Long-Term Investing Ideas in a Volatile Market
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
Ryan Henderson and Brett Schafer of Chit Chat Money discuss stock-based compensation, the gaming industry, and market volatility with 7investing CEO Simon Erickson.
July 12, 2022 – By Simon Erickson
There’s no shortage of things going on right now in the investing world. Rapidly-rising interest rates, inflation at a forty-year high, and a broad market selloff are giving investors and the financial media plenty to talk about.
However, there are also other factors — which aren’t necessarily making headlines — that will have deeper implications for long-term investors as well. Stock based compensation is one of those. SBC has traditionally been a great way for fast-growing companies to reward their high-performance employees and to encourage retention. When times are going well, everyone’s getting paid and everything is good.
But will things change in the current state of the market, with stock prices falling and companies struggling? Will it manifest in the financial statements of Silicon Valley’s high-flying tech companies? And will it impact the overall strategy of the executive teams of those companies?
We tackle those questions and many more in today’s 7investing podcast. 7investing CEO Simon Erickson chits and chats with Ryan Henderson and Brett Schafer from Chit Chat Money, to discuss how several companies are handling stock-based compensation in today’s era.
Ryan and Brett are also the portfolio managers of Arch Capital, which is a real-money fund that is actively investing in stock market opportunities. The two describe why they’ve taken several positions in the gaming industry — including Nintendo, Electronic Arts, and Take-Two Interactive. And in the final segment, the group discusses a few things investors should be keeping an eye on in 2022.
Publicly-traded companies mentioned in this interview include Apple, DocuSign, Electronic Arts, Microsoft, Nintendo, Peloton, Take-Two Interactive, Tesla, Upstart Holdings, and Yext. 7investing’s advisors or its guests may have positions in the companies mentioned.
Simon Erickson 00:00
Hello everyone and welcome to today’s edition of our 7investing podcast where it’s our mission to empower you to invest in your future. I’m 7investing founder and CEO Simon Erickson. I’m really excited to be joined by our partners to chit chat money today other long term investors who share a lot of the same perspectives on the stock market as I do. That’s Brett Schaefer and Ryan Henderson. They’re joining me today for our podcast. They’re also the two portfolio managers of arch capital. Bretton, right. Hey, nice to meet you guys. Nice to meet. Nice to see you guys. Again, it’s always a pleasure check checking in with you every couple of months.
Brett Schafer 00:34
Glad to be here.
Ryan Henderson 00:35
Yeah, definitely happy to be here.
Simon Erickson 00:36
We’ve got a bunch of topics we could talk about, we could always talk about the volatility of the market and interest rates going up and stuff like that. But I always like to kind of dig a little bit deeper into some of the sectors and even the companies that you guys like, and maybe even have a 10,000 foot kind of overall discussion as well. And so we’re gonna jump into gaming a little bit later on the podcast. But the 10,000 foot discussion I wanted to start with was on stock based compensation. This is something that when times are good, and it’s 2021, it’s step your foot on the accelerator, growth at any cost, this is not something that gets a whole lot of attention, right? Investors just kind of glance over and say, okay, it’s fine. Silicon Valley can pay these guys with a ton of money in stock. But now this is something that’s becoming more and more important for a variety of different reasons. Let me just throw it to you guys. What are your thoughts on stock based compensation? And maybe how is that a little different today versus a year or two ago?
Brett Schafer 01:32
Well, anyone that’s listened to our show on Chit Chat money knows that I am not a huge fan of stock based compensation. I definitely prefer cash. And there’s, I guess we can go into the deeper details of say the difference between when the stock soaring and kind of what companies are doing now with their stocks down, say, maybe 80%, or something like that repricing stuff like that. But the reason I like cash, if a company can do it compared to stock based compensation, is one, it’s so much simpler. It’s simpler for employees, it’s simpler for management. And it’s simpler for shareholders to track and two, SBC or options, or giving people ownership, directly instead of letting them decide whether they want to be a shareholder in your company themselves, puts leverage on your stock price that you wouldn’t have if you’re paying people in cash. So I get that some companies need to if they’re a startup or they’re burning money, growing quickly, it can be an advantage to you stock, and I’m not against investing in a company that uses heavy stock based compensation. We’re invested in companies that use heavy stock based compensation. But it’s definitely a lowlight for me. And I think in general, those are kind of the two main things. And I know there’s obviously more specific things for a lot of tech companies whose stocks might be down 50, 70% right now.
Ryan Henderson 02:53
Yeah. I mean, there’s like the yeah Brett’s probably more against it, I guess, than I am. I’m not the biggest fan of it. But the there is that side to it, the personal side, where you feel just I mean, you’re, well, your bonus is diminished, or you thought it was going to be worth more, because you decided to take options as an employee. And there is, I imagine kind of a knock on morale of the company, when there’s something like that, especially when everyone at the company is has been incentivized with stock. We’re starting to see, I think a lot of examples where top talent at some of the bigger tech firms are leaving, because they don’t see the opportunity there.
Brett Schafer 03:44
And leaving for mega cap, like FAANG, potentially, I guess that’s kind of the worry for a lot of these people, because we’ve seen, who was it? I believe Microsoft (NASDAQ: MSFT) like doubled their mid level salary or something like that. And these FAANG companies or FANMAG, whatever, the mega cap techs, they have so much cash on the balance sheet. Their stock prices have only gone down by say like 15 to 20%. They can offer way way better pay, even if you’re going to be in more bureaucracy maybe or you’re gonna be in a larger company that it might not be the job you dreamed of. In this environment, you might like that better than say, Well, do you have that DocuSign (NASDAQ: DOCU) example Ryan with everyone leaving?
Ryan Henderson 04:24
Yeah there’s been a lot of I believe that sales reps at DocuSign have been leaving this year. And I believe that’s part of the reason why Dan Springer ended up resigning here recently and they talked about on the last conference call. And they were basically asked like, why do you see so many sales reps quitting and Dan Springer said, One, I do think the most substantial component for us and pretty much everyone I talked to in the software world is this construct the equity values are clearly down pretty much across the board with the reassessment of multiples. If you would have paid, those employees their bonuses in cash, I think they would have been just as incentivized prior. And you probably wouldn’t have, I guess tied your ship to the stock price in in the way that they have. And I don’t know, it just, it never feels like a giant problem when things are going well, but you can see how much of a risk it presents when things start to go poorly. And I think DocuSign has kind of been one example in that case, that’s not I don’t know, the business that well, but one case where morale at the company has kind of deteriorated because of this tie in with stock price.
Simon Erickson 05:42
It makes a lot of sense. Especially when you’re talking about those cloud native, fast growing tech companies. We always like to talk about the price to sales ratio of them. And then a lot of the common commentary is how awesome their cash flow margins look too, right? Especially free cash flow margins. But like this discussion, in particular, points out some of the holes in our thinking, right? You take back out stock based compensation, and it’s not an issue and things are going great, your margins are fantastic, your cash flow margins are fantastic. But then when you realize this was kind of what a lot of people were counting on to sell that stock for X dollars. And now it’s x minus y dollars of what this is actually worth, that tends to tick off your sales force for a lot of the time. Especially for companies like DocuSign, that you mentioned there, Ryan. These companies that are adapting, and it’s not so easy to close deals, when budgets, kind of kind of slow down and you’ve got COVID still kind of lingering, it’s not so easy to get sales like it was in 2019 or 2018. Especially when money was free too. So it’s interesting. I mean, this is definitely something that we need to evaluate in the tech world. Are there certain companies that you think are either doing a good job or a bad job at managing their stock based compensation right now, in addition to DocuSign, like you just mentioned, who’s maybe not doing a good job with it right now?
Brett Schafer 07:06
Whoo, good job. I don’t know if I have any examples.
Ryan Henderson 07:11
Well, it helps when the stock doesn’t move that much.
Brett Schafer 07:15
Okay, here’s, I think it’s always helpful when you’re generate positive cash. So if someone generates positive cash flow, they have the ability to pay people in cash, okay, here’s the prime example, who has been the best example ever is the Constellation Software (OTCMKTS: CNSWF) software model where they require, they pay people in cash, they don’t do any stock based compensation, their share count has stayed the same forever. And they require people I believe it’s every employee. I’m not a deep expert on the company, but or say, from a certain like level up to the executive team. They require people to be owners of the stock but they pay people in cash. So you have the freedom of having the cash, but you also get people’s skin in the game, which you get worried about when you’re only paying someone in dollars that might be not be tied to the long term business success poorly. Well, I don’t know if I have exact examples, except for maybe Peloton (NASDAQ: PTON) who repriced a bunch of their options, but I don’t know if that’s even a bad thing because I think it’s something they’re maybe forced to do because they’ve made the mistake of tying so much of their compensation to their stock in the past. So to keep people around, they’re going to have to reprice their options lower. And I guess just to explain that typically, when someone who gets a stock option, you’re only allowed to vest that if the stock price is above your grant, whatever price, the price they give you, the strike price. Thank you Ryan. And with Peloton since their stock is really really in the tank, it’s way way below a lot of people’s strike prices. So those would most likely expire worthless and now Peloton is coming in and saying we can reprice you lower to around where the current share price is. Now, is that good for keeping employees around? Yes. Or is there something they may have to do? Yes, but is it bad for shareholder dilution? Also yes. So I think that’s something you have to be wary of or cognizant of as an investor like I don’t know if Peloton could do anything better, but it’s just not. If you’re making any sort of model or any sort of projections on what earnings per share will be, free cash flow per share will be or, where the stock price could be in five years, hence or 10 years from now. It’s going to be lower all else equal if they’re diluting you more at these lower prices.
Ryan Henderson 09:47
Yeah, I think there’s a lot of unfortunately, there’s probably a lot of bad examples now in the world. In sort of the tech world of companies that It’s not necessarily anchored to their stock price or let it like validate them as a company, but as we’ve kind of talked about, they gave it to employees, in a sense, in a way that made them, the employees sort of anchored to it. So it isn’t necessarily the end of the world, but no one wants to say, Yeah, I’ll take half the bonus that I had last year or a quarter of the bonus for the same amount of options. So it’s either going to be more diluted, or they’re gonna say, No, I don’t want stock. I’ve seen what the performance has been. Unfortunately, a lot of employees look at stock based compensation retrospectively. So they’re saying last year, my options were worthless. Now, when I took them or whatever it however many years it was ago, I think I’ll take cash. So suddenly, the stock based compensation line item on your cash flow statement becomes a cash charge. And so or worse, there’s more dilution, or they just get worse bonuses, and people feel like they want to leave, I think a company that actually did fairly well. I’m not gonna say this one, because I might get it wrong, but companies that use their stock to acquire other companies during the bubble. To say bubble, well, is that okay?
Simon Erickson 11:23
That was a much more advantageous time to do so. Right. Yes.
Brett Schafer 11:26
Yeah. With higher premium prices.
Simon Erickson 11:28
Ryan Henderson 11:29
And I think unless I’m wrong, I think Shopify (NYSE: SHOP) did a few equity offerings.
Brett Schafer 11:29
They did, yeah they did. Well, they didn’t buy anyone with it. But they did the equity offerings, and then they bought some companies later. Yeah, I mean,
Ryan Henderson 11:40
Tesla to some extent raised well.
Brett Schafer 11:41
Yeah, they did, yeah, they use that as well.
Ryan Henderson 11:47
You can try your hardest to keep your valuation generally within a reasonable range, which is ideally what you do, Buffett’s tried to do it pretty much his whole career. So it never gets too out of hand. But you saw, I mean, Elon Musk, even essentially, whether he tried to do it or not, said stock price too high IMO or whatever on that tweet, and the stock ripped afterwards. So you can’t really control what the open market thinks of your stock.
Brett Schafer 12:16
But you can control it if you do an equity offering. And you can control if you do an equity offering when your stocks expensive, and then you buy back stock, when it is cheap. I think this time period, the last three years and probably going over the next three years, will be very good, say tests for management teams, at least from my view, when I’m evaluating a management team. Did they make decisions that I think were smart for long term shareholders? Because if their stock price is super volatile, I don’t know if that’s getting off topic. But is that? Does that make sense to you guys where it can be helpful?
Simon Erickson 12:58
It’s kind of the perfect segue to where I wanted to bring this next which is we talked about kind of the the employees and how important that is for the sales force and stuff but a huge portion of stock based comp is going to executives, too, right? We have seen it popularized in the last couple of years of CEOs accepting the bare minimum in salary that they possibly can and accepting instead, these enormous stock grants if they knock it out of the park, right? Maybe it was Steve Jobs that was the first one to be like, I want a $1 salary right? Mark Zuckerberg followed up very shortly after, Jack Dorsey of Twitter did the same thing. But even today, even in today’s world, we’re starting to see other executives that are saying I want to be paid in stock based compensation or in options awards that are tied to something. And these are kind of one of two paths you take on this right? What is the performance of the company reward? Elon Musk is gonna get a huge payday if Tesla ships so many vehicles and the other operational metrics that are written into this. Tim Cook has something similar for Apple as well. But then you’ve also got some other executives that are tied to the stock price itself. And Brett I think this is kind of related to what you were just mentioning that you know when you have the Paul Gu’s of Upstart (NASDAQ: UPST) saying you know he’s gonna get a payday if Upstart’s stock price hits a certain amount. Yext (NYSE: YEXT) has a new CEO that’s gonna get a real payday if their stock price hits a certain level. You can do some earnings manipulation based on what the market wants you to do, and what Wall Street wants to see that may or may not be long term sustainable for investors. So I guess this is kind of my roundabout way of thinking of like, how do you want to see executives paid? Would you rather them take out a couple of million dollars in cash every year for a performance reward or are you okay, or at least somewhat okay with these enormous paydays that are tied to either performance of the company or the stock price performance?
Brett Schafer 14:55
Yeah, I think I have a lot of opinions on this one. Okay. So hitting on the the stock price one that seems so sound because you’re like, you lay out a table, okay, we hit this stock price, the CEO get this, everyone’s aligned, right, we all want the stock price to be higher five or seven years from now. And I kind of like that model. But the only thing that concerns me is that it can hit it say, and it usually has to be above it for 90 days or something like that, or 30 days or something like that. But that only means it needs to be above it for that time period. And if the stock rises super high, and then falls back down, the executive can get the compensation, just because the market was kind of in its manic, while maybe not depressive, manic exuberant state. And that, like, that makes that for my mind that makes that sort of compensation plan just kind of a negative for me when I’m looking at a company. And then generally when we’re looking at something, there’s usually bonuses that are tied to some sort of metric a lot of the times, and we like to look and see whether we think there’s going to be any issues where there’s more.
Ryan Henderson 16:13
Brett Schafer 16:14
Multiple metrics, yeah, it could be multiple metrics percentage for each, blah, blah, blah. But it can be a concerning thing if say, for example, a company is or sorry, an executive team is getting compensated based on an adjusted EBITDA target. And then its its stock based compensation for that because you can one, be heavily dilutive to your employee base to juice adjusted EBITDA to get your own stock grants, which get excluded out of adjusted EBITDA and free cash flow per share, which is the main thing that helps grow shareholder value over the long term that can be totally disregarded. So for us, and well, almost no companies use free cash flow per share for their targets. So it’s not like it’s a deal breaker for us, because you gotta use the cards that you’re dealt with. But it’s definitely a risk, we think, when the incentives are not aligned with us as outside shareholders and the amount of dollars people are getting paid. I don’t think that is a huge thing to focus on. Unless it’s super egregious. It is
Ryan Henderson 17:27
Ideally, they’re just founders,
Brett Schafer 17:29
And then they don’t get paid. Exactly that can be a huge positive.
Ryan Henderson 17:33
But, yeah, it’s always, I don’t know, that’s something that I’ve kind of always grappled with. And I never have found the perfect performance incentive, because you want, I think, a lot of like employees or executives, they probably want some consistency in their compensation. Whereas if you use free cash flow per share, it might not be smooth enough to provide that consistency, if that’s like your performance metric. So maybe you just get paid really well in cash. And then there’s a bonus built on some sort of.
Brett Schafer 18:13
Well, I don’t know if these executives are not going to be homeless if they don’t get this bonus. Usually their base salaries are mid six figures, mid six figures minimum.
Ryan Henderson 18:25
Yeah, it’s I don’t know. Cuz, like, adjusted EBITDA is not like the worst metric in the world.
Brett Schafer 18:33
Oh woah, I mean.
Ryan Henderson 18:34
But what if it’s purely revenue?
Simon Erickson 18:36
He said EBITDA not earnings, Brett.
Brett Schafer 18:39
But yeah, I mean, revenue revenue could be worse. Yes.
Ryan Henderson 18:41
You could sell things like a gigantic loss.
Brett Schafer 18:44
Ryan Henderson 18:45
So I mean, I don’t know. Some mix of metrics and making sure it’s just not completely egregious or too dilutive to shareholders.
Brett Schafer 18:55
Yeah, I kind of like yeah, the free cash flow can be tough, because sometimes there’s inventory. Sometimes there’s heavy capital investments. I mean, maybe a mix of gross profit and operating income seems very simple to me. Or operating both per share something like that.
Simon Erickson 19:11
So buyer beware, buyer beware for any tech companies out there. I think you guys do some great work of actually like digging in, like you said, to adjusted earnings adjusted EBIT da see what’s actually going on underneath the hood for a lot of these companies give me a lot harder to retain talent and also show profits for shareholders, especially with the climate we’re in right now. Let me shift gears a little bit. Gaming is kind of one of those topics. It’s hot. Everyone’s talking about the metaverse these days. But you guys actually have a lot of exposure in Arch Capital to gaming related companies. Tell us a little bit about why you’re interested in this market sector and maybe some companies you’re interested in there.
Ryan Henderson 19:46
As far as the companies that we are interested in or own, at least the three gaming related ones that we own. are Nintendo (OTCMKTS: NTDOY) Electronic Arts (NASDAQ: EA), and Take Two Interactive (NASDAQ: TTWO) what was the second part of your question. Sorry, I blanked. Why? The rationale?
Simon Erickson 20:02
Why gaming? What’s the state of gaming? We talk about Metaverse a lot. We kind of talked about movement to the cloud. A lot of companies are being acquired right now in the gaming industry. What’s your take on the industry? And what is interesting to you about it?
Ryan Henderson 20:19
It wasn’t an industry thesis. I guess we weren’t looking at it as gaming broadly, we kind of looked at each one of these companies individually, and they just happen to benefit from a lot of the same tailwinds. I don’t have the numbers in front of me, Brett maybe you do. But the growth of the industry has certainly been impressive over the last decade, it’s sort of gotten pulled forward in COVID I believe the projections are that it might contract a bit 2022. But it’s becoming more and more and I think Satya Nadella said this after they acquired Activision Blizzard, it’s becoming more and more software like that these businesses it’s not. I believe EAs gross margins have doubled over the last 10 years. And a lot of that is because it’s so many in game purchases. And it’s no longer this physical distribution business, where you can go in, you can download everything digitally, there’s less cost associated with the publishers now. And the lifetime value is way beyond just the initial game purchase. So you can kind of build these ecosystems within the game and Take Two and Electronic Arts have done that really well. Nintendo has been a little slower, but they’re sort of a unique, they don’t really, they’re kind of on their own. Like we wouldn’t lump them in with the big publishers, I guess, since it’s sort of a hardware software mix. But I guess we like each of those businesses individually, we think they have really good intellectual property of franchises that are going to be durable and going to be around for a long time. The primary ones that I’m probably thinking of are Grand Theft Auto for Take Two or 2k the basketball series for Take Two and then FIFA and Madden as well as Apex Legends has come on really strong lately for EA. Am I missing any other big ones?
Brett Schafer 22:11
I mean, the Sims is very durable for EA. There’s Red Dead Redemption is the other big three for Take Two and then within tendo. Everyone knows those brands that have been super durable Mario, Zelda, Animal Crossing, oh, gosh, and those are the big four. And I think Ryan hit on everything. And then there’s one other thing that we like about a lot of the gaming publishers is that games are much more social now. At least the bigger ones. Yeah, there’s still some popular individual games, what’s one that came out, that was more, I don’t know this game Exactly. See more individual base was like Elden Ring or something like that, I think they have online as well. But again, some of those, individual one time player games can be very lucrative if you get a hit out there. But if it’s just those individual games, you kind of sell your 20 million copies or 10 million copies. And then you’re done. With these social games, with these perpetual franchises, you one have recurring money coming in and two, you get a locked in player ecosystem, because the social aspect means it’s a winner take all phenomena. Winner take all really because FIFA had decent competitors back 10, 15 years ago, but when it moved to multiplayer, and they started getting the exclusive licenses from all the leagues, they didn’t have a monopoly, or sorry, they don’t have an exclusive license on making soccer simulation games. But while they started getting all the players, and all this and everything else, all the leagues, all the gamers as well. They’ve locked in with an incredible moat from the social aspect of that all the players are on FIFA. And if you want to go play the second rate game, there’s just going to be less players in your lobby to play online. And the experience is just so much worse. We think that makes again these publishers very, very moaty and that’s our thesis on that. But we can also talk about the industry in general there’s some.
Ryan Henderson 24:14
On the FIFA note I was gonna say that it has it really it has become a winner take all because more people know FIFA as a video game than FIFA as a Federation, which is what it is. And so as they transition away from this FIFA name, I think more people are just going to associate it with EA Sports FC because it’s going to be the exact same game. And the FIFA name might not be that relevant in 5 to 10 years, I would imagine. But it’s really hard now once you’ve built up sort of that network effect among players to go and find it. And well if there are competitors, it’s hard to find one that’s quite as good and I think it deters a lot of competition because it’s hard to pull players away from that game. Sorry to cut you off did you have something else to add?
Brett Schafer 25:09
Nope, all good.
Simon Erickson 25:11
It makes a lot of sense. I’m looking right now at your fund holdings which you can check out, anyone who’s listening can check out archcapitalfund.com.
Brett Schafer 25:18
Thank you for the shout out.
Simon Erickson 25:21
Put a little plug in there so they can see that you’ve got an 8.1% position in Take Two Interactive, you’ve got a 7.3% stake in Electronic Arts and that also that’s 7.3% in Nintendo, do you think the three of those do you look at all those the same or as Nintendo a different beast, because it’s been traditionally the NES, the Super NES, the switch the Wii there’s got to be a handheld device that they’ve tried to, I mean, is that a different beast than something like a Take Two Interactive, which is going digital?
Brett Schafer 25:51
It’s definitely different with the hardware model. So the similarities are that margins are going up, because you’re getting a lot more software downloads, and they’re also running these, they’ve launched these subscription services for the Nintendo Switch online that has 30 something million, at last count, probably 40 million now, subscribers, which is giving them solid recurring revenue. But yes, they are a lot different because one they’re getting third party revenue on the take rate from someone that sells through their devices. Two they’re really more on full game sales plus digital downloads after so they’re not doing recurring revenue for in game items and stuff like that. So they’ll sell the pokemon game, and then they may have some add on content a year later. And then third, they have to get it right with hardware. So when they released their new hardware, which will likely be within the next, well, let’s be conservative within the next three years, they can be very patient. They gotta get that right as well. So there’s a little more risk with Nintendo. And that’s probably why their earnings multiples are lower. There’s a few more variables at play. However, they probably had the best, the most durable franchises that have been around since almost since the 80s so.
Simon Erickson 27:04
Go ahead, Ryan.
Ryan Henderson 27:05
Yeah I was going to say I don’t think Mario or Pokemon or Zelda are going away anytime soon. And it is sort of that I think, Buffets got a quote that Disney’s got, with Disney’s IP, it’s like they go in, they drill out all this oil, and then it seeps back into the ground, and they pull it all out again, seven years later, whatever, Mario and pokemon. And those games benefit from that same advantage where the, I think they just did Mario Party eight or something like that. So I mean, Mario Party nine will probably be a great seller. And it’s just constantly iterated on those exact same franchises. And that is a huge source of value well that they can tap into.
Simon Erickson 27:53
Yeah, and that’s interesting, too. I mean, you’re so it seems like there’s so much media coverage about Netflix and Disney+ streaming and movies online and everything else like that. It seems like gaming, even though it’s several times several multiple times larger than the video entertainment industry is and gaming is just so much larger, but it seems like it’s still just under appreciated especially for a company like Nintendo.
Ryan Henderson 28:14
Simon Erickson 28:15
Catching up with those trends. Yeah. Okay. And then the last thing on this topic before we close this one out, I have to ask you about the the Microsoft, Activision Blizzard acquisition you mentioned a little bit earlier, is this a good deal for Microsoft? Is this a good deal for Activision what do you guys think about this?
Ryan Henderson 28:31
I think it’s good for both. Well, I think Activision it’s better for Activision. It was about time probably for a change, Activision. And I do think this benefits, the Xbox ecosystem or the Game Pass. Especially I know, they’re trying to essentially build out what is going to ultimately try to be a Netflix for games. And this probably gives them a good content base to do that with. It’s not necessarily going to be exclusive. I think the head of Xbox, Phil Spencer said, these games are going to stay platform agnostic. PlayStation users still going to be able to play Call of Duty, but it gives them good development teams to build potentially new exclusive content or just have if, if they I believe they’ve said that they’re gonna go, they’re trying to build a consoleless system with I think they’ve partnered with LG for smart TVs, it might not be LG.
Brett Schafer 29:32
It’s someone like that. Yeah, eventually, they want to make it. I mean, it’s a cross between for trying to make linear video not not linear. We’re trying to make video comparisons. It’s like a cross between Roku and Netflix a bit where they’re trying to get like a tiny little bit of hardware that you connect to your TV. And basically, you can have this cloud gaming service, which is the ultimate Holy Grail. And it feels like Microsoft is the number one candidate to do that. Sony’s got a lot of firepower as well. Nintendo is they do their own thing like you mentioned. But adding Activision on there is just a fantastic asset to have plus it generates a lot of cash. Yeah, they paid a hefty price for it, but they had been in a tough slump. And I think this acquisition will free them up, one, from the blizzard was to from the executive woes, both the sexual harassment stuff that it really bogged down the company, for obvious reasons that it’s such a such a big problem with that. And then second, they had been milking, and maybe milking is the wrong word. They had been possibly overdoing it with Call of Duty with a game release every year. And they’ve announced that they’re actually going to do take, I believe, 2023 off which it’s the biggest the biggest franchise in gaming. So I think it will free the it’ll it’ll Yeah, they’ll lose a bit of earnings in the short run, but over the long term, under the Microsoft umbrella, they’re going to be much more flexible, to be able to do what’s best for the long term health of those franchises if you get what I mean.
Ryan Henderson 31:06
Yeah, that’s what I was gonna say is the Microsoft umbrella affords them a lot of flexibility and time to go out and produce the absolute best games regardless of putting them on like a time schedule. Because yeah, they’ll probably still, I mean, you still want them to earn money, but their earnings are pretty much irrelevant to Microsoft’s or they’re just such a tiny portion that no one really cares. So you’ve got now the ability to really get the Xbox right without having to meet quarterly deadlines, or you have the ability to get to your content, right, without having to meet quarterly deadlines. I think that’s a big advantage for a lot of developers, I think that’s a lot of, it’s probably something a lot of developers like, is the flexibility that Microsoft, I imagine can grant them.
Brett Schafer 31:56
Now Nintendo does that same thing, but they just don’t care about what the shareholders think in the short run, which you can bid as a positive or negative, they’ll delay a game as long as they want. That’s that Japanese mindset. So it’s a little bit different. You have that that’s a huge give and take you have in the video game market.
Ryan Henderson 32:14
I think it’s a good acquisition. I also think it will go through
Brett Schafer 32:20
Well, Mr. Regulatory lawyer.
Ryan Henderson 32:23
I guess I’m not a regulatory lawyer. And I probably have no edge on that. But it’s not anti competitive, it doesn’t make X Box a monopoly. So I don’t know how it wouldn’t benefit the consumer, which I think I’ve once again, not a regulatory lawyer, but I imagine that’s one of the points that is pretty important in assessing that deal.
Simon Erickson 32:50
And to be fair, Microsoft has played well with regulators. So all things considered whether that’s cloud, whether that’s social, whether that’s gaming, they seem like they stay a little bit less out of their crosshairs than a lot of their other competitors.
Brett Schafer 33:03
Yeah, I think even if yeah, even if they are doing similar things, maybe they have just a better reputation, at least right now.
Simon Erickson 33:09
And the cultural stuff, too, there’s no doubt they’re going to clean a lot of that up. But it’s a real problem for Activision for so many years. Maybe one of the other things that, that I’ll be at least interested in as an investor is whether Microsoft can improve the relationship as a publisher of the games with the creators of the games themselves, right? Activision had problems with his terrible problems with this for years, right. They lost Destiny which was created with Bungee because of kind of a culture mix magazine, it was just in addition to the sexual harassment and all that stuff that was already exposed at Activision is just really a brutal culture of deadlines and it wasn’t a whole lot of fun that the talent and the developers didn’t love that. They missed League of Legends, that was the other big game out there created by Epic Games, not by Activision, as big as Activision was, it seemed like there was continually looking at the rearview mirror of how many more World of Warcraft expansions can they make? How many more Call of Duty expansions can they make versus creating the next big thing. To me, it’d be really interesting if Microsoft can partner with the right companies that have the talent to make those games. Right into game paths and be a step ahead, rather than a step behind.
Ryan Henderson 34:19
Yeah. I’m also kind of excited to see what other consolidation we see in the industry. This is something that
Brett Schafer 34:28
There’s a rumor about Electronic Arts.
Ryan Henderson 34:30
Yeah, your your colleague and our friend Matt Cochrane has mentioned is when this is the great time to if you’ve been thinking about getting into the video game publishing business, whether you’re, I mean, I feel like everyone at big tech has kind of dabbled with the idea.
Brett Schafer 34:45
Plus the media companies too.
Ryan Henderson 34:46
Yeah it’s a good time to buy a big publisher because you can piggyback off that Activision deal because unless someone buys EA at a huge premium, it’s not going to be bigger than Activision. So it pretty much gives you the regulatory greenlight to go do it, if they say yes to Microsoft and Activision, and that’s something that something that Matt brought up. And I think, I think there’s a lot of brands that people would, or media companies or big tech companies would want to acquire, by purchasing an either a Take Two or an EA.
Brett Schafer 35:20
Yeah, if you look at Meta Platforms, or otherwise known as Facebook, they’re trying to be the ones disrupting with the new VR platform with Oculus, and tons of hardware that they’ve come out with over the last few years and plan on doing for the next five years, that these publishers can be a huge strategic asset for someone to buy, even if it’s not Electronic Arts and Take Two Interactive, there are a ton of other smaller studios that they could go after, and probably want to go after. But Facebook isn’t allowed to do all that regulatory stuff. So that’s interesting as well. And actually, if the VR becomes the next big thing, that is a little bit of a risk for the publishers, because you have to be able to execute on getting over to the the VR software development platforms, winning those same consumers that transition from the Xbox, PlayStation PC systems over to the VR one. But that’s more of a long term threat that, yeah, maybe investors should just track every so often.
Simon Erickson 36:18
Yeah. And not to mention the advertising too, right? We talked about the upfront sale of the software, the in game purchases, when you’ve got a platform that’s gotten maybe a billion users on it, that you can start putting a plug in a game into and have a reduced cost, its advertising supported, we know that the big get bigger in that game. And that’s certainly an advantage for the Microsoft’s of the world and the larger companies.
Brett Schafer 36:39
Exactly. The last thing I would put out is there’s been a lot of reports, and this hasn’t been the number one news item. But there is a projection now that the global games and services market from one of these third party analysts is actually going to contract 1.2% this year. And people in history have written about how this makes it maybe video games aren’t recession proof, did the industry peak in 2021? At first, I was a little concerned about that, because typically, the industry has grown at about, I think it’s like 8 to 10% a year, for the last few decades. However, I think it’s just a little bit of a timing issue. One during COVID, there was a catalyst and little bit of an artificial boost to things. And we’re comping against that now, which makes it really tough to the timing of game sales. It’s just sometimes the cycle works out, we had a lot of big games at the beginning of this year, the game slate for the rest of the year is pretty light. If Call of Duty comes off the market for one of the years, like they’re planning on doing, which hasn’t been the case for the last at least decade plus, that will probably make the industry look worse. Even though at the Pacific level for a company that’s not Activision Publishing that nothing will really change and it might actually be a benefit for them. So if we are in a recession right now, and consumer wallets are a little tighter, and the industry only declines by 1%, in my mind, I think that’s pretty recession proof, especially given the COVID comp that we’re going under.
Ryan Henderson 38:12
Also I’d imagine that encapsulates hardware sales.
Brett Schafer 38:15
Oh right, forgot about that
Ryan Henderson 38:16
And then the chip shortage has put pressure on supply for a lot of those console makers. Nintendo included Playstation has talked about how they just cannot meet demand, despite having record demand for their new Playstations.
Brett Schafer 38:30
And when you buy a console, you buy at least one game so.
Ryan Henderson 38:33
Yeah and if you’re thinking if you’re like, oh, I’m going to upgrade to the next Xbox, maybe I hold off buying that game until I get it. I think a lot of people are probably in that boat. And so between what Brett mentioned with the time and this chip shortage associated with the console makers, I guess it’s not too surprising to think that there would be some contraction this year. But I imagine as the next gen consoles are in all the households around the world that have that game, we’ll start to see that return on spending or return into growth for spending across the industry.
Simon Erickson 39:14
Makes a lot of sense, guys. While I have you here one last outro question, which is that there are a lot of headlines and there are a lot of headwinds facing the economy right now. We it seems like every single day you hear about inflation and interest rates. Certainly these are things that we shouldn’t just brush aside and not think about. But we do like to think as long term investors, you know how they’re going to impact this. Anything that’s impacting your investing right now? Anything that’s on your mind that you’d like to share with our audience who are long term investors that maybe we should be considering about what’s going on in economy or macro or anything else in the financial media?
Brett Schafer 39:51
There are a lot of headwinds cost headwinds inflation like you just mentioned. And I like to think of it more proactively when looking at a company and say, Okay, does this company have a huge labor wage risk? And this is from an investor perspective. So say you look at Starbucks, you look at a restaurant operator, you look at someone like that, from, say, my personal perspective you’d like employees to get good wages, right? But as an investor perspective, now you want to make sure everyone in your every stakeholder you have is getting the value, but I would much rather invest in a company that doesn’t have that risk at all. So that’s kind of something I look at if there is this wage stuff that continues. Yeah, it’s probably a good thing for society. But as an investor, I just want a company that for whatever reason, has avoided either because their digital, I don’t know, their payment something or whatever.
Ryan Henderson 40:44
Yeah I guess I haven’t really thought about it from the macro lens. But I have just started to like, hone in more or be interested more on the more asset light business models, the ones that don’t have to have huge workforces, or see potential wage pressure. And even like the really, really good brands are starting to have difficulty with that, Starbucks is kind of one that comes to mind where there’s been the unionizing and the, I guess pushback from baristas that you could have the best brand and you could be known for being a good place to work. But when times get tough, it’s not. It’s just a risk that some of the more asset like businesses don’t face.
Simon Erickson 41:28
Great points. So once again, Brett Schaefer and Ryan Henderson are the hosts of the podcast, Chit Chat money. They’re our partner here with 7investing. They’re also the portfolio managers of Arch Capital, looking at the stock market every day, also have that same long term investing lens. Brett and Ryan, it’s always a pleasure. Thanks for joining me for the podcast this afternoon.
Ryan Henderson 41:46
Yep, thanks, Simon.
Brett Schafer 41:47
This is a fun discussion. Always glad to talk.
Simon Erickson 41:50
Definitely. As always a pleasure having you guys on our show. Thanks, everybody for tuning into this episode of our 7investing podcast. We are here to empower you to invest in your future. We are 7investing.
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
Anirban and Matthew were joined by Alex Morris, creator of the TSOH Investment Research Service, to look at seven former market darlings that have taken severe dives from...
On episode 5 of No Limit, Krzysztof won’t let politics stand in the way of a good discussion - among many other topics!