Dear Partners,
Rowan Street gained +49.2% in the first quarter of 2023. Please see disclosures for the historical performance data. Our top two positions we discussed in our 2022 year-end letter were the biggest contributors to the outperformance (Spotify +69%, Meta +76%).
Below we listed some historical annual returns for our core holdings. As you can see, in any given calendar year stock returns can be very erratic, depending on the mood that Mr. Market is in (and the mood swings have been pretty intense over the past 3 years). However, the fundamentals of companies usually do not fluctuate even nearly as much from year to year, and over time, stock prices tend to accurately reflect the underlying business results.
As we stated in our 2022 letter, we expected both SPOT and META to be significant contributors to our performance over the next several years (we just did not expect the outperformance to come this soon). Yet another lesson that trying to time the market and following the general market narrative is not only a waste of time and energy, but can be hugely detrimental to long term results .
This does not mean that this rebound will be sustained or that we could not experience further declines in the market this year. However, we believe that Mr. Market is rapidly repricing our portfolio companies in 2023, which were severely punished in 2022. Please refer to our 2022 year-end letter for a more detailed discussion.
“You were used to say extremity was the trier of spirits; that common chances common men could bear; that when the sea was calm all boats alike showed mastership in floating.” ― William Shakespeare
Extremity is an appropriate word that we would characterize the past 3 years. We believe that true character and success are defined not by how you act when everything is going your way, rather it’s how you act when everything isn’t.
That is why we believe that times like these are most valuable for us as fund managers (and most importantly as business owners) because they offer a unique opportunity to re-evaluate our business managers to really understand their true nature as well as re-evaluate the strength of the moat of the businesses that we own.
It can be difficult to distinguish the true winners from mediocre performers in a long lasting bull market when everyone is growing at a very fast pace, raising lots of cheap capital supported by sexy presentations of limitless Total Addressable Markets (TAMs) and endless growth opportunities in front of them — “when the sea was calm all boats alike showed mastership in floating”. Most CEOs are super charismatic and very skilled at story telling (that's how they got to be where they are), and most investors, overtaken by greed, can get easily excited about that ‘beautiful painting’ of the bright future in front of them. Thus, decisions are typically heavily influenced by emotion rather than rational thought supported by facts, data, and deep insight into the company fundamentals and competitive strengths. Groupthink (compounded by social media) tends to even further reinforce preconceptions and suppress critical thinking. When the tide raises all boats, anything can look like the “next Amazon.”
But we believe that it's times like 2022/23 that really separate the exceptional businesses and exceptional managers (few and far between) from the great story tellers that just mislead the public, and themselves for that matter, into believing.
What are we looking for from our managers?
Facing negative headwinds, many businesses instinctively play to the lowest common denominator and see change as a tax or burden to be dealt with. Meanwhile, adaptive leaders are playing up, playing to win. This means seeing change as a growth opportunity and not shying away from making bold decisions, even when it goes against what others around you are doing.
With that, let’s go through our top three holdings and look into how they are really handling the turbulent waters? Are they really playing to win? For the sake of keeping the length of this letter short enough to keep your attention span, we will go through the other 3 holdings on the list above — Topicus, Shopify, Netflix — in our mid-year letter.
Spotify (SPOT)
We spent a lot of time talking about Spotify and its future prospects in our 2022 year-end letter, so we will spare you another discussion in this letter. We encourage you to review what we wrote.
Meta Platforms (META)
META stock hit the lows of $88 per share in November of 2022, as the stock dropped a staggering 75% from its highs, while revenues only declined by 1% in 2022, gross margins dropped 4% and EPS declined 38% (please see the figures we included below). At the time we published a note: “Does a $750 billion decline in Meta’s market cap make sense?”
Source: Rowan Street Capital, LLC
Since those lows, Meta’s stock has increased +131% compared to the S&P 500 rise of +7% for the same time period. So how has Mr. Market’s perception of Meta’s future prospects change so much in just a few months?
As it usually happens after a huge rise in the stock price, analysts are now turning bullish on the stock and upgrading their price targets (akin to shooting an arrow first, seeing where it lands and putting a bulls eye over it). Their bullishness is largely based on the new discipline around expenses and capital spending.
On the latest Feb.1 quarterly call, Mark Zuckerberg discussed his management theme for 2023 as the “Year of Efficiency”. For most of Facebook’s history, they saw rapid revenue growth year after year and had resources to invest in many new products. But 2022 was a humbling wake up call for Zuck. The world economy changed, competitive pressures grew, and the company’s growth slowed considerably. They responded by scaling back budgets, shrinking their real estate footprint, and made a difficult decision to lay off 13% of workforce (note that in March ‘23 they announced plans to cut another 10,000 jobs and close 5,000 open roles — that is after an 11,000-job layoff in November). Below, we jotted down Meta’s hiring progression since their IPO in 2012:
Over this 10-year time period, they have increased their headcount at a staggering speed of 34% per year from 4,619 to 83,482 employees (note that this includes the ~11,000 employees impacted by previously announced layoffs who remained on payroll as of 12/31/22 due to legal requirements). In the same time period, their revenues have grown at a rate of 37% per year, so we can say that the headcount increase was justified for this ‘high growth era’.
If we look at the past 3 years (since COVID started), Meta has grown their headcount by 23% per year, while their revenues grew at a rate of only 18% per year, coming to a complete halt in 2022 (-1% revenue decline). So we can argue that Zuck is pivoting quickly and re-adjusting the company’s cost structure to the new world as well as his new expectations for growth ahead.
We estimate, based on the layoff figures that the company has provided, that Meta will finish 2023 with 62,482 employees — a dramatic 25% reduction from 2022. At the same time, Meta’s revenues are estimated to increase 6% in 2023 to $124 billion. Thus, we estimate that 2023 will be the highest ‘Revenue per Employee’ year in company’s history, coming close to $2 million per employee (please refer to the figures above).
More importantly, Zuck is not only focused on reducing heads, but on developing a flatter organizational structure that is conducive to faster decision-making. Here is what he said in his recent note to employees:
“It’s well-understood that every layer of a hierarchy adds latency and risk aversion in information flow and decision-making. Every manager typically reviews work and polishes off some rough edges before sending it further up the chain.
In our Year of Efficiency, we will make our organization flatter by removing multiple layers of management. As part of this, we will ask many managers to become individual contributors. We’ll also have individual contributors report into almost every level — not just the bottom — so information flow between people doing the work and management will be faster.
Of course, there are tradeoffs. We still believe managing each person is very important, so in general we don’t want managers to have more than 10 direct reports. Today many of our managers have only a few direct reports. That made sense to optimize for ramping up new managers and maintaining buffer capacity when we were growing our organization faster, but now that we don’t expect to grow headcount as quickly, it makes more sense to fully utilize each manager’s capacity and defragment layers as much as possible.”
Naturally, the 'Year of Efficiency’ and the focus on building the critical muscle for financial discipline going forward was music to Wall Street’s ears, and was almost entirely responsible for the stock more than doubling from November. We are huge supporters of this renewed focus as well. At the same time, Meta is an innovative technology company, and as long-term investors, we really liked hearing that Meta will still continue to invest heavily into its long-term vision despite the renewed focus on efficiency. They are not just playing defense and trying to survive, they are playing to win! Zuck emphasized this in his recent note to employees:
“In the face of this new reality, most companies will scale back their long term vision and investments. But we have the opportunity to be bolder and make decisions that other companies can’t. So we put together a financial plan that enables us to invest heavily in the future while also delivering sustainable results as long as we run every team more efficiently. The changes we’re making will enable us to meet this financial plan.
I believe that we are working on some of the most transformative technology our industry has ever seen. Our single largest investment is in advancing AI and building it into every one of our products. We have the infrastructure to do this at unprecedented scale and I think the experiences it enables will be amazing. Our leading work building the metaverse and shaping the next generation of computing platforms also remains central to defining the future of social connection. And our apps are growing and continuing to connect almost half of the world’s population in new ways. This work is incredibly important and the stakes are high. The financial plan we’ve set out puts us in position to deliver it.”
In summary, despite the stock more than doubling from November, we believe our investment in Meta still has meaningful upside in the years ahead driven by continued innovation, accelerating revenue growth, newly emphasized cultural principles that are guiding operational and cost efficiencies, and still attractive valuation.
Trade Desk (TTD)
Out of all our fund’s current holdings, we have been most impressed with Trade Desk, the strength of its business model and the execution by its management team, led by Jeff Green (Founder and CEO). It’s one of the few high-growth tech companies that consistently generates strong profitability and free cash flow. We have owned TTD for 3 years now, opportunistically establishing a position in March of 2020. Since then the stock has advanced +240% or 50% per annum, revenues have grown at 34% per year, adjusted EBITDA has grown at 50% per year and cash flow per share at 106% per year. One would have to agree that these are pretty stunning results!
Something that we really like to see is that in the last 6 months of 2022 they really started to separate from the rest of the digital advertising market. In Q3, they grew 31% while competitors were either in retreat or posting only single-digit growth. Same trend continued in Q4 when they grew 24% as most large competitors were posting declines between -9% and -2%. Jeff Green stated on the latest earnings call:
“I don’t think we have ever had the level of industry outperformance in 6 years as a public company. And it means we can be very confident that we are gaining share and that our platform continues to gain traction with advertisers.”
Trade Desk and its management team are taking advantage of current environment and really playing to win:
“Despite an uncertain macro environment, particularly in Europe, we remain focused on the long-term investments that will position us for strength when conditions improve. In an uncertain environment like today, advertisers become more deliberate with their ad spend, scrutinizing the effectiveness of their ad budgets much more carefully than they have done previously. As we have shown during similar environments in the past, as advertisers become more deliberate and data-driven with their ad spend, The Trade Desk wins more budget.”
Even though Trade Desk is forecasted to end 2023 with close to $2 billion in revenues, we believe they are still in very early in their growth cycle. Additionally, they have a huge industry secular tailwind at their back. Jeff Green recently talked about this on the earnings call:
“At The Trade Desk, we’re living a secular tailwind that I don’t know that we’ve ever seen before, and I don’t know that we’ll ever see again and that is going to continue into 2023, largely because of the amount of inventory that is coming online. But also as you look across the open Internet, and whether that’s inside of display or native or audio or any other channel because Connected TV (CTV) is leading the way in forging the future of identity, CTV is not just leading in our business, not just the most interesting thing happening in programmatic, but it’s the most interesting thing happening in ad-funded media. Over the most of the history of The Trade Desk we got the leftovers from search and social and the walled gardens. And what’s starting to happen now is we are getting the very first dollar, and that’s happening more and more. We expect that to continue as a secular tailwind that CTV continues.”
We believe that Trade Desk’s moat is widening and they are grabbing land and executing very well year after year. If we take a look at our 3 parts of an engine of a ‘compounding machine’ that we search for: (1) their moat is deepening and they have a long runway for growth (2) their management is top-notch and executing at a very high level (3) their reinvestment opportunities are immense as this is a huge industry and they are grabbing land at a rapid pace. This company has the potential to be a very attractive long-term opportunity — we will just have to see how the story plays out.
So if we think TTD could be such an attractive long-term opportunity, why isn’t it our number one position in the fund?
Currently, TTD is a #3 position in the fund. From the time that we first established our small position in March of 2020, it organically grew to 12% weighting in the portfolio. We haven’t had a chance to add to our position in the past 3 years for two reasons. One, is that it takes us time to really learn and get to know the business and its management team. Once the business and its management team meet all our criteria for investment, we like to establish a small position and keep learning and observing how they execute over time. Sometimes you get to the point relatively quickly, but a lot of times it could take years to understand how great a certain business really is and/or how great their management team is. Or vice versa, a business that you thought was outstanding could turn out to be mediocre once you have closely followed it and really learned all about it over a period of time. In fact, its rare that we like an idea as much after we’ve followed it for 2-3 years. Truly exceptional businesses are very rare, and if you are lucky to have found one, you want to allocate a meaningful amount of capital to it — our primary goal is to water our flowers (extraordinary businesses) and pull out the weeds (mediocre performers). Seems like a no-brainer, but you would be surprised how difficult it is to do in practice and how few investors are able to follow that simple objective.
Another aspect of this is the price. Even though we are more than willing to pay up for rare outstanding businesses, we don’t like to overpay. Even the best business could turn out to be a bad investment if you pay a foolish price for it.
Now with the case of The Trade Desk, we are not the only ones that recognize how good this business and its management team really are. The stock has always sold at super expensive prices, with the exception of March 2020 when we established our initial position (at the time, it briefly traded down to 8.4x sales, 27x Adj. EBITDA and 19x cash flow). Truly exceptional businesses are very rare, but the opportunities to buy them at attractive prices are even rarer (why should getting wealthy and compounding at above-average returns be easy?). After that short-lived decline, TTD’s stock took off like a rocket and spent the rest of 2020 trading at an average of 53x revenues, and in 2021 at 41x revenues. The stock corrected -51% in 2022 (along with all the other tech stocks) to an average valuation of ~15x sales and 19x gross margins, and traded as low as 37x cash flow in November ‘22, but still never got to attractive levels, in our opinion, that would justify a meaningful additional investment.
If we were to assume that sales grow by 25% a year for the next 5 years, they would reach $4.4b by 2027. If we assume that they get to a 25% operating margin by that time, they would earn $1.1 billion in operating income. From today’s valuation of $29 billion, unless their revenue growth explodes north of 30% per year and stays there for a long time (we don’t want to play those odds), it’s difficult to justify an additional investment that would earn an attractive return over the next 5 years. So our decision for the past 3 years has been to ‘Do Nothing’.
Conclusion
We think its appropriate to finish the letter with a very fitting quote from Warren Buffett:
“I don’t know how to predict the stock market, I don’t know how to predict the economy, I don’t know how to predict interest rates. All I know is if I buy the right kind of business with the right people at the right price, I’ll do well over time.”
And that is the only thing that we are trying to do here. We should add that buying the right business with the right people at the right price is only 20-30% of the battle. How many of us have owned great businesses in the past and sold them either to book a profit or because either Mr. Market soured on the stock or some consensus about the prospects of the economy scared us away from long-term ownership in the company, only to find the stock skyrocketing 5-10x after the sale? We can all admit that we have had those — we actually published our case study on Chipotle back in 2019 that describes such a situation.
So, the majority of success really comes from staying with the ‘right business’ through all the volatility, all the noise, all the fear and greed and from being able to sit still and to do nothing. That, ladies and gentleman, is the hardest to do in our business!
I have recently re-read the autobiography by Sam Walton “Made in America”. It’s one of my favorites and I highly recommend it to anyone interested in business biographies. I wanted to share some golden words from Mr. Walton, which make a fitting conclusion to our discussion in this letter:
“I don’t subscribe much to any of these fancy investing theories, and most people seem surprised to learn that I have never done much investing in anything except Wal-Mart. I believe the folks who’ve done the best with Wal-Mart stock are those who have studied the company, who have understood our strengths and our management approach, and who, like me, have just decided to invest with us for the long run.
I guess what’s annoying to executives—to anybody who tries to spend their time managing a company as big as this—is these money managers who’re always churning their investors’ accounts. You know, the stock will get to $40 or $42, and they’ll rush in there and say, ‘Hey, let’s sell this thing because it’s just too high. It’s an overvalued stock.’ Well, to my mind, that doesn’t make much sense. As long as we’re managing our company well, as long as we take care of our people and our customers, keep our eye on those fundamentals, we are going to be successful. Of course, it takes an observing, discerning person to judge those fundamentals for himself. If I were a stockholder of Wal-Mart, or considering becoming one, I’d go into ten Wal-Mart stores and ask the folks working there, ‘How do you feel? How’s the company treating you?’ Their answers would tell me much of what I need to know.”
We look forward to reporting to you again at the end of the second quarter. As always, should you have any questions or comments, we would be very happy to hear from you.
Best regards,
Alex and Joe
DISCLOSURES
The information contained in this letter is provided for informational purposes only, is not complete, and does not contain certain material information about our Fund, including important disclosures relating to the risks, fees, expenses, liquidity restrictions and other terms of investing, and is subject to change without notice. The information contained herein does not take into account the particular investment objective or financial or other circumstances of any individual investor. An investment in our fund is suitable only for qualified investors that fully understand the risks of such an investment. An investor should review thoroughly with his or her adviser the funds definitive private placement memorandum before making an investment determination. Rowan Street is not acting as an investment adviser or otherwise making any recommendation as to an investor’s decision to invest in our funds. This document does not constitute an offer of investment advisory services by Rowan Street, nor an offering of limited partnership interests our fund; any such offering will be made solely pursuant to the fund’s private placement memorandum. An investment in our fund will be subject to a variety of risks (which are described in the fund’s definitive private placement memorandum), and there can be no assurance that the fund’s investment objective will be met or that the fund will achieve results comparable to those described in this letter, or that the fund will make any profit or will be able to avoid incurring losses. As with any investment vehicle, past performance cannot assure any level of future results. If applicable, fund performance information gives effect to any investments made by the fund in certain public offerings, participation in which may be restricted with respect to certain investors. As a result, performance for the specified periods with respect to any such restricted investors may differ materially from the performance of the fund. All performance information for the fund is stated net of all fees and expenses, reinvestment of interest and dividends and include allocation for incentive interest and have not been audited (except for certain year end numbers). The methodology used to determine the Top 5 holdings is the largest portfolio positions by weight. The top 5 do not reflect all fund positions. The Top 5 can and will vary at any given point and there is no guarantee The top 5 will continue to perform and, more generally, there is no guarantee the fund will meet any specific level of performance.