VCS Agency - Lunar Capital

What’s Up Walt

The Walt Disney Company holds a diverse portfolio of brands and assets. These include Disney, Marvel, Star Wars, Pixar, 21st Century Fox, sports broadcaster ESPN, and Disney Experiences. Since the onset of the pandemic, Disney has faced challenges in maintaining its previous level of success. The segments have not always done well simultaneously.

Disney’s multiple business segments that drive the revenue for the company:

Experiences – includes their theme parks and Disney cruises.
Entertainment – includes their streaming platforms, linear tv assets, and box office hits .
Sports – includes their ESPN assets.

During the Covid pandemic, Disney’s streaming service, which was in its early stages, contributed to the company’s growth. The strategy was to leverage its extensive catalogue of creative and entertainment Intellectual Property (IP) to attract more users to its brand and transition users from its traditional linear television business to a more streaming-focused model.

Its Direct-to-consumer business (DTC) which includes Disney+ and Hulu, currently have just under 175 million paying subscribers globally. Average revenue per user (ARPU) per month in the United States for Disney+ is $7.70, compared to Netflix, which has an ARPU of $17.06. Netflix’s streaming service also boasts 282 million subscribers globally, over one hundred million more than Disney’s streaming platform.

Growth at Disney for its DTC business has slowed significantly since the peak during the Covid period. Revenue for the quarter for its DTC business increased by 16% to $5.8 billion. A notable development is that Disney’s operating income for their DTC platform was positive at $0.3 billion for the current quarter, an improvement from a peak loss of $1.5 billion in Q4 2022.

Disney’s parks and experiences business had the highest operating income among its segments, reaching $1.7 billion for Q4 2024. The segment performed well following the COVID-19 pandemic due to increased demand. However, with consumers facing financial pressure, the experiences business saw a year-over-year growth of only 1%, totalling $8.2 billion for the the quarter.

Disney’s CEO Bob Iger has stated that the current focus of Disney is to return creative control to their various brands and segments. He asserts that producing quality content for audiences encourages engagement with related content, whether from their streaming platform or their experiences business. It remains to be seen if Disney can effectively compete across all its business segments in the extremely competitive entertainment industry.

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Disclosures
Lunar Capital (Pty) Ltd is a registered Financial Services Provider. FSP (46567)
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The Lunar BCI Worldwide Flexible Fund Fact Sheet can be read here.
This stocktake is prepared for the clients of Lunar Capital (Pty) Ltd. This stocktake does not constitute financial advice and is generated for information purposes only.

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Mercado Libre – Seeking Credit

Weekly Stocktake / By VCS Agency

Mercado Libre (Meli), meaning “Free Market,” is an e-commerce and fintech company operating in Latin America. Revenue is primarily generated from its presence in Brazil, Argentina, and Mexico. Mercado Libre’s vision is to service parts of the market that weren’t traditionally being serviced.

Initially established as a marketplace platform for individuals to sell and trade second-hand items, Meli has evolved into a comprehensive e-commerce and fintech platform. It currently has over sixty million unique active buyers on its e-commerce platform, and over fifty million users on its finance platform.

Meli’s Q3 2024 revenue rose 35% to $5.3 billion, fuelled by more online activity. E-commerce revenue jumped 47% year over year to $3.14 billion, while fintech revenue increased 21% to $2.2 billion. Mercado Libre’s gross profit grew 16%, impacted by higher sales costs and finance expenses.

Meli has been aggressively expanding their fintech business, which has the potential for higher net margins if managed effectively. They have leveraged their e-commerce platform to support this growth. Meli believes that the richness of the data they receive will enhance their understanding of their customers. The percentage of monthly active sellers on their e-commerce platform who have obtained financing through Meli has increased from 9.9% last quarter to 21.8% this quarter.

Operating income for the company was $0.56 billion, down 29% year over year. Meli’s aggressive approach to grow their fintech business has resulted in them taking on a higher provision for bad debts. The risk of servicing markets that haven’t previously been serviced before is that there are a lot of unknown risks that the company takes on.

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Alphabet(ting) on AI

Weekly Stocktake / By VCS Agency

Alphabet Inc., the parent company of Google, generates a substantial amount of cash. The Google Services segment, encompassing Search, YouTube, and other platform subscription services, reported a revenue of $76.5 billion for the most recent quarter. After accounting for all operating expenses, Google Services achieved an operating profit of $30.9 billion, resulting in an operating margin of 40%.

Alphabet has leveraged this profitable segment to reinvest in its products, explore new ventures, and strengthen its balance sheet.

At the beginning of 2023, as interest in generative AI was increasing, Alphabet was among the companies with sufficient resources to invest significantly in developing generative AI infrastructure and offering products to customers.

Google Cloud has maintained its position as the fastest-growing segment for Alphabet over the last few years. Google Cloud’s revenue for the current quarter increased by 35% year-over-year to $11.4 billion. This growth was mainly due to the expansion of Google Cloud Platform (GCP) AI infrastructure, Generative AI solutions, and other GCP products. Additionally, Google Cloud has become profitable due to increased scale of operations. For Q3 2024, Google Cloud generated $1.9 billion in operating profit, compared to $0.3 billion for the same quarter last year.

To support the growth of its cloud business, Alphabet has invested heavily in its infrastructure. Since the beginning of this year, Alphabet has spent $38.3 billion on capital expenditure, compared to $21.2 billion over the same period of time last year. It is estimated that 80% of this year’s capital expenditure has been allocated towards data centres, which are used to compute data and power intensive AI workloads.

After all the spend in capital expenditure, Alphabet still had a cash and cash equivalents on hand worth $93 billion at the end of the current quarter.

Alphabet is expected to see its margins compress on its income statement next year when the depreciation on their capital expenditure reflects for the full year. There are concerns that Alphabet, along with their competitors, have been over-investing in generative AI products, without having a real gauge on what the AI market will look like in the medium-long term future. As it stands, Alphabet plans to continue spending on AI infrastructure, arguing that they do not want to be left behind in the AI race.

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Luxury Wars

Weekly Stocktake / By VCS Agency

Over the last two weeks, luxury fashion houses LVMH, Kering, and Hermes released their revenue figures for the third quarter. The companies reported weaker demand from various regions around the world as consumers show less inclination to purchase luxury items during tighter economic conditions and rising costs. Consumers are more selective with their purchases. The graph below shows the revenue for Q3 2023 compared to Q3 2024 from these luxury houses.

LVMH oversees numerous luxury brands, including Louis Vuitton, Christian Dior, Moet & Chandon, Hennessy, and Sephora. The company’s revenue dipped by 4%, mainly due to declines in its Wine and Spirits and Fashion and Luxury segments. It was partially offset by a rise in its Perfume and Cosmetics segment. The company operates globally, with an expanding presence in Asia. The depreciation of the Japanese Yen has led to consumers purchasing more in Japan, making Japan one of LVMH’s best-performing regions this year.

Kering, which owns Gucci and Yves Saint Laurent, has a more concentrated portfolio than LVMH. Gucci made up over 40% of Kering’s revenue this quarter but saw a 26% sales drop from the same quarter last year. Facing macroeconomic challenges and a lack of consumer resonance with their products, Kering has changed Gucci’s leadership to try to revitalize the brand. Overall, Kering’s sales declined 15% year over year.

Hermes, which has an even tighter portfolio, has experienced significant growth in the luxury sector in recent years. It has seen its sales this quarter increase by 10% year over year. The company targets ultra-high-net-worth individuals. Some bags sold by Hermes have year-long waitlists and can be priced around ten thousand euros. The company strategically limits the number of items sold to create higher demand for its products.

Consumer preferences can be unpredictable, significantly impacting the success of companies. Luxury brands not only compete with each other, but also compete with athleisure brands like Lululemon, which traditionally were not considered direct competitors.

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Chipping Away

Weekly Stocktake / By VCS Agency

Last week, TSMC (the semiconductor/chip manufacturer) and ASML (semiconductor-equipment manufacturer) released their respective Q3 2024 results. The outcomes illustrate contrasting scenarios regarding how each company is navigating the AI boom.

TSMC manufactures the semiconductors on behalf of companies such as Nvidia, Apple, and other designers. While ASML makes the advanced lithography machinery that is used in the process of making this machinery. It essentially uses light to etch the circuits onto the silicon to make a semiconductor. ASML sell their machinery to the semiconductor manufacturers such as TSMC, Intel, and Samsung.

For the quarter, TSMC reported a revenue of $23.5 billion, marking a 36% year-over-year increase. Their gross margin rose by 3.5 percentage points to reach 57%, and their operating profit was reported at $11.6 billion, reflecting a 58% year-over-year growth.

The surge in demand for specialized AI chips, which are critical for processing large volumes of data in AI applications, has resulted in a significant number of orders from TSMC. Notably, the high-performance computing segment grew by 11% quarter-on-quarter, accounting for 51% of TSMC’s total revenue.

It is estimated that TSMC produces 90% of the worlds super-advanced semiconductors. Intel Samsung, and other fabrication players have not been able to keep up.

In contrast, ASML recorded a revenue of €7.47 billion, representing a 10.6% year-over-year decline. Their gross margin remained stable at 50.8% compared to the same period last year, while their net income fell by 8.8% year-over-year to €2.1 billion.

ASML’s results have not correlated with TSMC’s due to delays in building new fabrication plants, particularly by Intel and Samsung. Despite grants and tax incentives from the Biden administration designed to “near-shore” semiconductor production, these delays have reduced orders for ASML’s advanced lithography machines.

Although ASML maintains an effective monopoly on the sale of advanced lithography machines, their sales can exhibit significant fluctuations due to the cyclical nature of setting up new plants, leading to considerable variability in their revenue streams.

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Quarterly Investment & Performance Review – 30 September 2024

Quarterly Performance / By VCS Agency

Sabir provides an update of the Funds’ performance and how Lunar Capital plans to invest in the current market climate

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JP Morgan: Bank On It

Weekly Stocktake / By VCS Agency

JP Morgan, known for its fortress balance sheet, released its Q3 2024 results on Friday. The bank reported net revenues of $42.7 billion, representing a 7% year-over-year increase. Net income for JP Morgan was $12.9 billion, a decline of 2% compared to the previous year. The bank’s return on equity (ROE) for the quarter stood at 16%. This was partly driven by efficiencies from tech investments and lazy deposits (customers who settled for lower returns on their deposits than they would get in other accounts.)

The discrepancy between the rise in net revenue and the decline in net income was attributed to higher provisions for credit losses, which amounted to $3.1 billion, an increase of 125% from the same period last year. Despite this, JP Morgan’s balance sheet is well-positioned to withstand such financial pressures.

Following the 2008 Global Financial Crisis, the Basel III framework was introduced to enhance banking regulation. One significant part of the regulation requires banks to maintain a common equity tier 1 (CET 1) ratio of at least 4.5%. Regulators may require higher ratios from specific banks. The CET 1 ratio reflects a bank’s core capital, comprising common shares, retained earnings, and additional paid-in capital. It is considered the most secure form of capital, essential for enhancing a bank’s financial resilience and safeguarding depositors during financial shocks. JP Morgan’s CET1 ratio is 15.3% on risk weighted assets of USD1.8tn, giving it an estimated loss-absorbing capacity of USD544bn.

With such a large asset and capital base, and broad product suite; JP Morgan services over 82 million US consumers, 6 million small businesses and 40 thousand large- and medium businesses around the world. JP Morgan’s strong balance sheet also allows it to take advantage of growth opportunities when the market goes through a downturn.

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Nike: Will they Do It?

Weekly Stocktake / By VCS Agency

Nike, which was expected to be ideally positioned for “running mania”, released its Q1 2025 results. Revenue for the quarter declined by 10% year-over-year, reaching $11.6 billion. Gross margin improved by 120 basis points to 45.4%, while net profits fell by 26%, amounting to $1.05 billion. Nike’s share price has dropped over 22% this year and more than 50% since its peak in November 2021.

Nike, renowned for its innovative products, memorable advertising campaigns, and strong athlete partnerships, has been losing market share to both established and emerging brands such as New Balance, On, and Hoka.

Under the previous CEO, John Donahoe, the company concentrated on expanding its direct-to-consumer business model. This included increasing capacity for its e-commerce channel and further developing Nike-run stores. The goal was to gain better control over sales and improve the bottom line by avoiding consignment fees to wholesale retailers. However, this strategy strained relationships with wholesale partners, leading some to remove Nike products from their stores.

This approach seemed adequate during the COVID-19 pandemic when online shopping surged. However, as demand for Nike’s products began to decline, the company struggled to maintain growth.

The new CEO, Elliott Hill, has placed a strong emphasis on mending relationships with wholesale partners and acknowledged that Nike had deviated from its core strengths of product innovation and designing athletic footwear. Hill believes that that Nike will only be able to generate strong demand for their lifestyle products after they accomplish the feat of designing great athletics wear.

While turnarounds are challenging to implement, especially in a highly competitive fashion and high-performance sports sector, Nike possesses a relatively strong balance sheet with $8.5 billion in cash. Time will determine if they can Do It.

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Good prices and good margin, How has Costco managed it?

Cost Conscious Costco

Weekly Stocktake / By VCS Agency

Costco has cultivated a devoted customer base in the US by appealing to price-sensitive consumers, addressing recession concerns, and focusing on selling products at lower margins than competitors. As of Friday, the retailer’s price-to-earnings (P/E) ratio was just under 60, compared to Walmart (41) and Target (16).

Over the last five years, Costco’s share price has risen by just over 200%. Examining the company’s financials, Costco reported revenue of $149 billion and a net income of $3.7 billion in 2019, resulting in a net margin of 2.5%. By 2024, the revenue grew to $253 billion, with a net income of $7.4 billion, reflecting a 2.9% margin.

In its most recent quarter, Costco achieved a gross margin of 11%. For comparison, Walmart’s latest quarter showed a net margin of 2.7% on revenue of $169 billion, with a gross margin of 25%.

Costco has managed to keep product prices low while maintaining respectable net margins through several strategies:

Membership model: Customers must have a Costco membership to shop, encouraging repeated purchases, and allowing Costco to collect personalised client purchasing data.
Bulk purchasing and limited selection: This approach allows Costco to negotiate lower prices and streamline inventory management, reducing costs further.
No-frills operations: By minimizing operational expenses, Costco maintains its ability to sustain a relatively healthy margin.

Given the high P/E ratio, Costco must adhere strictly to its reputation as an “extremely well-run, no-frills business.” Notably, the company’s membership fees are nearly equivalent to its net income, indicating that membership growth is important for overall expansion. Any significant misstep by Costco could lead to a substantial decrease in its stock price.

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Zara Fit Check

Weekly Stocktake / By VCS Agency

Inditex, the Spanish business which owns of fashion brands such as Zara, Bershka, Oysho, and Massimo Dutti, published its H1 2024 results last week. Net sales for the period reached €18.1 billion, reflecting a 7.2% increase year-over-year. The cost of sales rose slightly slower than net sales, leading to a 7.5% rise in gross profit to €10.5 billion. Net income climbed by 10.5%, reaching to €2.8 billion. This translated to a net margin of 15.3% for the period, up from 14.9% during the same period last year. The improvement in margin was mainly attributed to amortization and depreciation remaining unchanged from the previous year.

Zara represented 72% of Inditex’s sales for the first half of 2024. Zara’s sales increased by 5.4% compared to the same period last year. While most other brands experienced double-digit growth, their smaller size relative to Zara meant that Inditex’s overall net sales only rose by 7.2%.

Inditex places a strong emphasis on logistics, planning to invest €900 million annually over the next two years. This extra expenditure increases Inditex’s usual annual capital expenditure of €1.8 billion by 50%. Part of the capital expenditure will deployed to increase store space by approximately 5%.

Zara, famous for its quick turnaround time; has the ability to design, manufacture, and stock new items on store shelves within two to three weeks. The company maintains low inventory and has structured its manufacturing to ramp up production when certain items sell well; unlike competitors, who can take months to respond to trends.

Inditex operates in a highly competitive market. Despite having an efficient supply chain model that allows them to compete on design, they are susceptible to supply chain disruptions, such as those witnessed during Covid-19 and the conflict arising from Russia’s invasion of Ukraine.

Zara also believes that driving sales can be accomplished by attracting customers to their physical stores. To entice visitors, they lease historical and cultural buildings to add a unique appeal to their brand. However, if demand for their brand suddenly drops, they could end up paying higher-than-usual costs for unused space.

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