A few days ago we pointed out that one of the event risks in a sliding market is distressed M&A in which cash-rich buyers scoop up beaten down assets, and of which we have already seen two examples: Microsoft’s acquisition of a deeply discounted Activision and more recently, last week’s acquisition of Kohl’s by a consortium of buyers.
But it’s not just strategics that are finding good deals: financial buyers are also jumping in, as a tweet from Bill Ackman late on Wednesday showed.
The billionaire investor behind Pershing Square announced on twitter that “beginning on Friday and over the last several days, we acquired more than 3.1 million shares of Netflix… which makes us a top-20 holder.” Ackman, who also linked to a letter to investors laying out his thinking and math behind the purchase, said that “I have long admired Reed Hastings and the remarkable company he and his team have built. We are delighted that the market has presented us with this opportunity.”
Pershing Square’s stake equals about 0.68% of the streaming giant, based on 455.8 million diluted shares outstanding at Dec. 31.
News of the purchase sent shares of Netflix 4% higher in after-hours trading following news of Pershing’s investment. But it has a long way to go to catch up to where it was just 4 weeks ago: the stock has plunged more than 40% in 2022 alone, and closed Wednesday at $359.70, compared with a high of $691.69 on Nov. 17.
The recent plunge in Netflix stock came after the company said last week that it expects to add a much smaller number of subscribers this quarter than it did a year ago as it contends with a crowded streaming marketplace and ongoing disruptions from the Covid-19 pandemic.
However, one man’s collapsing growth story is another man’s deep-value investment, and that’s precisely what prompted Ackman to swoop in: “The opportunity to acquire Netflix at an attractive valuation emerged when investors reacted negatively to the recent quarter’s subscriber growth and management’s short-term guidance. Netflix’s substantial stock price decline was further exacerbated by recent market volatility” Ackman wrote in his letter to investors.
It is somewhat ironic that Ackman is now entering Netflix, as by doing so he once again crosses paths with his old Herbalife nemesis, Carl Icahn, whom he fought – and lost – last decade in an attempt to prove that Herbalife is a giant ponzi scheme, and where Icahn made billions. Well, it is the same Icahn who bought into Netflix almost exactly a decade ago at the urging of his son and planned to call for the company to explore a sale. But then Icahn met with CEO Reed Hastings, who arranged for a private showing of the soon-to-debut “House of Cards” drama starring Kevin Spacey, the streamer’s first original series. After seeing it and understanding Hastings’ vision, Icahn decided against the sale idea and abandoned his plans for activism. He cashed out in 2015 with a profit of about $2 billion, making it one of his best ever investments.
And now it’s Ackman’s turn to try to replicate Ichan’s success. Of course, for that to happen, NFLX stock would need to hit four digits.
But perhaps more remarkable is how Ackman funded his new position in NFLX.
Recall that for much of 2021 Wall Street was abuzz with reports that Ackman was building a major rates short (betting on higher yields). These reports culminated with Ackman’s presentation to the NY Fed, in which it urged the central bank to “begin hiking rates asap.” As we wrote at the time, “Bill Ackman, revealed on twitter that he “gave a presentation to the Federal Reserve Bank of New York last week to share our views on inflation and Fed policy. The bottom line: we think the Fed should taper immediately and begin raising rates as soon as possible.”
Ackman was not shy in revealing that he was obviously talking his book, stating that “we have put our money where our mouth is in hedging our exposure to an upward move in rates, as we believe that a rise in rates could negatively impact our long-only equity portfolio.”
In other words, Ackman is short rates, although it is unclear for now how large his exposure is.
We now have a pretty good idea of how large his exposure was: enough to make $1.25 billion in profit.
As Ackman writes in his Netflix letter, “in order to fund our purchase of Netflix, beginning on Friday and over the last few days, we unwound the substantial majority of our interest rate hedge generating proceeds of $1.25 billion. We retained interest rate swaptions that are currently out-of-the-money, and also purchased some additional longer-dated, out-of-the-money swaptions. The result of all of the above is that the notional size of our interest rate hedge has been reduced by 80%, the term of a substantial portion of the hedge we retain has been extended, and our dollar investment in hedges has been reduced by more than 90%.”
Amusingly, after making billions from bond CDS that blew up during the covid crash, Ackman has become rather sensitive to being accused of profiting from others’ pain (in this case the crash in stocks that will accompany a spike in the Fed Funds rate), Ackman added the following disclaimer:
Had we not sold the hedge, we could have likely realized more gains based on the increase in rates, largely today, since our sale.
But why did Ackman not hold on to his rate short – especially since his DV01 appears to be off the charts – if he has such a high conviction that rates are going even higher? Well, as he explains, “we believed the opportunity to invest in Netflix at current prices offered a more compelling risk/reward and likely greater, long-term profits for the funds.”
He then also gave the following explanation for why Pershing Square invests in such rate/swaption hedges:
We invest in hedges not to protect the funds from a short-term mark-to-market loss, but rather because they can become a large source of potential liquidity at precisely the time stocks become cheap. We invest in asymmetric hedges as they offer the opportunity for large gains without exposing the portfolio to meaningful losses in the event the potential risk does not transpire.
We invested in out-of-the-money interest rate swaptions in December 2020 and early 2021 because we believed that it was likely that the combination of aggressive fiscal policy, monetary policy, and the reopening of the economy due to vaccines would cause non-transitory inflation, which would require the Federal Reserve to raise rates. We believed that an unexpected rise in rates could cause a market correction. We viewed this outcome to be a likely one, yet the options we purchased implied that this scenario was very unlikely. Highly differentiated perspectives on future outcomes can yield attractive payoffs for investors, particularly when structured in an asymmetric format.
Said otherwise, Ackman is confident he will make more money going long Netflix today than keeping his rates short, or as he concludes his letter: “We are pleased to add Netflix to our portfolio. Many of our best investments have emerged when other investors whose time horizons are short term, discard great companies at prices that look extraordinarily attractive when one has a long-term horizon.”
The bigger question is now that Ackman has cashed the substantial majority of his big rate short, will the key thesis during the next marquee hedge fund idea dinner be to go long rates, especially as the US now appears to have a date with a recession, perhaps even before the midterms? Or view, is that going long rates here will end up bring much more profitable than continuing to press shorts, especially once it becomes abundantly clear to the market that the US is hiking rates right into a recession, if not an outright depression now that fiscal stimmies are history once the Democrats lose in November by an avalanche and now new fiscal stimulus will be conceivable until at least November 2024.
That said, the biggest question we have is when will that consummate financial value investor, Warren Buffett, who has long lamented the lack of bargains become the most prominent financial buyer of distressed growth (or value) opportunities. In a time when the Fed put has become the Fed call, that may be the catalyst to finally start buying.
Ackman’s letter to investors explaining the Netflix purchase can be found here.
