was an article in the Wall Street Journal maybe a month or two ago now that discussed specifically how Walmart was finding ways to work around the major ports that were congested. It's an example of exactly what Sam's talking about and we see the net result now when they report, their inventories are up 12% from a year ago. They're getting prepared for where they need to be for the months ahead. So execution is a massively important part. I think to Sam's point, when we talked about this last quarter, it was almost like the bomb had just hit. Now over the past three months, we've seen companies effectively make plans and execute against those plans.
[00:12:04] Mokaya: I agree. I think that's a nice segue also into the second topic that we wanted to address, which is supply chain congestion. A lot of companies say that most demand is not an issue. The issue is getting the inventory that they need. Especially the smaller retailers are having a difficult time. The larger ones, as you say, can use other alternatives. They're able to charter flights, they're able to get their inventory on time, especially heading into this holiday season. But then others can’t be able to get the inventory they need to the consumer on time. So in terms of the companies that you two follow, are there specific examples where you see brilliant ways in which companies have innovated to make sure that they get the inventories to the consumer on time? And also, are you worried that perhaps at some point we'll see a reversal in the supply chain, the supply chain easing up, and then companies stuck with a lot of inventory that is not moving?
[00:12:58] Sam: Yeah. That last question I think is interesting and let's not forget to talk about that, but regarding the supply chain, just as a continuation of what we were just talking about in terms of companies trying to figure stuff out. That's always the lesson of every earning season and the aftermath of any kind of crisis, whether it's a pandemic or a financial crisis or a supply chain issue or whatever it is these companies are figuring ways around this. I think of two examples, one of them was on Crocs. Crocs’ earnings call and Crocs’ earnings announcement. So they are one of these companies that source their footwear from Vietnam and because of the resurgence in Delta, there were all these issues with all the footwear companies trying to secure their goods from out of Vietnam. And one of the issues is because those factories are delayed, and then it gets onto a boat, and then it ends up in LA where it's going to get gummed up for weeks again, Crocs just airlifted their supply out of Vietnam.
Now, this isn't like a new thing that companies have just figured out overnight, but flying something across the world is a lot more expensive than shipping it. But it is of course faster. If you do have the margin to absorb those costs, then maybe you get to make it up on volume. Crocs were successful in the last quarter because there was a lot of demand. The last thing you want to do is have a customer show up to your store and not be able to sell them anything. I mean it's hard enough to get someone's attention to your brand. So it's just a disaster to have to turn them away. So I think that was interesting, that they were willing to absorb that cost so that they could get that footwear to their customers. They also mentioned that they're investing a small fortune into redesigning their supply chain structure so that air freight becomes a more permanent part of their procurement process.
And then another one, I can't remember. I don't know if this was a dream or I read in the paper or they said this, but it seemed kind of surreal to me and you guys can correct me if I'm wrong on this. But I recall Costco saying that to get their goods to their US stores quicker, they actually chartered, or maybe even got a share of a cargo ship or something. I don't know if it's true, I'm pretty sure it is. I'll have to Google it, but it just speaks to the extent that a lot of these companies would go to make sure that their customers are being served. So as much as there are all these efforts to preserve profit margins, it appears to be the case that a lot of businesses will go that extra distance, even if it costs them something so that they can make sure that they have the goods to sell. So I thought that was a really interesting thing in terms of working the supply chain.
The other thing that you asked about Erick is the concern that there's going to be too much supply down the road. I think that's just always going to be a risk. Especially now with all these pendulums swinging, like one day, there's not enough supply, the next day there could be too much supply. This is not just like retail and consumer goods, but also industrial products and all these things. I think one thing that's encouraging is that there still seems to be a lot of pent-up demand just across the economy that should be able to help clear out what could be inventory that's coming down the road. Let's keep in mind that CapEx orders are still at record highs, which means businesses that are creating stuff have plans for more business down the road. And don't forget there are also 10 million job openings, which is right below its record high and companies aren't planning to do the hiring, unless they are planning to use these people for something. So I think, yeah, there's always going to be a risk that there's too much inventory that could potentially be deflationary if we want to even go that far. I think one thing that has been a constant theme this quarter, as well as the last couple of quarters, is that demand is very high and it's expected to persist at least for the near future.
Let's keep in mind that CapEx orders are still at record highs, which means businesses that are creating stuff have plans for more business down the road. And don't forget there are also 10 million job openings, which is right below its record high and companies aren't planning to do the hiring, unless they are planning to use these people for something. So I think, yeah, there's always going to be a risk that there's too much inventory that could potentially be deflationary if we want to even go that far.
[00:17:20] Alex: Two things that come to mind for me as we think short-term and longer-term. Short term, the responses are a lot of the things that you'd expect companies like Dollar Tree or even Disney in terms of some of their offerings in the parks mentioned, for example, the idea of smaller pack sizes which some of them like Dollar Tree has been toying with those kinds of variables for decades now. So that's just a normal part of the business for them. I think what's interesting sometimes is that you see longer-term changes that come about as a result of some of these things. In the case of Dollar Tree, they've considered multi-price points. For those of you who don't know, Dollar tree is a US retailer that sells everything for a dollar, basically everything for a dollar. They've tested, multi-price points, effectively selling things for a $1.50, $2.50...They've tested that in the past, but they never took it particularly seriously. I think after what happened here with the supply chain, particularly their freight costs they've now really stepped on the gas. So it's just interesting to see how this seemingly short-term impact is, has led to a pretty significant change in terms of how they think about who they are long-term as a business. Another example, it's a little bit different, but I think Airbnb is another case where you have to deal with impacts to supply and demand. It’s very different than putting a box of some product on a ship and sending it over from China. Airbnb introduced certain product changes, specifically a feature called ‘I'm flexible’, where it allows them to match supply and demand in a way where someone's flexible on the search. They can meet that need in a way that they had not been able to do previously. So I think it's just another interesting example of how innovation and execution can resolve some of these supply and demand issues over time.
[00:19:02] Mokaya: I found the quote from Costco. Sam, I think I just put it below the pinned tweet. It's about Costco chattering three ocean vessels for the next year to move their goods from Asia to the US and Canada. Dollar Tree is indeed testing various price points beyond a dollar, which is very interesting too since they are sticklers to pricing items at $1 and below.
Trends in the labor market
[00:19:26] Maybe that's also a good segue to discuss a few of the issues which I've seen Sam address, a lot about labor issues. I know a lot of companies have been saying that it's really hard to secure labor for their stores. A lot of retailers said that. You had an article in your newsletter, Sam, that talked about 11 reasons why there are lots of issues at various points in the labor channels. So maybe you can discuss a little bit about that and tell us a bit more about what you wrote there.
[00:19:51] Sam: Yeah, sure. So this is something I wrote for Tker subscribers last week. If you guys want to go back into this, I have the link on my Twitter profile. A lot of the labor shortage issues relate to things that I think a lot of us have heard of. Things like people who are still concerned about catching and spreading COVID. Childcare issues are a huge one that's keeping a lot of parents out of work. Folks retiring and then not to mention there's this trend where for every couple of people who retire in a given year there is a percentage of folks who returned to work and retirements are high and the number of people who unretire is a bit depressed. Two more that are interesting and jarring to hear about, immigration is way down. It continues to decline year after year and this is something that began in 2016 during the Trump administration. Another one that I thought was interesting, and this is something that economist Diane Swonk tweeted a couple of weeks ago. Another interesting thing is the number of people who hold multiple jobs is way down. Millions of people who used to have multiple jobs are no longer in that demographic anymore. I don't know about you guys, but when I was in college, I had two work-study jobs and one of them was working part-time at a bar. There's not a lot of people who will work 40 hours a week as a bartender, but it's a great place to pick up a couple of extra hours. And suddenly if you do find yourself getting higher pay at one of your other jobs, and they're giving you more hours because there is this labor shortage and suddenly you don't have to work two jobs anymore. You can work one job. So this is among the many things that are creating these pressures for a lot of companies that can't seem to staff their businesses, even though people are coming into shops like crazy. So it's a weird conundrum to see exactly what happens with this. With stuff like immigration and retirement, these things are going to turn around very quickly. And then of course if you're following the CDC data, we see this fourth wave of infections that are happening in the US and this is happening with cold weather. So you can't expect folks who are concerned about spreading COVID to be coming back anytime soon.
But getting back to something that I mentioned earlier, one of the things that are keeping workers on the sideline is because they can. And one of the reasons for this is because of all this money that, not everybody, but a decent number of folks were able to save money because they didn't spend a whole lot last year. And then not to mention the fact that a lot of people got stimulus checks and different forms of government aid that gave them a little bit of breathing room so that they don't have to rush back to work. This stuff eventually runs out and it's kind of a complicated dynamic, but let's go ahead and throw in the whole fact that there's goods inflation, right? It's getting more expensive to pay for the goods and services that you need. And so eventually a lot of these extra savings, the financial cushion that people have accumulated in the last two years, goes away, which ends up becoming a source of labor supply for a lot of these companies. I think this is going to be the big theme to watch in the next couple of months and in the next maybe two-quarters of earnings to see to what degree companies complain less about labor. This is going to show up in monthly jobs reports, but eventually, these folks who have been sitting on the sideline of the workforce, maybe not all of them, but at least some of them are going to start coming back because they're going to have to start earning money again.
[00:23:48] Alex: Yeah. I don't have a ton to add to that other than, and this is only tangentially related and it's a bit anecdotal, but I've been interested to see how some of these larger tech companies, had a perception as being capital-light and did not need many people to run the businesses. I just think we've seen that kind of go way over time, obviously in terms of their CAPEX spend, but also in terms of their headcount. I'm looking at Facebook right now, a decade ago they had roughly 5,000 people working at the company based on the guidance they gave last quarter for 2022, there'll be closer to 90,000 people next year. So it's just interesting to think of some of these companies where you might not think that they would employ a lot of people, they're needing a much larger workforce than many may have anticipated. So, it's only 90,000 jobs, but there are a lot more companies than just Facebook that have similar demands in their business. So I just think that's interesting to keep an eye on as well.
Tech Companies in Q3
[00:24:45] Mokaya: Definitely. I sourced a few thoughts from many people on FinTwit and one of the thoughts was actually about Twitter itself scaling up in terms of hiring in the next quarter or so, which may affect that 2022 earnings. So it may not be able to be reflected this year, it will be reflected more next year, which may be one of the reasons why the stock is trending very low as it is currently. So I think we've gone through half an hour of discussing the macro topics. I would like to open up more to very specific things that you may have noticed, which may be unique to you. And at this point, I think I'll start with Alex who follows Facebook a lot, and you follow a lot of these companies. Maybe you can tell us a bit about what you saw, which are unique points that you've been following for awhile
[00:25:28] Alex: sure. Well, if we're starting with Facebook, there are like 10 different big things that we could talk about. The first one, I guess, at a high level is that the core business by my reading continues to do very well. They have a massive number of users across their platforms and the ability to deliver effective ads enables them to generate significant increases in ARPU as well because there's high demand for those impressions. So their two-year stack growth, I believe, I'm forgetting now, was either 60 or 70%, but that's still obviously a very strong growth rate for a business that has seen its revenue base increase multiple times over the past handful of years. So that's very impressive. Now they're dealing with the impact of Apple's ATT implementation, which if people are interested in learning a lot more about that topic, I highly recommend the podcast that Ben Thompson did with Eric Seufert, I believe his name. He's very thoughtful about online advertising and the whole industry. It's worth listening to. I think this quarter we saw Snap come out with their results and the stock got pummeled. I think effectively what happened is they did a really bad job of communicating with the investment community about the short-term impact from ATT.
When Facebook's results came out, they were impacted as well, but they did a better job of effectively communicating with investors about what the impact might be. They also laid out their plans for how to at least try to address it. There's a big problem here in terms of finding ways to close that loop between targeting and attribution, which is really what direct response advertising is dependent upon. So a lot is happening in the business and it's getting to a size where it's not going to increase the user base double-digit growth rates and perpetuity because they're going to round up people on earth eventually. But they're in a very strong spot in a lot of ways. The really big announcement was about their metaverse efforts and the name change. And they said that their investments in FRL would be a $10 billion hit to operating income this year, which is a very big number and much bigger than people had guessed based on what they had said previously. I don't have a ton to say about it, I mean, I wrote an article about it, so I tried to put my thoughts as clearly as possible in that piece. It’s incredibly early, but I think this idea of presence in digital spaces and just this is where the world is going to seem intuitive and it almost seems inevitable over a long enough period. I think it was interesting that the guy who runs Microsoft's Microsoft 365 business, said recently he was talking about Microsoft specifically, but he said the first digital revolution of ours was essentially about the digitization of paperwork. This next digital transformation that we're all going through is about the digitization of space and time. And I think that idea makes a lot of sense. So, it's incredibly early. But I think Zuck's a visionary in a lot of ways and he has the balance sheet and the income statement to invest aggressively and the voting shares as well. That's also very important. But this will be an interesting development to watch throughout the next five, 10 years, maybe longer.
The Metaverse
[00:28:32] Mokaya: Sam, any thoughts on the metaverse especially as on big tech, any of those companies? Because one of the things that we noted in The Transcript about big tech especially the social media companies saying that they're seeing the fact that their supply chain issues affecting some of the companies ability to spend on ads some, of the companies noted that they're seeing some other companies reducing their ad spend because of supply chain issues. An impact from some of the companies Apple’s privacy concerns. It's impacted the ability of some of the social media companies to be able to assess the impact of ads. And that has also made some of the companies reduce their spending in that regard. Maybe, Sam, you could tell us a little bit about any thoughts that you may have on tech and big tech and metaverse and all those.
[00:29:21] Sam: Yeah I think it was Snapchat that had the headline, that they were saying ad spend declined because of businesses that said, well, if we don't have the inventory to sell any of this stuff, then why are we trying to advertise so hard to draw people into our stores and our online portals and stuff, to look at goods that they can't order anyways. So maybe that explains a little bit of why companies were able to save a little bit on their profit margins. I don't know if I buy that it's going to move the needle by that much but that's an area that's very personal to me. If anything it was more personal before, but it's a little bit less now. For the last 15 years, I was working at news websites where it was all free and it all depended on companies being able to spend on digital advertising so that we could monetize our free content. I'm not sure I'm that's going to be something that persists, but regarding the metaverse though, I think it's just really interesting. It's fun to poke around and joke about and stuff, and I'm not completely sure it completely displaces everything that we do in terms of work on and interaction with each other. But I can certainly see it having a huge impact on how we do a lot of the work that we do, especially as companies try to figure out ways to increasingly streamline their businesses and cut costs and stuff. There's going to have to be a way that companies save in other areas.
And this is also going to be something that if this is a source of cost savings, this is going to be something that offsets something where costs might eventually rise soon. I think one thing that we have learned during the pandemic is that these extremely efficient supply chains and just-in-time delivery and all this stuff are while efficient, really cost-effective, and all this stuff, it's incredibly fragile. So you see silly things like Costco getting into the boating business because they're trying to make their supply chains more robust, but that's going to cost something and they've got to figure out how to save elsewhere. And so maybe they cut their corporate real estate in half and do all of their meetings in the metaverse or whatever. But I think it's something to not laugh away because I think it could be something that does have a huge impact.
My question, maybe Alex, you can speak to this or because I'm just really not that well versed in this. But my question is, what's stopping Microsoft from having a better metaverse or maybe converting Slack into -- we saw Netflix pivot from DVDs to streaming. What's going to stop Slack from going from chat to this metaverse kind of experience. From a competitive standpoint, I don't know exactly where I would be putting my money in terms of betting on the metaverse. But I do think it's something that will be a bigger part of our lives much sooner than we think.
[00:32:28] Alex: Yeah. I think it's a fair question. And it's one that Facebook shareholders or Meta shareholders like myself should be asking themselves. I think I’ve pitched this every time I talk anywhere, but Ben Thompson's newsletter is a must-read for anybody interested in technology generally. He did a really good podcast basically on this exact topic where he broke down how he sees the competitive landscape between four key players. One being startups of some kind, two being Apple, three being Meta and four being Microsoft. The point that he made that resonated with me is this idea of Microsoft Teams as kind of a key layer of what Microsoft brings to the table. And this idea that the adoption of AR-VR, whatever you want to call it, for lack of a better term is more likely to mirror what happened with PCs, where adoption started in the workplace, started in the enterprise, and found its way into the home, as opposed to what we saw in mobile, where people essentially already had a phone in their pocket We just went from a phone that did nothing besides phone calls and text messages and now it does whatever you could possibly want it to do. So that was more of a consumer-driven adoption as opposed to an enterprise-driven adoption where the use case and the price point for the technology are going to find their best use, at least at the start in terms of enterprise application.
So his argument at the end of the day is that the front runner in this race is actually Microsoft. I don't want to misquote him, but I think his addendum to that was Facebook is second given who Mark Zuckerberg is and given the resources that he has at his disposal. So it'd be very interesting to watch, but yeah, I think it's incredibly early and maybe a more tangible thing to talk about in tech is kind of this just the idea of digitization generally. Satya Nadella, who's Microsoft CEO, said about a year ago that over the next decade, they think that technology spending as a percentage of GDP is going to double and just looking at the results as of late it's hilarious. I think we talked about this last time as well, these companies just get bigger and bigger and bigger. And the growth rates that they're putting up in some cases have only accelerated, they're not even slowing down. In Microsoft's most recent quarter, their cloud business revenues were up mid-thirties year over year. It's at a run rate north of $80 billion, which is three times larger than it was three years ago and now accounts for nearly half the business. Just to put that in context, they only ever set a financial goal for their cloud business back in 2015, with this target of $20 billion run rate revenues by FY 18. So we're 4X that level now it's half their business and it's growing, the mid-thirties. So just crazy and AWS results, very similar run rate north of 60 billion and growth last quarter in the upper thirties. So I just think we're witnessing some very large long-term structural trends and their global trends. What that means is that for a certain number of companies, there are astounding results currently being reported.
[00:35:24] Mokaya: Pretty incredible actually to look at some of the companies and the kind of results they reported this quarter. About the metaverse maybe to add a comment there, I think listening to Zuckerberg what he said is they're not going to build a metaverse alone, so there are going to be multiple players in this space. There may be a few winners in the end but I think at the beginning there are a lot of companies that have a very high interest in this space, and there's going to be a lot of collaborations needed to build and to take advantage of the opportunities in this space. I think that's one key thing that came about. But also in terms of Facebook changing its name to Meta, I think one of the things that stood out for me is that Facebook in the space of one quarter, just turned the conversation about metaverse from being very niche to being mainstream and now everyone is talking about it a lot more. Some companies have been playing in this space for a while. I think listening to a company like Roblox, they've been doing it for a while. I went and listened to Invidia’s call. They also have been doing it for a while. Theirs is called the omniverse. I think there are companies which are playing in this space if you're very interested, I think that there are a couple of companies like those that you can follow: Roblox, Facebook now Meta, and of course also Tencent. They have very many quotes in this space.
Opportunities and Challenges in Streaming
[00:36:38] Maybe turning to one more thing that I wanted to hear, maybe more from Alex is about Netflix and the Squid game. I think this was a stunning quarter listening in on their earnings call or reading the earnings transcript, you could tell that they were very surprised as Squid Game took off in the way in which it did. And then I think Disney also had quite a tough time, I mean, it's especially been a bit tough in the Disney+ space. They've hit 118 million subscribers on Disney+. So maybe I wanted to hear your thoughts on those two companies and whatever else you saw in that space of streaming services.
[00:37:10] Alex: Yeah, sure. Well, let's start with the fun one. Yeah, Netflix released Squid Game, which I'm sure everybody knows they released it in mid-September. I wrote about this and it's kind of funny that the show had been rejected for about a decade by local studios in South Korea and then Netflix took a local content team there, they signed to deal with the writer and director in 2019. So yeah, they released a show and it built somewhat slowly but it's become a huge phenomenon sun, sun. And I think the number they gave on the call was 142 million member households had watched it, I believe. And that was still relatively early into all this. So that number is north of 150 million. And just to put that in context, that's three times larger than the total population of South Korea and it has been a top program in nearly a hundred countries around the world for Netflix. I've been somewhat doubtful about the ability of video content to travel globally and to have a big impact on engagement, user retention, and all the important metrics. And I think this isn't the first time that Netflix has had a successful show like this that traveled borders in a big way. I think the big knock-on idea is that thesis that I had previously and as you're thinking about Netflix’s business long-term and you think about global scale if that fact is true, it's incredibly important to the business.
In terms of Disney, it's funny to think that six months ago people were having a conversation about Netflix and its ability to grow and add subscribers and whether or not they'd kind of hit a wall and well that narrative has changed and Disney was somewhat able to avoid that earlier this year. I think in hindsight, with clear data, we can see that that was driven by these very low ARPU Disney+ hot star subs, primarily in countries like India. So, how you think about that is important, but they've hit a bit of a snag in the short term, and this is kind of the reality of running a D2C business and learning the ropes and they've been impacted by their ability to get content to the services as a result of COVID, there were delays associated with that. So they won't hit their stride in terms of the content they need till six to nine months from now. And a period like this also presents questions to management. I wrote in the introduction to my Disney article that's going to come out
Sometimes when you report earnings or report some news as a company, the market reacts a certain way and the right thing to do is just disregard a short-term noise in the market to do what it does. I think other times the market reacts a certain way and people have questions about your strategy and you really should consider effectively what they're saying, the people who are selling the stock and pushing the price down. I think this is probably a case where Disney needs to think about the effectiveness of having multiple services as opposed to consolidating it all into a single lap, kind of an all-you-can-eat model that Netflix has utilized. Disney has done the same thing, even in markets like throughout Europe or in Canada, they have Disney+ with the star tile built into the offering. And for stars, basically, just call it an equivalent of something with Hulu. It's a more general entertainment offering that they decided to consolidate into a single app.
“Disney+, ESPN+, and Hulu continue to perform incredibly well with 118.1 million, 17.1 million, and 43.8 million subscribers, respectively, for a total of 179 million subscriptions. To put this growth in perspective, in the past fiscal year alone, we have grown the total number of subscriptions across our DTC portfolio by 48%, and Disney+ subs in particular by 60% -- We are enormously proud of all that we've accomplished with the service in just the first 2 years. It has exceeded our wildest expectations” - Walt Disney (DIS) CEO Bob Chapek
So I think they're seeing that the strategy they currently have in a market like the United States maybe needs to evolve a bit to more effectively service the needs of the business. So it's still incredibly early. They launched Disney+ two years ago now. Expectations at the time were for something like 60 to 90 million subs globally in five years. And, as I mentioned about the hot star subs, there's probably some adjustment needed to that number for an apples-to-apples comparison. But the reality is if you look at it today, from where you thought they might end up two years ago, they knocked the ball out of the park. So as always in business, you need to adjust the realities on the ground at the time you're making the decision. And I think in this case, Disney needs to do that and I ultimately think they will do.
[00:40:53] Mokaya: Thank you, Alex, for that. I think from my readings of the transcripts of those two companies, Disney and Netflix, I would say mostly, especially about Disney, that they're going to spend a lot on CapEx in the next year to try and get more content, especially on Disney+. So it's going to be a challenging year, maybe short-term challenges, but the long time is very good. They have a very ambitious goal of getting to around 200 million-plus subs by 2024. I'm pretty sure that they're capable of that. We will keep watching in that space.
What Surprised you the most in Q3?
[00:41:21] So maybe I want to turn to Sam, you had an article titled “counterintuitive trends that surprised Wall Street”. So in that same regard, I wanted to ask you, what kind of things surprised you in Q3 from the earnings of the companies that you followed generally, or maybe key themes that surprised you and the same for Alex.
[00:41:40] Sam: That article related to how companies were able to maintain their profit margins at near-record levels. I know that you read a lot and you hear a lot on CNBC and Bloomberg and a lot increasingly about how companies have this pricing power. When you hear about it at this high level, it's like, okay, that's interesting. But I thought one call from earlier this week was extremely interesting and that was the TJX companies. If you guys aren't familiar, TJX is the parent company of TJ Maxx and Marshall's, and growing up, this is where I did all of my shopping because I didn't have a job that could pay for the actual nice clothes. And my parents weren't giving me shit for allowance. So if I wanted to try to get something that was a decent brand but affordable, you went to TJ Maxx and you went to Marshall's because that's where, Polo and Monica and Levi's when they had too much inventory, it gets sent to these stores, it gets marked down by 50% and suddenly, you look cool in middle school or high school. All the places that you would think that would have a little -- I would struggle a little bit with inflation or inventory or costs or anything. You'd think that TJ Maxx might have an issue there, but I believe their quote was that they were, I guess, strategically raising prices and the quote was there was “no pushback from the customers”. So this company that sells consumer goods to a consumer that knows inflation is happening but is specifically targeting people in lower-income demographics is raising prices and people are taking it. They are still buying these goods. So I think that speaks to how crazy things are in the world right now with both sentiments being very sour because of inflation being high. And yet every company, including discounters are actually raising prices and they're still able to send off those costs to their customers. So I think that was one thing that just really stuck out to me because this is not some fluke that pricing power is sort of happening very quietly, but even discounters are raising prices. I think that was probably the biggest surprise to me. And, again, I think, looking out and until the next quarter, the question is going to be, to what degree pricing continues to stick. If it continues I think I would be surprised again. And if profit margins continue to be at record levels, I would be surprised again. But if there's anything the last two quarters have taught us is to not be surprised by that kind of thing.
One thing that Alex mentioned in passing that Erick, I think you mentioned in one of the, I don't know maybe in a DM or something, was in this quarter, investors and traders punished companies on missed expectations. More so than considerably more. And I think you had a chart and maybe you can share this. I think JP Morgan or someone did this analysis, but I think in a given quarter when a company misses on earnings, you see, so I'm looking at this, there's like an average sell-off of about 1.7%. I believe it's the relative one-day performance relative to, I guess the S&P. You typically see maybe about a 1% sell-off when you miss on earnings. In Q3, the sell-off was the under-performance was 4.3%. So companies were getting smoked for falling short of expectations. And I think this is something to watch or just to be mindful of as an investor who might be thinking about making tactical tweaks to their portfolios, or making changes before the year is over. I'm not making any kind of recommendation or anything here, but to me the way I interpret what's going on right now is, God, I hate to use this phrase, but this is telling me that the market is generally getting to that point where you can call it priced to perfection, where you have to either meet expectations or beating expectations tends to be what the market actually expects. But if you're falling short of expectations, your stock is going to get dinged. So, I think that is something to certainly be mindful of as an investor as you think about your positions.
[00:46:25] Alex: Yeah. I don't know if I have anything, in particular, to shout out from this quarter that surprised me outside of probably just broadly speaking. It's amazing to think about what we just lived through over the past, I guess, 24 months to see a business, it's a younger business and it has some structural tailwinds [but it’s growing anyway]. So it's kind of a cherry-pick, but a business like Airbnb, where the bookings on the platform this past quarter are down by a pretty immaterial amount relative to where they were pre-pandemic. I mean, just the ability of the economy to weather a lot of these issues and to adjust and to find a way forward is just amazing. The economy is just the accumulation of all individual people and companies and all the decisions they make and the investments they make, et cetera. So I've just been amazed by a lot of the results that I've seen from a lot of the companies that I follow. It's really something.
Maybe the one other one that wasn't from an earnings call, but I know you'll appreciate this is probably Comcast paying $2.7 billion to keep the Premier League rights in the US where the prior deal had a value over the life of the contract of the comparable length of time. That was a billion dollars. So I'm still trying to wrap my head around how they justify paying for that. And also the decision that they announced earlier this year that they're shutting down NBC sports, which for those who don't know, that's the channel where they feature the vast majority of their EPL rights. So I don't know how to read into what they're doing there, but I found that a bit mind-blowing. So maybe that could be my answer.
[00:47:52] Mokaya: Yeah in addition to that, I think what I saw from the Netflix earnings call is that they say that a lot of traditional broadcasters are trying to bank on live sports as the way to save themselves from cord-cutting. And I think the streaming companies also, eyeing this piece of live sports to also boost their viewership. It’s pretty interesting that they're paying that much, but I'm told if you put that in a context in the US that's very small compared to what other companies pay for the rights for baseball or basketball and all. I'm not so sure. I just saw someone comment below the tweet that you had. Is that true, Alex?
[00:48:28] Alex: Yeah. I mean, some of the rights are incredibly expensive, particularly the NFL, and obviously, you're getting a lot less tonnage in terms of the number of games. The premier league has I think it's 300 games, 300 and something games in a season, something crazy like that. So, if you're paying up, for example, an ESPN package from NFL football, they're only getting, whatever it is, 15 games a year or whatever it may be. So yeah, it's a huge price tag. That’s a good point though. I think we're starting to get to a place where the role of sports and I guess you could say live programming, generally stuff like news and how it interacts with some of these D2C e-sports services, it's going to be very interesting to see because it has a place and it's very big in terms of retention and engagement. So I think Netflix, they've said for years that they don't think that their next best dollar is spent acquiring sports rights. And I think the reasons they've laid out are very logical. And I think it makes sense. That said, they saw something with the F1 series that they had. And, I don't know if it means that they'd be interested in looking at buying a league like Formula One or how they would look to get more involved. Maybe it's just more shows like the F1 series that they have. It's a very interesting landscape. It's going to evolve a lot over the next couple of years.
[00:49:42] Mokaya: Yeah, they do have a really good quote about opportunity cost, I think. And that's what makes them, they don't see value in live sports, but come to think of it, imagine being able to just log into Netflix and being able to watch all your favorite sports in one space. And then you just pay one subscription for all of the games and for all the sports. It can be pretty impressive of course the rights will be very expensive. I know Formula One had their own exclusive channel where you can pay a monthly subscription and then get access to all of these channels. But that's very interesting whatever is happening in that space. I know EA Sports is also having issues with FIFA in that regard also. They want to have the product itself, not associated with FIFA itself because FIFA wants them to pay very high costs for that.
So perhaps this is towards the tail end of our talk today. Maybe I would ask one more question because this is the last earnings call for the year because the next earnings season is early next year. So perhaps you could tell us what you’ll be watching over this space until next year. And maybe also you can plug in your various Substacks and also tell listeners where they can find you and maybe some closing comments. You can tell us where readers can also find you, what are you watching and what should the listeners and readers be looking at, and also where can they find you?
What to Look Out for in Q4
[00:51:02] Alex: Sure. Let me start by saying thanks for putting this together again. I think it's an enjoyable conversation. I always like hearing Sam's point of view on things. I'm going to take them in reverse order real quick. So my service is the TSOH investment research service on Substack. You can find it on my Twitter page, Twitter bio. I have an article coming out in two weeks, it'll be available to free subs and pay subs available to everybody where I'm going to lay out my investment thesis. And the reason why I wrote the article is because I started investing in, I believe it was 2007 and over the course of the past 10 plus years, a lot of the things that I believe fundamentally have not changed in a big way, but how I apply that in terms of my investment process has evolved a bit.
So I think it's worthwhile for me to put that on paper, one for prospective subscribers or current subscribers to see whether or not it aligns with their own view of the world. And I also thought it might be helpful for me to write it down just so I could have it very clearly stated somewhere. So the point of me saying that is, and I’ve outlined in that article in more detail, obviously I'm a long-term investor, who looks to own high-quality businesses and typically fairly concentrated positions. Something like 5 to 15 positions total with the top handful being the majority of the portfolio. I say that because when I listen to the next rounds of earnings calls, just as I do with every set of earnings calls, I'm looking for a handful of things. I want clarity and vision from management. I want clear explanations for the things that are not going well. I want a real reason to believe that the people that I've entrusted with my capital to run these companies have the same long-term goals as I do in terms of maximizing the per-share value of the business, but also ensuring happiness and satisfaction of all stakeholders to some degree. And also that they're continuing to move forward in a way that I think makes sense. So those are the things that I'll be listening for and we'll see how that goes. Hopefully not too many surprises. It sounded like people had a lot of surprises in Q3. I think I luckily missed a good amount of those generally speaking, but that might just mean I have them coming in Q4. So I'll keep my fingers crossed. Thanks again for having me.
[00:52:59] Sam: And it's called The Science of Hitting. You forgot to plug in the name.
[00:53:03] Alex: I forgot my name. Yeah. The Science of Hitting. Thank you, Sam.
[00:53:05] Sam: Yeah likewise, it's great to hear from Alex and Erick. Thanks for setting this up. It's great hearing from Alex. Cause a long time ago I spent a lot of time analyzing equities at that company level. So it's good to know that there are still people who take great care when doing that. Tker, the newsletter that I write, the link is in my Twitter profile, really focuses on the macro themes, the big picture, the backdrop that the companies that Alex covers are operating in. I think one of the things to look out for, and this is something that I'm going to be writing about, on my Sunday issue and if you guys want to check that out, this is the preview of what that's gonna look like. And my Sunday issues are always free. So that goes out every Sunday weekly.
But I think the big thing to watch right now, and I think it's super bullish is to see what companies are doing with inventory and specifically the inventory rebuild. This is not even about the degree to which companies are converting this into sales and revenue. We know that the demand is pretty robust, but even if things go sideways, companies are still having to restock their stock rooms. A lot of the sales and earnings beats that we've heard about in the last two quarters has been because companies have been depleting the hell out of their inventories. And there's a lot of nuance to this too. Keep in mind that, when companies have a lot of inventories, that means they also have to do something about clearing this stuff out, which means, clearance sales, markdowns, promotional pricing, and all this stuff. And that has just not been happening. As much as it used to in the last couple of quarters, and this actually sort of feeds into a lot of these inflation stories. One of the reasons why my jeans are so expensive this year isn't so much because the price went up. TJ Maxx didn't have them on markdown this year. So this whole story about inventory and companies getting their inventories back to those normal levels I think ends up becoming an incredibly bullish story for the economy.
So this whole story about inventory and companies getting their inventories back to those normal levels I think ends up becoming an incredibly bullish story for the economy.
And, again, this is not just retailers, capital equipment, I mean we know everything we know about, tech companies and chip suppliers on, of course, the auto companies as the supply chains do loosen up and they are loosening up. I mean, as much as they're still backed up and you hear about these bottlenecks when you do look at the data, it turns out that the port of LA is processing more goods this year than they were last year, even though it looks worse now it's because of all this demand. So I think it's going to be interesting to see these conversations about inventory and it's going to be incredibly boring conversations. It's the kind of stuff that happens in the middle of the Q&A as analysts are trying to tweak their models and adjust how they analyze a company's balance sheets. But I think this inventory conversation is gonna be really interesting because the more companies talk about how they're right-sizing their inventories in an expansionary way. That is someone else's business. And that also is going to translate into a huge tailwind for stuff like GDP. So keep an eye on inventories. My newsletter is called Tker, that's TKER and you can find that at tker.co.
Conclusion
[00:56:29] Mokaya: Thank you. Thank you, Sam. Thank you, Alex. It's always a pleasure. I religiously read your newsletters every time they come to my inbox. So it's a pleasure to come and listen to you. I love your writings, so I enjoy them a lot and share them with friends as much as I can. It's always nice to host this. This is our second quarterly review. So we'll be doing another one again early next year. So in the meantime, it's good to tell our listeners I just posted the links to Sam and Alex's various newsletters. You can just subscribe to them and follow them. We also have our newsletter, The Transcript, where we read earnings call transcripts and summarize the key thoughts and key quotes that can also impact your portfolio. Also, subscribe to thetranscript.substack.com. The key themes which we've been following with Scott, he was not able to join today. Mostly, we are also looking at supply chains, we're trying to see when they will turn. And we are also looking at inventories as Sam says also if they are also going to pile up once the supply chain situation eases up. But also we are looking at various other aspects like we track quarter to quarter and see what a company is saying, and we try to analyze the key themes and trends for you and to distill that in our weekly newsletter. So do follow us and we hope that we can also do another one like this early next year. In the meantime, we wish you happy holidays and see you next year. Thank you, Sam. Thank you, Alex.
[00:57:49] Both: Thanks, everybody.
[00:57:50] Mokaya: Thanks for joining us today.
Q3 2021 in Review