Sunday Finds + 3 Thoughts From Last Week
Applied Materials + Formula One
Welcome to Chit Chat Money’s Sunday Finds + 3 Thoughts From Last Week. In this newsletter you will find three topics I thought about last week, links to shows we’ve recently released, and links to some interesting articles, podcasts, and tweets. Check out the archive here.
1. The 10 year U.S. Treasury Yield Reaches 2.5%
Late last week U.S. treasury yields started rising rapidly after recent comments from members of the Federal Reserve, including Chairman Jay Powell:
The 10-year rate at its highs of Friday’s session hit 2.503%, its highest level since May 2019. The yield started the week near 2.15%.
Most investors primary concern isn’t the loss in value of treasuries (rising yields mean a falling price) but the second-order effects of what it may mean for equities. We’ve all been taught that U.S. treasuries are the risk-free rate for investors, and that yields for other assets like equities generally follow treasuries. As of this writing, Multipl.com is telling me the S&P 500’s earnings yield is around 4%, which is still a decent gap between the 10-year at 2.5% and the 1-year treasury, which is at 1.66%.
If treasury yields continue to rise, will the earnings yield of the S&P 500 rise along with it (and therefore cause equity prices to drop)? Maybe. Well, probably. But I don’t think it is worth considering when making a decision on whether to buy or sell a stock if you have a long-term time horizon. Why? Because if you have a prediction on the direction of interest rates as one of your inputs when making an investment decision, that means you are trying to make a prediction on where the market will go in the short-term (i.e. you are market timing). It just seems entirely unpredictable to me. It is definitely fun to discuss and have debates about, but (and this might seem controversial) if you have to make a bet on interest rates before buying a stock, that stock probably doesn’t belong in your portfolio.
(If you want any information on how we make investment decisions, check out our 2021 Annual Letter)
2. To Include SBC, or not include SBC, that is the question
One of the fiercest debates in finance is whether to include stock based compensation (SBC) or exclude it when doing your free cash flow (FCF) calculation. If you do the standard FCF calculation of FCF = Operating Cash Flow - Capex, then you are adding back SBC as a non-cash charge even though it will be an expense for shareholders through share dilution over the long-term.
If you want to learn in more detail (and hear a good argument for why you should not add back SBC when doing FCF calculations), read this piece:
The reason that non-cash expenses like Depreciation and Amortization and Stock Based Compensation are added to Net Income to create Cash Flow from Operations is because these expenses don’t represent literal cash coming from a business.
Stock based compensation expense is similar but different. A company can issue shares to pay its employees as bonus compensation, and this does not come out of cash from the business.
Instead, shareholders are essentially footing the bill to compensate employees inside the company. Often SBC doesn’t make up a big portion of FCFE, and so its dilution effect to shareholders is generally close to nil.
My strategy for calculating FCF is to use the standard method (i.e. not count SBC as an expense for FCF) but have the stock-based “expense” show up in the share count. To do this, I add all stock options, RSUs, and other potentially dilutive securities to the current shares outstanding, no matter what the audited number is. This means I am accounting for the SBC (which is a true expense, I think we can all agree) with a larger denominator rather than a smaller numerator when doing a free-cash-flow-per-share (FCF/s) calculation.
I like this method for two reasons. One, by moving the SBC expense from an abstract dollar amount to the actual dilution embedded in the share count, we get closer to what the true expense from share grants will actually be. Two, when using this method, your free cash flow is the actual cash available to return to shareholders. Of course, each company has its own nuances, and I’m sure there are some special situations where SBC should be used differently or when other line items should either be added back or not added back to your FCF calculation. But that’s what makes investing such a fun game.
Lastly, I think excluding the SBC add-back from operating cash flow while also including the fully diluted share count in your denominator for FCF/s is unhelpful. It unnecessarily penalizes companies that use SBC to finance growth by double counting dilution. I believe that can blind investors to the true value a company is generating for shareholders.
(I’m still forming my thinking on SBC, and would be happy to have my mind changed. Let me know if any of this thinking is flawed)
3. Can individual games become subscription services?
The two most important trends in the console video game industry are the emergence of subscription services and cloud-based gaming. Think of it as the “Netflix-ification” of the industry. Microsoft is leading the charge on both fronts, with Sony, Nintendo, and EA dipping their toes in the water.
The potential transition to a subscription-based model for gamers this decade will be crucial for all links in the value chain to navigate. Publishers don’t want someone like Microsoft to gain huge leverage over them by having a subscription service like Game Pass be the main way people interact with console-style games. At least, not without retaining their current revenue streams.
Unlike the traditional TV/movie industry, which has gotten totally steamrolled by streamers like Netflix, I think big publishers will do just fine if subscriptions and cloud gaming take over the industry. Why? Because unlike in TV/movies, a few entertainment brands dominate the industry.
Take, for example, what Rockstar announced with Grand Theft Auto this week:
GTA+ is a new membership program exclusively for GTA Online on PlayStation 5 and Xbox Series X|S — launching on March 29 and providing easy access to a range of valuable benefits for both new and long-standing players on the latest generation consoles.
Being a GTA+ Member gets you a recurring monthly GTA$500,000 direct deposit to your Maze Bank account, plus the opportunity to claim properties in and around Los Santos that unlock gameplay updates you may have missed out on, special vehicle upgrades, Member-only discounts, GTA$ and RP bonuses, and more each month.
The subscription will cost $5.99 a month. It’ll be interesting to see how much adoption this gets, but I think it is a smart move for game publishers to lean in to subscription services as a way to counterposition themselves vs. the fast growing multi-game subscription services like Microsoft Game Pass.
Only a few top franchises like Grand Theft Auto, FIFA, or Mario Kart could pull this off, and it is definitely not for every type of game. But charging $10 a month for a game like Fifa in perpetuity sounds a lot more appealing than undercharging $60 each year and then over monetizing with microtransactions. I think consumers would be more happy with the publishers, and in the long-run it would likely bring in more revenue/cash flow to the companies.
Again, there are a lot of moving pieces here though, and things could play out totally differently over the next five years.
See you next week,
Brett
***Our fund, Arch Capital, may own securities discussed in this newsletter. Check our holdings page and read our full disclosure to learn more.***
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Catch-up on Our Shows From Last Week
3 Good Reads
The Death Wish - Tom Morgan
“The critical error is letting what you think you want get in the way of what’s actually unfolding”
How People Think - Morgan Housel
I don’t think I’ve met, or know of, anyone with outsized success who gained as much happiness as an outsider might expect. That doesn’t mean success can’t bring pride or contentment or independence. But it’s rarely what you thought it would be before achieving it.
Fertilizer Firms Spread Wealth to Shareholders as Farmers Weather Extreme Prices - Lee Harris
In the summer, Hurricane Ida ripped through the U.S. Delta region, which accounts for large amounts of nitrogen. Plants were mostly unharmed, but electricity came back on for residences first, causing a delay in nitrogen production. In December, fears of war in Ukraine sent prices higher. All told, by the end of 2021, global fertilizer prices had increased 80 percent.
1 Good Listen
Oil: The Making of the Modern World - The Rest is History
Discussion covers the first oil well ever drilled, how it's hard to overestimate Hitler's obsession with oil, and the formation of OPEC in the aftermath of the Suez Crisis.
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