Please refer to our disclaimers, which can be found in the footnote of this page and here.

Contents

• Contents
• Performance
• Process & Portfolio Discussion
• Alibaba Update
• Charter Communications Update
• Business Update

Performance

Performance for 1Q 2024 was+2.6% net (vs. the MSCI ACWI at +8.2%). Since inception, the portfolio has compounded at +18.4% gross / +15.7% net (vs. the MSCI ACWI at +12.8%), representing +5.6% gross (+2.9% net) annualised outperformance. Top contributors for the quarter were Salesforce, Meta Platforms, and Alphabet. The biggest detractors were Charter Communications, Twilio, and Snowflake.

In late 4Q 2023, we reduced our positions in Block, Twilio, and Salesforce. All three decisions were driven by strong price appreciation requiring an adjustment in position size. We also re-entered Visa, a company we have owned previously. In 1Q 2024, we reduced our positions in Meta Platforms (price above $500), Salesforce (price above $300), and Okta (~$108), again due to price appreciation and position size. We added incrementally to Charter Communications and Alphabet. Charter Communications was down -25% for the quarter. It sold off following an earnings report as residential broadband growth continues struggle while fixed wireless takes incremental share (discussed below). Alphabet was down mid-quarter (when we added) on the usual concerns around the impact of AI on search but finished the quarter up +8%. Alphabet also had a strong 1Q 2024 report and is up significantly post quarter-end. We began the quarter with 13% cash and finished with 10%. We continue to see markets as expensive, with the exception of China.

Returns Summary

Portfolio Statistics

Process & Portfolio Discussion

We typically split our time equally between existing and new positions. Our most recent areas of new work in 2023 included architectural design and construction software, insurance software, carbonated beverages, and coffee. We underwrote several businesses in depth but made no purchases for valuation reasons. This quarter, we revisited the Chinese eCommerce landscape to re-underwrite our position in Alibaba. It also led to a potential new position that we have been underwriting in depth, and we hope to share more in our next letter. We also spent time this quarter re-analysing our position in Charter Communications, which sold off following its 4Q 2023 earnings report.

Alibaba Update

We have owned Alibaba since the inception of the strategy, and it has been a key detractor of performance. Our commentary here is intended as an update rather than an overview of the business. For those unfamiliar, Alibaba is a large conglomerate in China. Its primary business is China’s largest eCommerce marketplace (Taobao/Tmall), which attributed 141% of EBITA in FY2023. It has various other businesses including China’s leading public cloud business, payments, various direct sales eCommerce/retail businesses, international eCommerce, food delivery, logistics, and a long-form video business. A good summary of the business can be found here.

The principal reason for its underperformance, other than the macro, is the stalling of growth in its core domestic eCommerce business (Taobao/Tmall) and its cloud business. Taobao/Tmall have been impacted by the entry of Pinduoduo (another eCommerce marketplace) as well as Douyin and Kuaishou (both social / short-form video entertainment platforms with burgeoning eCommerce businesses). Additional factors included the cancellation of the company’s planned spinouts as well as the removal of former CEO Daniel Zhang.

We were first introduced to Pinduoduo in 2018, while it was still a private company, and have followed the company since then. As we mentioned in our last letter, we were sceptical of the sustainability of its aggressive advertising and marketing spending to buy market entry. We were wrong. As it turns out, the company had exceptional execution and it is now a fully scaled business with similar incumbent advantages to Alibaba’s Taobao. It is a remarkable feat as prior to its rise, the strength of the incumbent platforms should have enabled them to rebuff Pinduoduo’s entry. As we discuss in our business quality framework, network effect business models have some key vulnerabilities. In this case, Pinduoduo targeted a value proposition (“very low-price value-for-money”) and a customer segment (lower income / lower tier cities) that wasn’t being served adequately by Taobao/Tmall and others. This, alongside great execution, enabled the company to establish a strong foothold from which to expand. Pinduoduo also pioneered the team-purchase model, which enabled greater discounts for group orders and incentivised word-of-mouth customer acquisition, enhanced by smart use of social acquisition channels such as WeChat (at the time unavailable to Alibaba given competitive exclusion from Tencent). China’s economic hardship over the last 3 years also had a role to play as it meant a general shift towards lower-priced items just as Pinduoduo came to scale.

Alibaba unintentionally aided Pinduoduo by degrading the Taobao merchant value proposition over time. As higher-value products were sold through Tmall, with higher associated platform marketing spend, Alibaba was able to boost its profits by directing more traffic from Taobao to Tmall. That is, they did not create an even playing field for traffic acquisition spending between the two. Our channel checks indicated that this left merchants frustrated. It also made it harder for Alibaba to reverse this stance as it would hurt margins and cash flow. Alibaba was also slower to adopt the manufacturer-to-consumer model in its domestic business because of the disruptive impact this would have on 1688.com, its domestic wholesale marketplace. Both issues meant Alibaba faced a counter-positioning[1] problem from Pinduoduo. We think management now realises its error and is working to rectify this with its “Return to Taobao” strategy. Alibaba had also become a bloated organisation. Various former employees complained to us about too many mid-level managers, too much competition for shared tech resources, and too many hoops to jump through to execute on new things. In contrast, Pinduoduo is much leaner and has an aggressively entrepreneurial culture. This makes Alibaba much slower to adapt and change. Alibaba has been responding by reducing headcount, which may help, but we think this advantage is a hard-to-replicate cultural edge for Pinduoduo.

We think Pinduoduo, and others like Douyin, will continue to steal share from Taobao/Tmall. However, we do not think this is the end of Taobao/Tmall. They too serve a strong value proposition and continue to maintain strong user engagement as the largest platform by gross merchant value (“GMV”…i.e. sales) and timeshare. We have spoken with various merchants who sell through the platform. In fact, most of the brands we spoke with were very negative about selling through Pinduoduo as they did not want their brand associated with a discount platform. Some had indicated that they are closely watching the space and may consider offering only clearance items. When asked why Tmall’s growth was struggling, their view was that it was more likely due to the macro-economy and some impact from Douyin, where the branded merchants are allocating marketing budget. They argued that Tmall remains “the” platform for branded goods. While the macro-economy suffers in China, higher-priced branded retail is likely to remain depressed, but we do not see this as permanent. We had always underwritten a share loss for Taobao/Tmall, but we now underwrite a greater decline. At first (in 2018/19), we underwrote a stable margin in the core business, but we now assume a continued decline. It is hard to know exactly where the margin will stabilise, so we reverse the question and consider what we need to believe given the current share price.

Alibaba’s cloud business has also decelerated. We would expect this given China’s macroeconomic backdrop, but it has also been impacted by the migration of TikTok from its services after the US mandated TikTok to store data domestically in the US. That aside, Alibaba’s cloud business is complicated. The reported numbers are not purely public cloud. They also include its content delivery network (“CDN”) services and managed private cloud businesses, which are both lower margin businesses. The public cloud penetration in China remains well below the US but, according to China Chief Information Officer surveys, the public cloud remains a strong priority. These same surveys indicate Alibaba Cloud as a top beneficiary of this shift. As indicated by other positions in our portfolio, we strongly believe in the value proposition of the public cloud. As the public cloud part of the business continues to grow, it represents a greater and greater share of the overall cloud revenue. Management disclosed that it reached 70% of its 3rd party total cloud revenue in 3Q 2023. We think some of these issues are masking a good business underneath. We are now underwriting continued pressure on the cloud business in 2024 with a re-acceleration from 2025 as some of these issues roll off.

Alibaba currently trades on a low double-digit forward-free cash flow (“FCF”) yield. We think the overall business can very conservatively compound FCF in the high single-digits. Even without a compression in the FCF yield when the China macro-economic picture stabilises, this provides a high-teens IRR[5] over 5 years. There is a lot embedded in this, but in brief, we can achieve this even assuming flat revenue growth in the core eCommerce business (low single-digits GMV growth, equating to roughly 8% share loss, offset by compression in the monetisation rate due to competition) as well as further margin pressure. It assumes the cloud business recovers (as mentioned above) with modest margin expansion with scale, and reduced losses in non-core businesses (either through business improvement or divestment). We sense check this with a conservative sum-of-the-parts valuation. In essence, we only need to believe that the core eCommerce business can stabilise to produce attractive returns. We think it can.

Like many Westerners investing in China, we have naturally asked why we bother given some of the geopolitical challenges, government regulation, and the natural disadvantage we face not speaking the language or being based locally. As is usually the case, the investment community worried more about China after the broad-based and deep market sell off than it did prior. These risk factors have always been present (e.g. China’s anti-monopoly regulation was well telegraphed for several years prior to Western investors raising it as a concern). The time to worry the most about such broad risks was when valuations were also high. Today, many Western investors have given up on China and this is reflected in current low valuations. Some investors now argue that China is not investable at any price due to the risk of major conflict with the West. We disagree with this and do not think any public equity market will be safe in that eventuality. At the same time, we must consider our opportunity cost. Western markets are significantly more expensive today and so the current opportunity cost is low. Despite the attractive valuation, Alibaba is still only sized at ~6%. We have always limited its size to respect some of the aforementioned risk factors.

Charter Communications Update

We have owned Charter Communications (“Charter”) in various sizes since 2020. However, I first invested in the company in early 2016 on a personal basis, pre-dating our inception. The stock is down circa 40% since the 3Q 2023. As for Alibaba, our commentary here is intended as an update only, not a comprehensive investment memo.

For those unfamiliar, Charter is predominantly a cable broadband business. Broadband accounts for just under 70% of net revenue[2] and over 80% of EBITDA. We like the business because of its stable, recurring revenue and entrenched oligopoly/monopoly position. We estimate that just over 50% of its footprint is a monopoly, with no other competition capable of > 1 Gbps speeds[3]. Its core moat lies in its hard-to-replicate assets and broad ownership of customer relationships. The returns available for a new entrant overbuilding in cable’s core markets are typically too low to make it attractive. There is also an interesting opportunity for Charter in offering mobile services via its network agreement with Verizon combined with offloading traffic to its own infrastructure. This enables Charter to offer mobile services at a significant cost advantage relative to the mobile network operators.

While we like the business, there are some structural things not to like. First, its core moat relies on economic rationality, which in our experience is not always reliable (sometimes market participants do irrational things!). Second, the business is capital intensive. The network infrastructure requires upgrades to maintain its competitive position versus fibre. At various stages over the years, the investment community champions the stock on the basis that once the current network upgrade ends, cash flow and ROIC will improve. However, once an upgrade cycle ends, there is usually another announced. Third, the business has high leverage, though we are comfortable with the maturity profile, fixed-rate nature, and the serviceability of the debt. Management also has flexibility to reduce spending on rural initiatives or share repurchases if required. As a result, we do not think the business quality is as high as other businesses in our portfolio, and it therefore carries a higher cost of capital for us. We also size it more conservatively despite its more attractive valuation.

The recent underperformance predominantly relates to its decelerating residential broadband growth, which has been the result of fixed wireless offerings from T-Mobile, Verizon, and now AT&T (plus some impact from the ending of the government Affordable Connectivity Program). Fixed wireless is a service whereby the customer’s home connection is direct to the mobile network utilising mid-band 5G spectrum. T-Mobile has the most attractive mid-band spectrum for this. While its impact is recent, the technology is nothing new. In fact, I was a fixed wireless customer in London some years ago on 4G. As can be seen in the table below, fixed wireless has been taking most of the incremental net customer additions of late given its lower price point and positive early customer reviews. T-Mobile expects to reach 7-8m fixed wireless subscribers over the next two years, Verizon 5m, and AT&T has not released a target. This represents 9-11% of addressable households in the US and about 700k adds per quarter.

Broadband Net Subscriber Additions

We have spent considerable time with network engineers and business managers from the fixed wireless teams to understand the path forward. The consistent opinion was that the stated targets from T-Mobile and Verizon are fair, but that it would also be hard for them to go much beyond this range. Fixed wireless customers use considerably more data than mobile customers and so the revenue per gig of data, and therefore customer unit profitability, is an order of magnitude lower. In addition, the capacity of mobile spectrum is limited, which means most of the spectrum must be reserved for mobile customers. The strategy of the networks is to sell only spare capacity on a tower-by-tower basis. This also means customer acquisition is complicated since it is highly localised and customers may not be able to transfer their service when they move (moving equals churn). Further, fixed wireless customers rank below mobile customers and business customers when the network is congested and are the first to face speed-limiting. We have also heard that the fixed wireless teams must fight with the mobile teams for capacity allocations. As the spare capacity is used up, the positive experience of the fixed wireless customers is likely to degrade. Indeed, this was my personal experience after being a 4G fixed wireless early adopter (I churned back to wired broadband). Our understanding from these conversations is that it would require very significant capital expenditure and acquisition of new spectrum to go much beyond the stated subscriber targets, which is not feasible unless it would also lead to significant mobile subscriber acquisition (unlikely given already mature mobile market penetration). Our view is that fixed wireless will continue to gain share but will plateau over the next 24 months, allowing cable to return to a more normalised path. This has also been signalled by the mobile networks themselves.

Longer-term, we remain more cautious of fibre competition than fixed wireless competition. Charter has a very credible network upgrade path to remain competitive with fibre on a symmetrical (download/upload) basis. However, fibre is still a superior asset. It has fewer outages, has a lower maintenance cost, and the back-end is easier to manage. New home passings by Charter are done with fibre (as is the case for their government subsidised rural build programs). Over the ultra-long-term (say 30 years), we think the cable companies will gradually replace their network with fibre.

Charter’s competitive overlap with fibre has risen from 25% of its footprint 5 years ago to circa 48% today, and we forecast this to rise to roughly 65% over the next 5 years. This has a much bigger impact in the medium-term than fixed wireless in our view. We conservatively assume in our base case that Charter declines to 30% penetration where fibre is present versus an increase to 65% penetration in non-fibre areas. Combined with Charter’s rural expansion initiative (not a topic in this letter), this implies broadband subscriber growth over the next several years will be relatively flat. We may prove to be too conservative here in Charter’s ability to maintain share in its competitive footprint. The end of zero interest rates has made the economics of new fibre projects even harder, which should help cool the recent fibre building.

On a more positive note, Charter has been growing its mobile subscribers more strongly than we anticipated and finished 2023 with 7.8m mobile lines (representing 47% growth). We think this is a great opportunity for Charter given the aforementioned cost advantage it enjoys. However, we are also cautious here. Management reports a strong 20-30% margin before customer acquisition costs, but there is a sleight of hand in these numbers. The company records a higher revenue with an offsetting 1st-year discount in the marketing line, which is excluded from their margin number (i.e. it is inflated). In addition, because the mobile business does not have high switching costs, the customers need to be reacquired every couple of years, whether through renewed line discounts or handset subsidies. As such, the marketing expense becomes a recurring cost item rather than a one-time customer acquisition cost and should be included in the contribution margin. We estimate a fully loaded EBITDA margin of -7% today, which should expand as the business scales, but remain significantly lower than that of the broadband business. Overall, we still see this as a strong positive for Charter and it is the strongest element of growth in the business. Although the margin is less attractive, it helps reduce churn in the broadband business and to grow overall FCF per subscriber, which is the real key to value creation. Because the mobile business is lower in quality than the old video business (not the current video business in decline), the end state of the mobile+broadband business is lower in quality than the old cable business of video+broadband.

With the picture painted above, how can the returns be achieved? Our conservative base case has flat revenue over next 5 years. Broadband has a low single-digits revenue CAGR [4] (slight volume decline with low single-digit pricing growth), while mobile is growing strongly, offset by continued video decline. We think the overall margin compresses as the lower margin mobile business expands. The key lies in falling capital expenditure. As mentioned above, we think the current network upgrade expenditure is renewed with yet another upgrade announcement and is therefore more recurring in nature. However, the capital expenditure load over the next few years is significantly elevated due to their rural expansion initiative. For brevity, we won’t go into the details, but early signs indicate that Charter is executing well here. This component of capital expenditure will only remain recurring if there is continued success and value creation (a good thing). This expenditure is growth orientated. If we normalise for this, run-rate FCF can expand meaningfully. Combined with share repurchase, our base case has FCF compounding in the mid-20s over a 5-year horizon. The business currently trades on a ~7.5% FCF yield (also on a depressed forward-FCF), which gives us a mid-20s IRR[5] without any compression in the yield (i.e. without multiple expansion).

Business Update

We are grateful to welcome another new client to Kalakau Avenue.

Matthew Brown

Founder & Chief Investment Officer

Footnotes

[1] See Helmer’s “7 Powers: The Foundations of Business Strategy”

[2] Revenue adjusted for pass through programming costs

[3] This was reported as 56% in 3Q 2022

[4] Compounded annual growth rate

[5] Refer to our disclaimers, we make no guarantees of future performance, and our projections should not be relied upon