2022 Annual Letter

We are witnessing the beginning of a new era. The days of zero interest rates, lofty valuations, and the misallocation of capital has ended. Future investment returns will be driven by thorough fundamental analysis and a proper understanding of price and value.

As we look back at 2022 it will be remembered as a year of fundamental change. The U.S. equity markets endured the worst performance since the Great Financial Crisis in 2008. The S&P 500 ended the year down nearly 20% and the NASDAQ ended the year down nearly 30%. Ouch.

Investment performance over the past decade can be characterized as an anomaly supported by central banks around the world implementing zero or even negative (ie. Japan and Europe) interest rate policies. Consequently, discount rates were decoupled from reality and this sent valuations soaring. Companies that didn't make any money attracted multi-billion dollar valuations. Below is a list provided by MarketWatch on 15 different billion dollar unicorns that have collectively racked up over $135 billion in losses.

It's pretty incredible how companies like Teledoc (NYSE:TDOC) have been in existence since 2002 and the company still doesn't generate a profit. In fact, Teledoc is still generating about $1 Billion in losses per year!

Zero interest rates have been the primary culprit behind the major misallocation of resources. In my opinion those days seem to be over. The NASDAQ has been routed and is down 30% in 2022 and Cathie Wood's ARK Innovation ETF (NYSE:ARKK) is down about 65%. As capital gets flushed out from speculative uses, it will eventually be refocused towards profit-making companies that add real value to society. That is a good thing.

A new era has finally begun. This is being driven by a confluence of rampant inflation, the war in Ukraine, shifting global supply chains, energy security, and more. Jerome Powell and the U.S. Federal Reserve's top priority is to kill rampant inflation in our economy by hiking interest rates. This has lead to the fastest rate hiking cycle since the 1980's. In the short term this is causing a lot of market panic and the stock market responded pretty quickly. Private market assets haven't followed suit just yet, but I imagine things will start to break. WSJ Prime Rate has increased from 3.25% to 7.50% in just 12 months. Commercial real estate deal making has come to an effective standstill as buyers and sellers are trying to figure out how things are going to shake out. Loans needing to be refinanced over the next 12-24 months will make things interesting.

There has been a lot of commentary on the U.S. entering a recession in 2023 assuming we are not in one already. I personally don't place much value on economic predictions. There's the famous saying that "economists have predicted nine out of the last five recessions". Maybe there will be a recession, maybe there won't be. It doesn't matter. Recessions are not all that uncommon and are just a natural part of the economic cycle.

I'm primarily focused on investing in companies that generate strong levels of free cash flow and maintain wide economic moats. Whether a recession is around the corner, or if interest rates are increasing, it doesn't bother me at all. The companies I am invested with have low to modest leverage, and have strong and stable margin profiles (no commodities) that puts them in a position to take market share from weaker competitors. Our portfolio companies are prepared to weather the storm, and it helps me sleep well at night knowing I own a portfolio of high quality compounders. As in all recessions, the survivors end up stronger on the other side.

Over the course of 2022 we only had two exits. One was a core position that reached our estimate of fair value, and the other was a small hedge position we decided to monetize at a slight profit. Details below:

Equity Residential (NYSE:EQR) - Exited

We initiated a position in EQR on 6/23/20 during the depths of Covid-19 as a core position in the fund. EQR is a class A apartment REIT that owns and operates premier luxury apartment buildings primarily on the West Coast and East Coast. Their target tenant demographic generates a household income of over $100,000 a year. These were not the type of tenants that were granted rent moratoriums or falling delinquent on rent. Collection rates across EQR's portfolio remained over 90% throughout all of Covid versus lower tier apartments that struggled to maintain occupancy and rent collection. Yet EQR's stock price continued to crater from nearly $90 to $55, which is where we started purchasing shares. This very high quality apartment REIT was trading at an implied 11% cap rate based on my calculations while private market values were in the 3-4% cap rate range. Although most transaction activity was paused during Covid-19, I had a high level of confidence EQR and its tenant base would make it through unscathed. Fast-forward to 2022, the narrative changed from basic survival to a narrative of a housing shortage with rents rising double digits across many markets. EQR subsequently recovered back to the $90 range as investors placed a premium valuation on the company. We exited at $91 in January 2022 as we believed upside was limited and there were more attractive opportunities to deploy capital. We generated a 40.83% IRR and 1.7x MOIC over a 1.5 year holding period.

Scorpio Tankers (NYSE:STNG) - Exited

Scorpio Tankers is not in-line with our typical holding company. STNG is an oil tanker business that faces volatile pricing as it transports refined petroleum products worldwide. The industry itself is not that great as price is dictated by volatile spot rates. STNG is also a levered company, and the CEO is borderline criminal (he loves trading options on the stock). However, STNG was trading at a significant discount to book value, and I was concerned about oil prices going parabolic. Although I tend to avoid commodity businesses like the plague, I figured this would be cheap insurance that had optionality to produce significant upside. The fund initiated a relatively small position (less than 1%) in May of 2020. Soon after purchase at ~$21, STNG started to nose-dive. Although shipping rates were attractive and helped many oil tanker companies print money, STNG was basically setting money on fire. Instead of paying down debt or allocating money to share buybacks, they decided to pay out dividends. STNG's peers saw huge increases in their stock prices while STNG did the opposite. However, during 2022 just as the overall stock market started tanking, STNG was marching upwards as oil prices shot up to ~$120/barrel. We recovered all of our losses plus some healthy dividend income along the way. We decided to monetize this hedge in April 2022 at $23. Admittedly, we sold way too early as the stock now sits at sub $50. I don't regret selling STNG though. We achieved our objective with our STNG hedge providing liquidity during the market selloff and were able to protect principal just as liquidity was drying up. We reallocated our STNG proceeds towards much higher quality businesses trading at attractive prices. In the 2 years we held STNG, we generated a 5.74% IRR and a 1.1x MOIC. The takeaway here is a reminder of why we avoid mediocre commodity related businesses. Although STNG was really more of a hedge for us that did its job, it was really more of a distraction that I was eager to sell when it was in the green while the rest of the market was painted red. This was not a company you want to be stuck bag-holding when oil prices/spot rates drop. We generally don't use hedges in our portfolio and I don't expect us to do so moving forward.

In regards to new positions in the portfolio, 2022 was an extremely busy year. Given our portfolio consists of 10-15 holdings with a target hold period of 5 years, that generally means we look to deploy capital into maybe 2 new positions each year and dispose roughly 2 positions a year (obviously subject to market conditions). Since the market nose-dived and hit lows in June and October last year, we acted quickly and decisively by deploying capital into 4 new operating companies. We are not market timers and we believe that trying to time the bottom is a loser's game. We may have been early in some positions, but as long-term investors we think we are buying excellent companies at very attractive prices. Details on purchases below:

META Platforms Inc. (NYSE:META) - New Purchase

META, formerly known as Facebook, needs no introduction. There's been a ton of bashing on the company for a variety of reasons, some of it justified. There is a laundry list of risks including: Apple iOS privacy changes, TikTok competition, bloated headcount, Reality Labs losses, and the weakening ad market. However, we believe that all of these issues are temporary and are not only fixable, but in some instances self-inflicted. We've started to see greenshoots on multiple fronts.

The fund has really never invested in tech companies primarily due to the sky high valuations in the sector. But when META fell off a cliff from ~$380 down to ~$220 we started to get interested. People tend to forget that META generated ~$46 Billion in operating profits in 2021. Just to set the stage for how great this company is let's look at a few statistics over the last 5 years (2017-2021).

1. Revenue - $40.6B to $117.9B, a 30.51% CAGR

2. Operating Income - $20.2B to $46.7B, a 23.34% CAGR

3. Net Income - $15.9B to $39.7B, a 25.37% CAGR

4. Earnings Per Share - $5.39 to 13.77, a 26.43% CAGR

5. Free Cash Flow - $17.4B to $39.1B, a 22.3% CAGR

We believe the TikTok threat was greatly exaggerated. META's products are doing fine, and they are starting to see positive feedback on their Reels product (META's counter to TikTok). Our investment thesis is not predicated on a TikTok ban from the U.S., but it would certainly be a positive development. META is also starting to lapse the iOS changes so that shouldn't be a factor moving forward (META also confirmed on their Q3 earnings call). Most importantly there are plenty of low hanging fruit for the company to go after such as monetizing WhatsApp and we are starting to see activity pick up on that front. In all, we think revenue growth will return, and in the meantime META is buying back stock, which we fully support at these prices.

Now, onto the biggest elephant in the room and the primary reason why shares have sold off as hard as they did. META grew headcount from 25,000 employees to 87,000 employees in just four years. That's just nuts. Although the market has telegraphed its displeasure with these bloated headcount expenses and metaverse capex, Mark Zuckerberg just didn't seem to care. His response was to plow forward with $10-$15B in metaverse spending while modestly growing headcount. The stock ultimately dropped from the low $200's where we entered the stock down to around $90 per share. It was a painful drop, but literally a self-inflicted wound. I think Zuckerberg is a great CEO and a smart guy, and he realizes that he's going to lose a lot of talented employees if the stock price stays too low for too long. In November he finally did an about-face and decided to layoff roughly 11,000 employees, which is a 13% reduction in META's workforce. That's a good thing, and the market has responded positively with shares up to around $130.

2023 has a great setup ahead. META and many other tech companies just have too much fat. Recessions will be good for tech companies as they focus on becoming more efficient and more profitable. People may be surprised by how quickly META can increase profits in a downturn with the amount of fat they have available to cut. They have also been steadily reducing the share count since 2016 (repurchased $44.81B of stock in 2021 alone) and current buyback authorization sits at nearly $18B as of Q3 2022. We believe share buybacks will be extremely accretive at these levels. We believe META shares are worth $400 and is a great long-term compounder that we are purchasing for a below market multiple. META is projecting EPS growth of 15-20% in a "down" environment. We attribute no value to the metaverse, but we think this could be worth a lot of money at some point. Reality Labs revenue has grown over 100% each year for the past 3 years. That is not nothing.

Alphabet Inc. (NASDAQ:GOOG) - New Purchase

Alphabet, aka Google, is another big tech household name. The big tech selloff has taken down everything, including high quality tech companies that generate copious amounts of free cash flow. Google has a fraction of the issues META is facing but they too have to deal with a slow ad market, which is short term in nature. We initiated a position around $120 and the GOOG shares are still selling off. We are comfortable adding to the position at these prices, currently around $90. A few interesting takes on GOOG over the past 5 years:

1. Revenue - $110.8B to $257.6B, a 23.47% CAGR

2. Operating Income - $28.8B to $78.7B, a 28.49% CAGR

3. Net Income - $12.6B to $76.0B, a 56.5% CAGR

4. Earnings Per Share - $18.0 to 112.2, a 58.01% CAGR

5. Free Cash Flow - $37.09B to $91.6B, a 25.4% CAGR

Similar to META, these are pretty enviable numbers. Soft revenue due to a slow ad market is affecting companies across multiple industries as everyone is tightening marketing budgets in anticipation of a recession. This short term phenomenon will pass and in the meantime Google will just keep getting stronger. We expect 30% earnings growth and the company has $70B authorized under its share repurchase program, which is nearly 6% of the current market capitalization. We estimate GOOG's fair value at roughly $180 per share and is probably the best company in existence. We continue to add shares.

Warner Bros. Discovery, Inc. (NASDAQ:WBD) - New Purchase

WBD is a product of a spinoff merger where WarnerMedia spun off from AT&T and then merged with Discovery, Inc. This was a case of a minnow swallowing the whale and is basically a leveraged buyout transaction. We were excited about this transaction for multiple reasons, including:

1. Premium assets.

2. Very cheap valuation.

3. High FCF conversion.

4. 5.0x gross leverage at deal close to 3.0x in 24 months (directly accretive to equity).

5. Fixed rate debt at ~4% with 14-year weighted average maturity.

6. Top tier management team.

7. $3B synergy potential (now $3.5B, and could reach $5B) and quality assets being managed by Discovery team vs. mismanagement at AT&T.

LBO transactions can be pretty attractive investments. The downside is the high leverage these companies start with and the low multiples the public market will assign to these highly leveraged companies. However, if you are a patient investor and can hold for the long-term, there is home run potential. The combined WBD is a collection of tremendous assets including: HBO, Discover, CNN, HGTV, DC, Harry Potter, Game of Thrones, Batman, Friends, Big Bang Theory, and many more. Today there are only 5 major movie studios and WBD is the second largest behind Universal.

In regards to quality, look at how HBO compares to Netflix and Apple TV+. They have no equal.

The transition from linear to streaming has formed a mini bubble, which has finally popped. It seems everyone was enamored by subscriber numbers, similar to page views leading up to the dotcom bubble. The only people in the room sounding the alarm was the management team at the newly formed WBD, CEO David Zaslav and CFO Gunnar Weidenfels. They have been pounding the table on EBITDA and free cash flow since the transaction closed in early 2022. They immediately killed projects that didn't meet their ROI hurdles, including CNN+ which launched just before the merger and even killed nearly complete films like Batgirl. Zaslav & company are utilizing every avenue of the combined WBD to make money and they made it clear that streaming is merely a single cash register out of the many others they have at their disposal. I think their strategy to utilize all sources of revenue versus collapsing multiple viewing windows into one streaming window will be a wise one. Management expects their DTC (direct to consumer) segment, currently called HBO Max (combined service to launch 2023), will breakeven in 2024 and will generate $1B in EBITDA by 2025. They also project long-term margin potential at 20%+ with incremental margins at ~50%. People tend to be short-term focused, but we think long-term streaming prices across the industry will rise, and this will be a very attractive business. We are already starting to see price increases happen and eventually this business won't be much different than linear (ie. linear 2.0).

Zaslav and Weidenfels are experienced operators that have proven their operating acumen from their Scripps acquisition, outdoing synergy guidance which doubled earnings from $1.78 per share in 2017 to $3.69 per share in 2019. Cable Cowboy John Malone is also a major shareholder who was instrumental in closing this transaction. Since taking over CHTR in 2013, Malone's company is up 30.9% per year over the past 8 years. Management is best in class and they are being heavily compensated to succeed. David Zaslav's compensation package of $246 million seems high, but it mainly consists of stock options that vest over a number of years at sustainably higher prices. Conversion prices range from $35.65 to $43.33. We think this compensation structure is highly motivating for management to create shareholder value.

The merger, like all big mergers, are pretty messy early on. There is plenty of work to undo as WarnerMedia assets were mismanaged by AT&T which caused the new management to reset expectations right out of the gate. On the flip side, synergy guidance has increased and 9 months since the merger management seems to have a solid command and control of the business. Leadership positions have been appointed, restructuring costs are primarily complete, merger accounting is behind us, and mass layoffs were all thrown into the 2022 bucket so that 2023 can turn the page back to building the business.

As it stands after Q3 2022 earnings, we have updated our valuation of WBD shares and our forecast for 2023 and 2024 given WBD's updated guidance.

Our current cost base is $19.47. We've been continuing to add to our position as the price has dropped into the $10 range. As you can see, the ROI range is pretty attractive across our forecast as we think a few years out we will double or triple our capital. Looking past 2024 we believe this is a solid company that will be a strong cash flow machine with 50%+ free cash flow conversion and a management team that knows how to allocate capital. We assume $4B in debt paydown per year, but this could prove conservative. With 4.0% fixed rate debt over 14 years, we think WBD will be able to repurchase debt below par value given how high rates have shot up since then. Debt paydown is directly accretive to equity holders. We also believe that once debt gets under 3.0x it's reasonable to assume multiple expansion from a deleveraged balance sheet. LBO transactions derive value from three sources: EBITDA growth, multiple expansion, and debt paydown (typically the largest contributor to value). There's also been talk of potential industry consolidation and that WBD could be a potential target. We are agnostic to this outcome, but I actually prefer WBD remaining a standalone company, and as a shareholder, continue to reap the attractive economics of this business for the long-haul.

BlackRock Inc. (NYSE:BLK) - New Purchase

BlackRock is a company we understand very well and have invested in before with much success. The fund originally purchased BLK shares back in 2018 and as shares approached our fair value estimate in July of 2020 we exited our position at a 22.55% IRR and 1.4x MOIC. Then stock prices went parabolic and BLK shares doubled. I was kicking myself for selling out of such a high quality business. But then the market bubble came crashing down in 2022 and we were able to repurchase shares at attractive prices. We purchased shares at ~$596 and BLK has since rebounded to ~$738. Asset managers tend to selloff pretty hard when recession chatter starts picking up and we purchased shares when BLK was trading at ~15.0x P/E. BLK should be able to grow revenue organically at ~4% a year and generate stable operating margins in the 40-45% range. CEO Larry Fink is a great capital allocater and is actively buying back stock at these cheap prices. We believe when the market stabilizes, BLK will return to trading at a market premium. 2023 EPS targets sit at $34.84 which at a 25.0x multiple gets us to $850 per share. A 20.0x multiple gets us to ~$700 per share.

We may have taken an early plunge on some of our newly invested portfolio companies, but we think these are all excellent business. We look forward to growing our capital alongside management teams that know how to create shareholder value. The key to our success is having the patience to wait and see things through. Although some of our new holdings have taken early hits to their share price, that is not a reflection of the underlying business value. If anything, most of our portfolio companies are repurchasing shares at huge discounts to fair value and using this opportunity to the benefit of shareholders. Once the market stabilizes and we get to the other side of this rough patch, I think investors will look back at this time period and realize what a great opportunity this was.

I'm an optimist by trade - you kind of have to be in order to succeed in this business. While most people have their natural flight or fight instincts take over their investment decisions, here at Seaside Private Capital we remain calm and patient. We take a long-term approach by focusing our capital on high quality companies and avoid the daily emotional gyrations of the stock market. We prefer to act and invest as business owners, which we believe will prove to be prudent over the course of our investing careers.

I wish everyone the best in 2023. Stay safe out there.

Daniel Fas

Founder & CIO at Seaside Private Capital