Stock Talk Podcast Episode 199 Show Notes

KeyStone’s Stock Talk Show, Episode 199.

We are happy to be back with you to announce the launch of our 2023 first half Live Webinars on March 7th and 9th.  We will start by talking some hot button issues including retail giants Walmart and Home Depot forecasting a consumer slow down and touch on Netflixx’s password crackdown. In our Your Stock Our Take segment, Aaron answers a listener question on DigitalOcean Holdings Inc. (DOCN:NYSE), a cloud computing solutions provider for start-ups and small-to-medium sized businesses. Shares are down 74% since their peak – Aaron answers whether or not this high growth business is finally trading at value prices. Second in our YSOT segment, Brennan answers a listener question on Spin Master Corp. (TOY:TSX), a children’s entertainment company that creates, designs, manufactures, licenses, and markets various toys, entertainment franchises, and digital games in North America, Europe, and internationally. Spin Master is a great Canadian success story and has grown into a world-renowned toy company, that has shown strong long term fundamental performance in growing both its revenue and EPS.  But is it a good investment? Brennan lets you know. Finally, Brett answers a listener question on Grayscale Bitcoin Trust (GBTC:OTC) – is solely and passively invested in BTC, enabling investors to gain exposure to BTC in the form of a security while avoiding the challenges of buying, storing, and safekeeping BTC, directly. The listener noticed that it trades at a significant discount to the value of the bitcoin it owns and asks if this was an opportunity.

Consumer slow down Walmart and Home Depot:  

Monitoring Economic Conditions Broadly – given the fact the NASDAQ, which was down 33% in 2022 started 2023 with a bang up over 13% at one point. Our question is whether or not the market move is sustainable or a dead cat bouncing.

One tool to use is the stated “outlooks” from some of the largest retailers including the likes of Walmart and Home Depot. This week Walmart easily topped expectations for the holiday quarter, but it gave a weaker-than-expected outlook for the year ahead.

Home Depot, for its part, issued similar guidance. The home improvement retailer, which also reported fiscal fourth-quarter earnings this week, said it is planning for flat same-store sales, as stubborn inflation and climbing interest rates cause consumers to watch their spending.

To quote Home Depot Chief Financial Officer, “We’ve seen an increasing degree of price sensitivity as the year’s gone on, which is actually sort of what we predicted in the face of persistent inflation.”

Again, the significant price increases of everyday goods including food, couple with potentially higher mortgage payments at present or on the horizon should lead to a weaker consumer – particularly on discretionary items. This is not great for economic growth near-term and can hit the stock market.

One could argue that with the declines in 2022 – that hit already came – but the current valuations are still historically on the higher end, so caution remains.

Discretional retailers are likely in a tougher position. Many mall players, such as Macy’s and Nordstrom, skew toward discretionary goods like apparel, handbags and shoes. Those two companies already warned investors about their holiday results.

In the cases of Walmart and Home Depot – they both sell consumer staple (particularly Walmart) so they should fair better in a recession. What I worry about is the fact that Walmart and Home Depot still trade at premium mulitples- Walmart at 24 times forward earnings and Home Depot at 18.2 times forward EPS with EPS expected to be lower on the year.

KeyStone’s 2022 Cash Rich Profitable Small-Cap Special Report 

KeyStone’s 2023 Cash Rich, Profitable Canadian Small Cap Special Report provides clients access to statistical data and additional analysis of ~62 stocks that were pulled from over 3,500 in Canada in the course of our research into small-cap companies with strong balance sheets and current profitability from operations. The report includes Cash Rich Recommendations from our Canadian Small-Cap Focus BUY Portfolio and Recommendations from our Canadian Small-Cap Discovery Small-Cap Portfolio. We have included 6 Cash Rich Canadian Small-Cap Top Tier Monitor List stocks that we are monitoring closely as businesses that could potentially find their way into either our Focus BUY or Discovery Portfolios over the next 1-2 years. Finally, we have added a special section with reports on 13 additional Micro-Cap (under $50 million market cap) stocks which are cash rich and profitable to our Canadian Small-Cap Discovery Small-Cap Portfolio Monitor List. Small-Cap Reports: Included in this section are companies which are either in our current coverage or passed a significant level of our investment criteria to be noted as companies we currently rank as MONITOR and may be looking at as potential “cash rich & profitable” opportunities over the next 12 months.

YSOT

Question from – Brian via email.

Spin Master Corp. (TOY:TSX)

Price: $37.35

Dividend Yield: 0.71%

Market Cap: $3.8 Billion

Description:

Spin Master is a children’s entertainment company that creates, designs, manufactures, licenses, and markets various toys, entertainment franchises, and digital games in North America, Europe, and internationally. Its product categories include activities, games and puzzles, plush toys and action toys.

The company offers its products under popular names including PAW Patrol, Kinetic Sand, Air Hogs, Hatchimals, Rubik’s Cube, Etch A Sketch, and Orbeez brands. It also produces television, video-on-demand, subscription video-on-demand, and movies.

Operational Updates:

Spin Master will release the sequel of PAW Patrol: The Mighty Movie™ on October 13th, 2023.

In July 2022, the company’s Board of Directors authorized and declared a quarterly dividend of CAD$0.06. (The first time it has ever paid a quarterly dividend as a public company).

In the summer of 2022, Spin Master entered into a global licensing agreement with Sony Interactive Entertainment (SIE). Spin Master will be the global master toy licensee for the PlayStation brand including God of War, Horizon Zero Dawn, The Last of Us, and UNCHARTED, and will develop toys relating to these products. Spin Master’s PlayStation toy line is anticipated to launch in Spring 2024.

On February 28, 2022, Spin Master announced that it renewed its global licensing agreement with Warner Bros. Consumer Products (WBCP) and DC for the iconic Batman franchise and other DC Superheroes. The licensing agreement is for a four-year term beginning in 2023 through to 2026.

Spin Master has made 28 acquisitions since its IPO in 2015:

• On January 10, 2023, Spin Master acquired the HEXBUG brand of toys.
• On November 22, 2022, Spin Master announced the acquisition of Canadian-based 4D Brands International Inc. (4D), an innovative disruptor in puzzle model construction. 4D has made an indelible mark on the puzzle category with its signature line of 3D model construction kits, where puzzlers can create iconic replicas of well-known historical landmarks, pop culture elements and movie memorabilia. Including franchises such as Star Wars, Disney, Harry Potter, Marvel Universe, DC Comics and more.

Recent Financials (Q3 2022)

• Q3 2022 revenue was $624.0 million, a decrease of 12.7% from $714.5 million.
  • The decrease was driven by reduced shipments in Q3 2022 compared to the prior year as a result of customers ordering earlier in the current year.
  • Entertainment revenue was down due to due to lower distribution revenue related to PAW Patrol: The Movie ($26.0 million, in the prior year), offset by higher licensing and merchandising revenue in the current year.
  • Digital Games revenue decreased due to lower in-app purchases in Toca Life World.

• Q3 2022 Adjusted EBITDA was $167.6 million compared to $217.3 million, a decrease of 22.9%.
• Net income for Q3 2022 was $141.4 million, an increase of 4.4% from $135.4 million.
• As at Q3 2022, Spin Master was cash rich balance with $674.9 million in cash and Debt & leases of $71.0 million, providing a net cash position of $603.9 million or $5.87 per share.
• Trades with a trailing P/E of 9.4 times and an EV/Adj. EBITDA of 4.9 times, which IMO is attractive.

Decrease in Fiscal 2022 Guidance:

Management now expects 2022 Toy Gross Product Sales, in constant currency, to increase low single digits compared to 2021, as compared to low double digits announced on July 27, 2022. And management now expects 2022 Adjusted EBITDA Margin to be slightly below 2021 Adjusted EBITDA Margin as previous guidance announced 2022 Adjusted EBITDA Margins to be in line with 2021 Adjusted EBITDA Margin. (Excluding the PAW Patrol Movie).

CONCLUSION

• Spin Master is a world-renowned toy company, that has shown strong long term fundamental performance in growing both its revenue and EPS. Increasing its revenue through organic and in-organic means at a CAGR of 19% from $417.7 million in fiscal 2012 to $2.0B in fiscal 2021.
• Looking forward for growth, the company is expected to release the sequel of Paw Patrol in late 2023 and a PlayStation line of toys expected to launch in the spring of 2024… but considering management’s lowering of guidance the near-term growth outlook is difficult to determine.
• Spin Master maintains a cash rich balance sheet and recently started paying a CAD$0.06 quarterly dividend, but the company continues to be only as good as its next best toy and an investment thesis would be dependent on management continuing to execute on growth moving forward.

Grayscale Bitcoin Trust GBTC:OTCQX

We got a question about the 46% discount to NAV on the Grayscale Bitcoin Trust symbol GBTC on the OTCQX trading at $11.88 and a market cap of $8.2 Billion. The trust was founded in 2013 as a private fund and began to be publicly quoted in 2015.  GBTC is a trust that holds Bitcoin as its underlying with the goal of giving investors exposure to Bitcoin less the fees and expenses, but as the current discount implies it has failed at this goal.

So what do I mean by trading at a discount to NAV? NAV stands for Net Asset Value which is the cumulative value of the underlying asset or assets in this case Bitcoin. On a per-share basis, the trust holds 0.00091 Bitcoin or roughly $22.27 but only trades at $11.88, creating a 46% discount as of the market close on February 21st. Previously GBTC has traded at a significant premium, only start to trade at a discount in early 2021, and has had an increasing discount quite consistently since. [YChart GBTC Discount]

As this is structured as a Trust there is no guaranteed redemption option for holders to close this spread. As of right now, the price and therefore discount of GBTC is purely based on the supply of demand of the product, and as other products now exist to gain Bitcoin exposure the demand for a structured product like this has dramatically fallen. This is the same reason why it has previously traded for a significant premium as the market price exceeded the NAV for a long period of time. Investors were willing to pay a premium to gain access to the market.

This is different compared to an ETF which GBTC has the goal of converting to. An ETF allows authorized participants like banks or market makers to purchase the ETF share on the open market and redeem it with the issuer for the underlying asset. This is important because it allows the authorized participants to conduct an arbitrage trade if a significant discount like GBTC’s occurs. There are fees to take into consideration but ETFs should trade within less than a % of the NAV, with some significantly less than that.

The sponsor of GBTC tried to convert to an ETF in 2022, the sponsor Grayscale is the organization that promotes and brings in capital to the trust and is responsible for the creation and redemption of shares. In this case, was the initial creator of the trust structure but that isn’t always true. In exchange for the services the sponsor provides they receive fees in this case a 2% annual fee of the NAV, which is quite a significant fee given its duties and operations.

The switch to an ETF structure was blocked by the SEC because they believe there are no safeguards to protect against market manipulation. Grayscale expecting to be blocked initiated litigation on the same day against the SEC following the decision. The SEC has previously approved Bitcoin Futures Exchange trade products but not any spot Bitcoin ETFs. Grayscale argues that a spot Bitcoin ETF that they are trying to create is the same product as a Bitcoin Futures ETF. The key difference is the existing futures ETF is purely cash settled based on an index, compared to a spot ETF needing to interact with external exchanges to create and redeem shares. However, I would argue in favour of Grayscale in this case as the benchmark that the futures ETF use is ultimately derived from the prices of these exchanges, meaning if large-scale manipulation were to occur it would appear in the CME futures market and ultimately future ETFs, but I am clearly not the SEC, so we will have to await the decision of the lawsuit of which initial oral arguments begin on March 7th.

If Grayscale is successful in its lawsuit you will see an immediate snap to or very near the market value of the underlying Bitcoin, a nearly 100% increase for investors overnight. This would likely lower the price of Bitcoin as the trust holds 600 thousand Bitcoin and arbitragers would be selling Bitcoin while going long on GBTC until an equilibrium price were to be reached.

If Grayscale were to be unsuccessful, they have stated they may do a tender offer for up to 20% of the outstanding shares. But have no plans to allow continuous redemption, as it has previously allowed redemptions but was halted in 2014 after the SEC deemed it violating financial regulations

As there currently is no redemption possible the only way out is selling in the open market. Since the crypto market was devastated in 2022 with multiple large bankruptcies some of whom held GBTC, the shares were liquidated the only way they could by hitting the bid over and over, ultimately increasing the discount over the year.

Additionally, the parent company to Grayscale, Digital Currency Group or DCG, facing financial troubles after another one of its subsidiaries Genesis is facing bankruptcy. This has increased selling pressure as DCG has reportedly sold much of its GBTC holdings. If DCG were to face bankruptcy as well Grayscale would likely be sold, and if Grayscale itself were to face bankruptcy the trust’s sponsorship would likely be sold or moved with Grayscale. The trust itself faces minimal risk beyond the holders of the shares liquidating.

In summary, GBTC has a discount due to only having one way out, the open market, and as demand for the shares has been lowered with other products on the market and now weakened financial markets with increased selling pressure from financially troubled institutions.

We got a question about the 46% discount to NAV on the Grayscale Bitcoin Trust symbol GBTC on the OTCQX trading at $11.88 and a market cap of $8.2 Billion. The trust was founded in 2013 as a private fund and began to be publicly quoted in 2015.  GBTC is a trust that holds Bitcoin as its underlying with the goal of giving investors exposure to Bitcoin less the fees and expenses, but as the current discount implies it has failed at this goal.

So what do I mean by trading at a discount to NAV? NAV stands for Net Asset Value which is the cumulative value of the underlying asset or assets in this case Bitcoin. On a per-share basis, the trust holds 0.00091 Bitcoin or roughly $22.27 but only trades at $11.88, creating a 46% discount as of the market close on February 21st. Previously GBTC has traded at a significant premium, only start to trade at a discount in early 2021, and has had an increasing discount quite consistently since. [YChart GBTC Discount]

As this is structured as a Trust there is no guaranteed redemption option for holders to close this spread. As of right now, the price and therefore discount of GBTC is purely based on the supply of demand of the product, and as other products now exist to gain Bitcoin exposure the demand for a structured product like this has dramatically fallen. This is the same reason why it has previously traded for a significant premium as the market price exceeded the NAV for a long period of time. Investors were willing to pay a premium to gain access to the market.

This is different compared to an ETF which GBTC has the goal of converting to. An ETF allows authorized participants like banks or market makers to purchase the ETF share on the open market and redeem it with the issuer for the underlying asset. This is important because it allows the authorized participants to conduct an arbitrage trade if a significant discount like GBTC’s occurs. There are fees to take into consideration but ETFs should trade within less than a % of the NAV, with some significantly less than that.

The sponsor of GBTC tried to convert to an ETF in 2022, the sponsor Grayscale is the organization that promotes and brings in capital to the trust and is responsible for the creation and redemption of shares. In this case, was the initial creator of the trust structure but that isn’t always true. In exchange for the services the sponsor provides they receive fees in this case a 2% annual fee of the NAV, which is quite a significant fee given its duties and operations.

The switch to an ETF structure was blocked by the SEC because they believe there are no safeguards to protect against market manipulation. Grayscale expecting to be blocked initiated litigation on the same day against the SEC following the decision. The SEC has previously approved Bitcoin Futures Exchange trade products but not any spot Bitcoin ETFs. Grayscale argues that a spot Bitcoin ETF that they are trying to create is the same product as a Bitcoin Futures ETF. The key difference is the existing futures ETF is purely cash settled based on an index, compared to a spot ETF needing to interact with external exchanges to create and redeem shares. However, I would argue in favour of Grayscale in this case as the benchmark that the futures ETF use is ultimately derived from the prices of these exchanges, meaning if large-scale manipulation were to occur it would appear in the CME futures market and ultimately future ETFs, but I am clearly not the SEC, so we will have to await the decision of the lawsuit of which initial oral arguments begin on March 7th.

If Grayscale is successful in its lawsuit you will see an immediate snap to or very near the market value of the underlying Bitcoin, a nearly 100% increase for investors overnight. This would likely lower the price of Bitcoin as the trust holds 600 thousand Bitcoin and arbitragers would be selling Bitcoin while going long on GBTC until an equilibrium price were to be reached.

If Grayscale were to be unsuccessful, they have stated they may do a tender offer for up to 20% of the outstanding shares. But have no plans to allow continuous redemption, as it has previously allowed redemptions but was halted in 2014 after the SEC deemed it violating financial regulations

As there currently is no redemption possible the only way out is selling in the open market. Since the crypto market was devastated in 2022 with multiple large bankruptcies some of whom held GBTC, the shares were liquidated the only way they could by hitting the bid over and over, ultimately increasing the discount over the year.

Additionally, the parent company to Grayscale, Digital Currency Group or DCG, facing financial troubles after another one of its subsidiaries Genesis is facing bankruptcy. This has increased selling pressure as DCG has reportedly sold much of its GBTC holdings. If DCG were to face bankruptcy as well Grayscale would likely be sold, and if Grayscale itself were to face bankruptcy the trust’s sponsorship would likely be sold or moved with Grayscale. The trust itself faces minimal risk beyond the holders of the shares liquidating.

In summary, GBTC has a discount due to only having one way out, the open market, and as demand for the shares has been lowered with other products on the market and now weakened financial markets with increased selling pressure from financially troubled institutions.