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News of the Week (September 25 - 29)

Meta; Amazon; Uber; Costco; Nike; PayPal; Shopify; Lululemon; Final Headlines; Macro; My Portfolio

Brad Freeman

Sep 30, 2023

Hey guys. I’ve been pretty sick with Covid all week. If there are a few extra typos in here, I apologize in advance. I’m quite out of it.

1. Meta Platforms (META) — Meta Connect 2023

Founder/CEO Mark Zuckerberg and his team took to the stage to share some exciting developments within Quest and AI. Here, I’ll condense that hours-long event into a few minute article on the highlights that you need to know.

On Quest 3’s Approach vs. Apple:

Meta announced Quest 3 AI headset this week. It’s 40% thinner than Quest 2 and will start at $499 -- less than 15% of the cost of Apple’s Vision Pro Headset. That’s an important point. The two companies are approaching this hardware disruption in opposite ways. Meta is selling at cost to drive access and ubiquity. It’s a classic case of commoditizing one piece of a value chain to ensure dominant market share… then leveraging that share for profits later and elsewhere. Apple will sell the hardware with its typical gaudy gross margins and lean on its sticky ecosystem to drive adoption. Both approaches should work. There’s likely a future duopoly forming.

“It’s not just our job to make these things possible. It’s our job to make them affordable and accessible.” -- Founder/CEO Mark Zuckerberg

On What’s New for Quest 3:

Quest 3 will be the first “mainstream mixed reality headset” to market. When putting the device on, you’ll see your physical space. From there, you can augment that environment with digital objects suspended in your actual room. Whether it’s watching sports on a giant virtual screen (or sitting courtside through X stadium), playing games on interactive holograms, or practicing surgery in a risk-free environment, real use cases are abundant.

The headset comes with 10x more pixels vs. its Quest 2 predecessor to ensure graphics and latency-reductions are as optimal as possible. Beyond more pixels, the infused next-gen Snapdragon chip from Qualcomm and a new pancake-style lens enhance graphics further. That enhancement paves the way for a new feature: The mixed reality hardware can map your actual space to better merge physical and digital worlds. Zuck offered examples of what this will mean:

Throwing a digital ball at a physical wall and having it bounce off that wall as a real ball would. Not interesting.
Using your actual couch in a room to take cover while playing a social shooting game. More interesting.

Generally speaking, better graphics means better gaming quality. This is important considering gaming is currently the most popular use case for these headsets. That likely will be the case for a while. While Apple will surely add more content over time, Meta runs laps around them in terms of size and quality of its gaming library. That library just got better:

Microsoft’s Xbox will integrate with Quest 3 for the first time. This will bring hundreds of iconic Xbox gaming titles to this hardware form factor.
As constantly rumored, Roblox’s gaming suite will be optimized for Quest 3 and integrated as well.

Still, while gaming is king of headsets for now, Meta is hard at work on building enterprise use cases. As previously announced, it will integrate Microsoft 365’s productivity apps. Much more to come here.

Finally on Quest 3, there was a popular Lex Freidman interview with Zuck this week. It showed off Meta’s hyper-realistic Kodek avatars and how the Metaverse will create a sense of remote connection. This was mostly review/expected for those of us who have been closely tracking developments.

On Artificial Intelligence & Chat Bots:

While LLAMA 2, Meta’s open source large language model (LLM), garnered much hype, Meta has a lot more innovation in the docket. It announced Expressive Media Universe (“EMU”) as a newer model to generate images from texts in 5 seconds (not minutes). It is building this directly into all of its chat functions (WhatsApp, Messenger etc.) to upgrade things like Stickers. I toyed around with the tool this week and candidly it’s quite limited. That’s to be expected initially and quality will only improve from here. With EMU, stickers will transform from a static library of options to a generative AI-powered tool to create whatever image your mind desires.

Beyond EMU, Zuck spoke at length about “Meta AI.” This is a chatbot assistant to field basic queries and is based on LLAMA 2. It pulls from a partnership with Microsoft’s Bing Chat (noticing a pattern?) to infuse real-time, current information. That feature eliminates outdated responses.

META AI will be open sourced and open to 3rd party developers in the coming months to build and customize on top of.

For more specific model use cases, Zuck detailed some fun additional models:

Max the Chef helps you use your available food to cook up recipes.
Lily is its editor AI model.
Lorena is its travel concierge model.
Victor (played by Dwayne Wade) is its personal trainer model.
Snoop Dog is its role play gaming model.
Bru (played by Tom Brady) is its sports trivia model.
Kendall Jenner is its big sister advice model.
Mr. Beast is its Funny Man Model.

These models do not have access to real-time data like Meta AI. The company is working to add that feature in the coming months.

To make 3rd party developer life even easier, Meta is building “AI Studio.” This will function as its open-source platform to enhance and customize Meta’s models for more granular use cases. It will provide intuitive processes for building on top of Llama 2 and other Meta LLMs. It’s also building a sandbox to ensure this can be done in a no-code manner. Businesses will be able to integrate these custom models into their own customer service functions to enhance quality and speed of interactions. This test launched with just a few clients today and will likely take a full year to be rolled-out.

Why do Chatbots Matter?

Meta will monetize chatbots through business use cases like automated customer service. That, however, is not the most exciting part about chatbots. Instead, the thing I find most promising is the indirect lift to app engagement. The longer Meta keeps its users entertained on these apps, the more incremental and relevant data it has to use. Why does that matter for an ads-based company like Meta? More data means more algorithm training to uplift its targeting capabilities. This will mean more valuable placements and a larger number of placements thanks to the added time spent. That’s the holy grail for Meta.

This theoretical boost must play out for the heavy costs associated with model training, inference and maintenance to be justified. LLMs are expensive. Meta thinks it will play out (so do I).

On Going Slow with AI Innovation:

Meta is intentionally slow playing the roll-out of these models. Why? It wants to make absolutely sure that it has the proper guardrails, self-regulation and rules in place before giving this to the masses.

On its New Ray-Ban Smart Glasses:

Zuck revealed the next generation of Meta’s smart glasses. The new Quest headset will likely approximate this look over time. And that’s necessary if broad adoption is to be realized. For now, the glasses offer some bare bones products and a comfortable form factor; the headsets do a lot more but candidly are not comfortable for extended wearing.

The new glasses come with better cameras, better audio and a lighter frame. They also allow for live streaming the field of view to followers. Zuck walked us through an example of Formula 1 driver Charles Leclerc taking us on a race with him for an idea of how this could be relevant.

The new glasses will also be fully equipped with Meta AI which facilitates some cool use cases. More use cases will come next year after a planned free software update to make the glasses multi-modal. Use cases described by Zuck include:

Using the glasses to replay a pickle ball shot to see if it was in or out. That could have solved some major fights with my siblings growing up on the tennis court.
Ask your glasses how much more time that steak on your barbecue needs to cook.
Translate that sign for me and tell me what building I’m looking at. This would’ve made school field trips a lot more fun.

As Zuck explained, the best way to train AI models is to show them exactly what a person sees and hears. The Meta AI integration means this training can be taken to a new level within the comfortable, Ray-Ban hardware. These will launch next month starting at $299.

Conclusion:

The near-term value of these AI models is clear. Outside of AI, none of this will be material to Meta’s financials in the near term. Still, I find all of this to be exciting as a long-term shareholder. Meta is innovating where needed to ensure it’s a primary piece of the future of social media the next computing form factor. It’s laying the groundwork to ensure that it continues to be the disruptor rather than the disrupted. Fun event.

2. Amazon (AMZN) – Anthropic & More

a. Anthropic

Amazon announced a $1.25 billion equity investment in Anthropic. It has the option to invest another $2.75 billion and Google is a smaller investor here as well. Anthropic is a generative AI research firm and model builder with founders from OpenAI. And speaking of OpenAI, the two are often compared while the direct competitors are broadly seen as the cream of the crop in this niche. Microsoft invested $10 billion in and partnered with OpenAI earlier in the year, and this is Amazon’s response.

As part of the arrangement, AWS will become Anthropic’s primary cloud provider. It’s not the exclusive provider like Microsoft Azure is for OpenAI. Amazon’s Bedrock (and AWS customers) will get early access to Anthropic’s new models like Claude 2 while the two work closely to build more models. Bedrock is Amazon’s internal foundational model that 1st and 3rd party developers build on top of; Anthropic will make its own foundational models available here to further customize.

Anthropic will use Amazon’s Trainium and Inferentia chipsets as part of the deal. As the names imply, these are Amazon’s chipsets internally built to train and sharpen model inference more cheaply. As an aside, that’s where I see AWS (and possibly Google) potentially standing out from Azure if these chipsets prove successful. They allow Amazon to enjoy more efficiency-fostering vertical integration with more revenue generation opportunity.

Like OpenAI and Microsoft, this is a match made in heaven. Very few companies have the infrastructure to rationally host generative AI models at scale – doing so is wildly expensive. Amazon (like Microsoft/Google/Meta) is one of those companies. This merges that strength with the world-class models being built within Anthropic. Pairing those models with Bedrock and the rest of Amazon will surely create broader, higher quality use cases similarly to what Microsoft did with OpenAI and Bing. Now Amazon can fixate on building the best infrastructure and quality chipsets while using Anthropic (and Hugging Face through a separate investment) to partially alleviate allocating finite resources to model building.

I’ve heard leadership interviews indicating that Amazon wanted to do ALL of this internally. There’s no reason to do so. Just building out a few pieces internally will still leave Amazon with a gigantic addressable market. And it will speed the pursuit of that addressable market with a higher probability of success. There was no reason to make this harder than it needed to be or to welcome Anthropic with open arms. AWS customers are demanding rapid product enhancements while this will materially speed its innovation cycle. Tighter focus… better models… happier customers… good decision.

b. More

Amazon will infuse ads into Amazon Prime Video next year. This is yet another high margin lever for the company to pull.

The FTC and 17 Attorneys General sued Amazon over monopolistic claims surrounding Prime Subscription practices. It accused the giant of using its market power to strike unfair deals with subscription partners. To be candid, this is irrelevant to me. It will probably result in nothing material. In the VERY slim chance Amazon is forced to break-up, the sum of the parts is likely worth more than the whole. That would simply mean a nice pay day for shareholders and me moving on to other opportunities. That’s an easy worst-case scenario to stomach. I added this week following the volatility based on this headline.

Amazon made Bedrock fully available to developers while adding Meta’s Llama 2 model. AWS will be Meta’s application programming interface (API) partner for this open sourced model. AWS is the first cloud-hosted foundational model product to offer Llama 2. Amazon also debuted its Generative Business Intelligence tool to turn conversational language into graphs, and code (with the help of CodeWhisperer).

3. Uber (UBER) – Europe & More

The News:

The European Commission (EC) and Parliament are now negotiating gig worker protection legislation passed by EU member states this summer. The legislation is called the “Platform Work Directive” and is something for investors to watch.

The concern here for Uber is the risk of needing to grant gig workers full employment rights. Uber’s head of mobility in Europe, Anabel Díaz has warned the EC about potential implications. According to her, full employment rights would cut its capacity to employ by 50%-70% and would force it to shut down in hundreds of the 3,000 cities where it operates. Drivers would essentially lose all flexibility. They’d be required to keep strict hours and to work only for Uber while being prohibited from rejecting any rides or deliveries.

Consumers would have to pay up to 40% more for the services and wait times would skyrocket due to the smaller fleet. Uber’s margins would likely be mostly unaffected, but volumes would surely take a hit.

What do I See Happening?

The main risk for firms like Uber and Airbnb has been and will always be regulation. These companies have been able to overcome countless legislative headwinds to build large, growing, cash printing businesses. They’ve relied on unmatched scale and deep pockets to skew the landscape in their favor and to seamlessly comply with fluid rules. Richer, larger companies naturally have an easier ability to do so. But what will likely happen here?

I see this playing out similarly to the UK in 2021. In that country, Uber considers its drivers to be workers and grants them a toned-down benefits packages including paid time off. It’s been able to build a great business there with employment rights more restrictive than other geographies but falling short of full employment rights.

If we go back to June when legislation originally passed, signs of the U.K. being the blueprint were emerging. Member states like Spain demanded concessions to reduce rights and strike a middle ground between full employment and gig worker style. Spain and several other countries ended up securing desired amendments and abstaining. These countries are all represented in the EC and have shown a consistent motivation to tighten up worker rights in a way that will allow marketplaces like Uber to still thrive.

I don’t see full employment rights as the likely outcome here, but it’s still clearly a risk to the business. Uber generates about 24% of its revenue from Europe, Middle East and Africa (EMEA). It does not break out Europe revenue alone, but it’s safe to assume that Europe is a large portion of that bucket. Let’s assume it’s ⅔. If this law had been implemented for 2023, Uber’s year to date revenue growth would have been 13.0% instead of 20.9% Y/Y. That’s very material, but again the hit will almost surely be far less than that.

Loophole?

The June legislation passed also comes with an interesting potential loophole. In it, only companies that “control hours and mandate uniforms” would be subject to the new laws. Uber doesn’t control hours and has no uniform.

b. More

Uber announced Prashanth Mahendra-Rajah as its new CFO this week. He will replace Nelson Chai who stepped down earlier in the year. Mahendra-Rajah comes from Analog Devices where he was the firm’s CFO. Previously, he was the VP of Finance for Applied Materials, the Head of Global Planning at Visa and the VP of Finance at United Technologies. He’s currently a Goodyear Board Member.

Uber entered a partnership with Southern California taxi fleets to add those drivers to its network. While Uber once considered taxi cabs purely as competition, that’s now morphing into a partnership approach. It has struck similar deals in other countries, but this is the most notable headline for taxi integration in the USA to date.
Uber and DoorDash lost their appeal to prevent New York City’s new Delivery Minimum Wage Law.

4. Costco Wholesale (COST) – Earnings Review

a. Results vs. Expectations

Beat revenue estimate by 2.4%.
Beat member fee estimate by 3.4%.
Missed EBIT estimate by 1.8%.
Beat $4.78 GAAP EPS estimate by $0.08.

b. Balance Sheet

$15.2 billion in cash & equivalents.
$6.4 billion in debt with $1.1 billion current (due in the next 12 months).
Inventory fell 7% Y/Y.
Share count is flat Y/Y.

c. Call & Release Highlights

Timing:

Costco’s quarters are not all 13 weeks. This quarter was 17 weeks vs. 16 weeks in the Y/Y period. A bit annoying, I know. Because of this, for example, EPS growing from $4.20 to $4.86 Y/Y is not an apples-to-apples comparison. Assuming it earned the same amount every week (which it didn’t), EPS would have been closer to $4.57 for the quarter.

Financial Metrics:

Total comparable sales rose 1.1% Y/Y and 3.8% excluding gas, deflation and foreign exchange.
E-commerce sales fell 0.8% Y/Y (very tough comps).
Traffic rose 5.2% Y/Y overall and 5.0% Y/Y in the USA.
Ticket size fell 3.9% Y/Y overall and 4.5% in the USA. This was driven by weakness in big ticket discretionary purchases.

Membership Stats:

Costco has 127.9 million cardholders vs. 124.7 million Q/Q and 118.9 million Y/Y. Its executive paid membership rose from 31.3 million to 32.3 million Q/Q. These executive members are 45% of total paid members and 73% of total revenue.

Membership fees were 1.95% of sales vs. 1.88% of sales Y/Y. Membership fees overall rose by 13.7% Y/Y but would have risen by 7% Y/Y without the extra week. Renewal rates ticked slightly higher in North America to 92.7% and fell slightly elsewhere due to new store openings.

Margins & Theft:

Gross margin rose from 10.2% to 10.6% Y/Y which was helped by gas prices. In terms of theft, Costco is not struggling with the issue like Target and others are. Its theft rate has risen by just 1 basis point Y/Y and by a few basis points over the last few years. The rise is via debuting self-checkout and not via rising instances of organized crime. It’s a bummer that retailers need to talk about this on earnings calls. Scaled theft is a real problem in the United States, and it saddens me to be writing that. Costco’s store layouts, business model and receipt checkers at the door are all allowing it to overcome the societal struggle.

E-Commerce:

E-Commerce trends improved vs. Q2 and Q3 despite remaining slightly negative. It upgraded its mobile app with tools like shopping lists and searchable inventory. These changes helped push its app rating from 2.3 stars to 4.7 Y/Y. Traffic is up 40% Y/Y and installs 46% Y/Y.

Inflation:

Costco saw cost inflation between 1%-2% for the quarter. It continued to trend down throughout the period.

5. Nike (NKE) – Earnings Review

a. Results vs. Expectations

Missed revenue estimate by 0.5%; Met vague revenue guidance.
Beat GPM estimate & same guidance by 50bps.
Beat EBIT estimate by 18.3% & beat vague guidance by about 20%.
Beat $0.76 GAAP EPS estimate by $0.18.

b. Guidance

Nike reiterated its full fiscal year 2024 guidance of mid single digit revenue growth. This includes a 400 bps Y/Y comp headwind from accelerated inventory liquidation and 5 seasons of wholesale revenue during fiscal 2023. It also reiterated plans for 150 bps in Y/Y GPM expansion and that sales, general and administrative (SG&A) costs will rise slightly faster than revenue.

c. Balance Sheet

$8.8B in cash & equivalents.
Inventory down 10% Y/Y.
$8.9B in debt (none of it is current).
Share count is down 2.5% Y/Y.
Dividends up 11.1% Y/Y.

d. Call & Release Highlights

Demand:

6.8% 3-yr sales CAGR vs. 26.7% Q/Q (easy comp) & 7% 2 Qs ago (normal).
Continued to take market share across all key geographies including Greater China.
Jordan Brand revenue rose double digits Y/Y.

World Cup:

Nike’s “Dream Arena” World Cup-themed experiential store in Australia did very well. This sets a blueprint for how Nike can continue to drive more engagement and interest in its physical stores. The concept comfortably beat sell through plans and was credited for its double-digit Y/Y soccer revenue growth.

China:

Nike revenue rose double digits Y/Y in China for the 2nd straight quarter. Full price sales proportion rose and all app traffic and engagement metrics were strong.

Inventory & Margins:

Nike’s inventory position was called “healthy.” This includes both direct and partner wholesale channels. The improvement powered the gross margin beat as Nike did not discount as aggressively as it has in recent quarters. Easing ocean freight rates are also helping gross margin just like for virtually all other retailers. Foreign exchange, conversely, shaved 90 bps off of its gross margin for the quarter.

“We are very comfortable with the level of inventory in the marketplace in relation to the retail sales that we're seeing as we begin increasing levels of wholesale sell-in in our second half.” – CFO Max Friend

Its tax rate was 12% vs. 19.7% Y/Y which helped net income.

Nike Direct Members:

Engagement rose double digits Y/Y.
Average order value rose Y/Y.
Store traffic rose double digits Y/Y.
Member contribution to total revenue rose Y/Y.

Digital:

Digital sales rose 2% Y/Y but saw acceleration throughout the quarter. Liquidating inventory last year mainly propped up e-commerce sales which led to a very tough comp. App traffic briskly rose Y/Y along with buyer frequency.

Wholesale:

While wholesale revenue rose by just 1% Y/Y, some channel partners delivered much faster growth. With Dick’s Sporting Goods, JD, Zalando and others, growth was above 10% Y/Y. Footlocker revenue continued to decline and is expected to do so through the near future.

6. PayPal (PYPL) – Staying the Course

Nothing has changed about my fundamental investment case for PayPal. Still, the price action has been nasty, so I wanted to reiterate my plans for the name. It’s quickly shrinking in terms of portfolio allocation, but I do not have any interest in adding today. I also won’t sell. As I’ve said many times, I need to see a transaction margin bottom to add to my stake. That’s the only way this company can briskly compound profits in the years ahead. Cost cuts can only take the bottom line so far.

PayPal still dominates branded checkout with stable market share, e-commerce and high margin cross-border growth are showing signs of life, Braintree is dominating with margin levers just now kicking in, Venmo checkout is building traction and new leadership is in place. Furthermore, the company will buy back 10%+ of its shares through the end of 2024 at today’s price. I still see a sleeping giant disguised by markets as a dinosaur. Transaction margin expansion will be the sign to me that I’m right.

I am committed to giving the brand-new CEO (Alex Chriss) some time to right the ship. He started this week.

7. Shopify (SHOP) – Miscellaneous

Shopify is investing in Faire to extend its business-to-business (B2B) channel utility. Faire is a B2B market and will become the preferred B2B wholesale channel partner for Shopify. Shopify will integrate Faire’s product suite into its ecosystem to help merchants more intuitively and actionably take advantage of wholesale opportunities.

B2B functionality is a big part of Shopify moving from “arming the rebels” to arming the rebels and the generals. A large chunk of giant retailers rely on this selling vector as a means to control inventory and maximize financial success. Earlier in the year, Shopify debuted a separate B2B channel that can be run together with all B2C channels or in parallel. Since then, it has been working hard to fortify the value that this channel provides. Faire is another step to bolster that value.

Separately, Shopify added TikTok and Snapchat to its roster of ad networks for its Shopify Audiences product. It also debuted a new checkout flow featuring one-page checkout. Less pages and clicks means higher conversion. In turn, that means happier merchants, customers and Shopify shareholders like me.

8. Lululemon (LULU) – Peloton

Lululemon will partner with Peloton as the two signed a 5-year contract. Peloton will create at-home fitness content for Lulu’s “Lululemon Studio.” Lululemon will be “Peloton’s main apparel partner” as part of the arrangement as well.

With Lululemon’s hardware-free fitness subscriptions gaining some traction, this makes sense. It’s a far more asset-light way to go about growth here vs. its failed Mirror Hardware purchase and experiment. I don’t see Peloton as needle-moving for Lulu’s financials. I do see this as a sign that Lululemon has learned its lesson on at-home fitness hardware. Just stick to content.

9. Final Headlines

Disney just rolled-out its expected password sharing policy crackdown in Canada.
JFrog CFO Jacob Shulman will step down. The company’s VP of Finance, Ed Grabsheid, will replace him next year. Shulman is leaving to “pursue another opportunity.”

10. Macro

Output:

Building permits roughly met expectations.
New home sales for August were 675,000 vs. 700,000 expected and 739,000 last month.
Core Durable Goods Orders M/M for August rose 0.4% vs. 0.1% expected and 0.1% last month.
Durable Goods Orders rose 0.2% vs. -0.5% expected and -5.6% last month.
Q2 GDP Q/Q was 2.1% vs. 2.1% expected and 2% last quarter.

Consumer & Employment:

Conference Board Consumer Confidence for September is 103 vs. 105.5 expected and 108.7 last month.
Initial Jobless Claims were 204,000 vs. 215,000 expected and 202,000 last month.
Personal spending for August met expectations with 0.4% M/M growth.
Michigan Consumer Expectations for September came in at 66.0 vs. 66.3 expected and 65.5 last month.
Michigan Consumer Sentiment for September came in at 68.1 vs. 67.7 expected and 69.5 last month.

Inflation:

Core Personal Consumption Expenditures (PCE) for August rose 0.1% M/M vs. 0.2% expected and 0.2% last month. Probability of no hike in November rose from 50% to 88% following this release.
PCE for August rose 0.4% M/M vs. 0.5% expected and 0.2% last month.
Chicago Purchasing Managers Index (PMI) for September was 44.1 vs. 47.6 expected and 48.7 last month.
Michigan 1-year inflation expectations for September are 3.2% vs. 3.1% expected and 3.5% last month.
Michigan 5-year inflation expectations for September are 2.8% vs. 2.7% expected and 3% last month.