Ramon Laguarta, Pepsi’s CEO discussed the company’s strategy going forward. Market share and efficient distribution are central to maintaining Pepsi’s competitive advantages. Discussing these factors, Mr. Laguarta said the following:
“…Whoever wins in e-commerce now and is able to capture those families that are trying this e-grocery service for the first time, I think, is going to win those families in the future. So we’re investing heavily in trying to be the first in that channel and trying to — and again, the investments that we made in the last few years, last year in particular, are helping us both from the data availability, the agility of our infrastructure to supply those channels, etc. So, e-commerce is a key area where we think we can gain market share.
Second is the strength of our DSD system and our ability to service the stores directly. I think it’s a capability that is quite unique, and it gives us the advantage to keep the supply chain going in spite of all the challenges we’re all facing. So that’s also an area where we plan to double down. That improves our execution in store and the inventory in store. And that is also a sustainable advantage.
The third one is brands. I know we have — we’re seeing consumers going back to brands that they trust, and we have quite a lot in many markets that consumers trust. There’s big brands that have been around for some time. We’ve modernized them. We’ve kept them relevant to the consumer.”
All of that sounds great. It’s all logical from Pepsi’s perspective. However, the underlying assumption is that Pepsi can win share of mind in an e-commerce world. While brands are objectively important, it will be interesting to see which brands are the winners. Will customers think of Pepsi or Amazon/Walmart when they think of grocery shopping on the internet?
The key issue will be whether Pepsi’s brands have the strength to pull consumers to those products going forward. The challenge Pepsi (and others) will continue to face is the internet is not the grocery store isle. There is unlimited “shelf space” and the distributor is the entity that owns the share of mind on the internet. To be fair, traditional distributors (grocery stores) also owned share of mind. However, the internet is different because the attention seems to trend toward natural monopolies.
Interestingly, barriers to entry to create a new e-commerce distributor are minimal. On the other, barriers to scale and mind share are immense. Thus, barriers to entry are minimal but barriers to success are huge. Therefore, successful, large scale e-commerce companies may be able to increase their bargaining power over Pepsi, Coke, and other CPG companies.
That said, the large CPG companies are going to have the ability to purchase the prime advertising slots on Facebook, Instagram, Google, Amazon, and Walmart. They will be able to release brands quickly and tailor ads to local consumers. Will the economics of these relationships be similar to traditional slotting fees? Maybe. Maybe not.
Regardless, it will be very interesting to watch. There’s always been a middle man between large CPG companies and the consumer. CPG has combatted that via advertising and owning shelf space. However, those company strategies were extremely effective in a world where attention aggregation was much easier (think TV and barriers to shopping outside a local area) than it is today.
It’s hard to argue Pepsi is thriving like it would have if the internet didn’t exist. These financial results, while acceptable, are far from stellar. That said, Pepsi has a heck of a business and returns on capital are improving.
It appears returns on capital have improved driven, at least in part, by improving the cash conversion cycle from 13.57 days in 2014 to -18.33 days in 2019. Straight out of the AB InBev playbook. Interestingly, Pepsi referenced zero based budgeting in the 2Q20 earnings call.
“As it relates to becoming stronger, we are putting an even greater emphasis on our businesses to have a zero-based spending mindset in which we must earn our budgets.”
This will be an interesting one to watch going forward.
It’s been an interesting couple months in the market. While the blog has been quiet, the market certainly hasn’t. Thankfully, the portfolio emerged unscathed. In fact, it’s arguably the best it’s ever been.
We added TransDigm as a core holding. Most of the position was added between 3/16/20 and 3/20/20. We initiated a position and quickly took it to 10% of the portfolio at cost. In retrospect, 10% may have been too small but it would take a truly exceptional opportunity to purchase more than 10% at cost.
TransDigm, at that time, was one of the easier additions to the portfolio I’ve ever made. Investors appeared worried TransDigm might have covenant problems, which brought the possibility of bankruptcy into play. Those fears were misplaced as TransDigm’s covenants only “sprung” when TransDigm drew more than 35% of it’s revolving credit facility. As of 3/16/20, it was pretty clear that TransDigm could survive for at least 1.5 years without tapping at least 35% of the credit facility.
Investor fear wasn’t completely unwarranted (though it did lack nuance) as TransDigm runs a highly leveraged strategy supplying parts to the aerospace industry. Aerospace was one of the hardest hit industries from COVID-19. While many were, and some remain, concerned that travel would be permanently altered by COVID-19 that concern is misplaced. At worst, a recession would potentially impair the long term growth rates in travel. But the desire to travel is highly unlikely to disappear. Just look at history.
At a ~$15.5Bn valuation the free cash flow yield to equity, on a normalized basis, appeared to be ~6-7%. Not screamingly cheap in absolute terms, but pretty solid considering:
near 0% interest rates,
potential upside from additional efficiencies from the Esterline acquisition
the quality of the company.
People will push back on business quality. The most common criticism involves TransDigm’s “aggressive” pricing. That criticism has an element of truth to it but seems far closer to convenient criticism than reality. Yes, TransDigm increases the prices of some parts when they acquire companies. Yes, those parts generate absurd margins when viewed in isolation. However, people need parts and low volume parts need to cost a lot in order to justify production. That’s true in every industry. For instance, there are businesses that warehouse odd bolts, screws, and springs in order to sell them to refineries for thousands of dollars per bolt, screw, and/or spring.
While that may seem crazy to some, it’s also how business works. I’d rather partner with the people smart enough to find those opportunities than complain about them existing. After all, we live in the world that exists not the one we think “should” exist.
The most difficult question to answer was whether TransDigm would be able to refinance its debt maturities. A large portion of the company’s debt is due in 2026. The company’s ability to refinance that debt will be a function of whether (a) travel returns by 2023/2024 and (b) (1) the rate environment and (2) why rates are where they are.
It’s important for travel to return, or begin to trend in that direction, by 2023/2024 because lenders are going to want to see solid trends to refinance into. As stated, it’s highly likely that travel substantially returns. Thus, we are comfortable accepting the refinancing risk despite it introducing a potential total loss to the equation.
As of this writing, TransDigm’s stock increased ~70% from our cost basis. To be sure, today’s price might be insanity. In fact, we trimmed a bit of the exposure on 6/5/20 as Transdigm became 13% of the portfolio and the quoted price gives your manager indigestion. That said, TransDigm will remain in the portfolio regardless of quoted prices. It will leave the portfolio only if travel doesn’t return. Consequently, we look forward to a long partnership with TransDigm.
In conclusion, today’s buyers need to have much more nuanced views of when travel will return, how many acquisitions TransDigm can accomplish, and whether the company can increase pricing. Those are much tougher questions to answer. Thankfully the panic sellers helped us avoid those hard questions. Price dictates due diligence and the market rewards patience. Try to avoid the difficult questions by swinging big when you see the easy ones.
Your manager doesn’t have the answers to the questions today’s world poses. Nor does anyone else. In three weeks, I have gone from (a) contemplating what all the “fuss” was about to (b) realizing the human species is at war against a virus. War forces people to contemplate things they never thought they would have to.
As for your portfolio, we are positioned more defensively than normal. To be sure, the time to position defensively is when times are great. Times are not great. However, the possibility of going much lower exists today. It’s also very possible, though unlikely in my view, that I am writing this at the exact bottom. Humility is why we remain allocated to equities.
Our current bond/stock allocation is ~34/66%, respectively. We will deploy half the bond allocation if things get “stupid cheap.” Moreover, our stock holdings have substantially moved into the “quality” realm; perhaps at the exact wrong time.
People will criticize me for style drift. I could care less. My job is to make sure this family’s wealth escapes this period in tact. As a reminder, wealth is not a number; it is relative purchasing power. Will people accumulate more wealth than we will by seeking distressed assets and being right? Yes. But, we will survive. Survival is our most pressing concern.
If I were you, I would ask why our holdings have changed so much despite my claims of being a “long term investor.” I will discuss a couple major changes below.
It’s no secret I pounded the table about airlines “being different this time.” In fact, on March 4th (only 12 days ago), I said we would hold airlines through this draw down. What changed?
On March 7th, I received a transcript of a discussion that opened my eyes to what was about to happen. If that transcript was even remotely accurate I determined airlines were about to have a liquidity crisis. Yes, the balance sheets are strong, but, in the short term, so is the cash burn. The potential duration of the cash burn is “what’s different this time.” Compounding the problem was the US policy response as of a week ago.
Fast forward to March 14th and The White House mentioned governmental assistance for the airlines, cruises, and hospitality industry. Therefore, I feel somewhat validated in my conclusion. The terms of any bailouts are not being discussed so it’s too hard to handicap how impaired the equity will be (if at all). Therefore, it’s simply too difficult to hold that risk when there are alternative ways to express our view that travel is a staple.
I humbly ask forgiveness for taking a loss on the position. A black swan occurred and I bailed. Whether the risk/reward was dumb at the time of the bet is something we can discuss. Whether bailing was the correct decision in the long term is also debatable. In hindsight it will all look obvious. In real time these have been very difficult decisions.
AB InBev and Phillip Morris
We sold these positions for correlated reasons. Both positions were taken because I viewed emerging market growth as a positive. While AB InBev executed sub optimally, Phillip Morris has done a fine job. That said, both of these companies sell vices into large emerging market populations. Many of those populations are South of The Equator. It is about to get cold there. COVID-19 thrives in the cold.
On or around March 7th, JP Morgan stated (on a call) that emerging market health systems are woefully unprepared to deal with the coming crisis. Further complicating the outlook, COVID-19 is killing people with preexisting conditions. Heavy alcohol consumption has been a contributing factor to COVID-19 mortality rates. Data suggests the majority of alcohol is consumed by the top decile of drinkers. Smokers’ lung health is unquestionably poor.
Accordingly, I have a high degree of certainty that smokers and heavy drinkers in emerging markets will prove among the more vulnerable (unless we eradicate the virus). Thus, I painfully report that I expect deaths to result in a negative decline in the demand curve for these products. Moreover, this instance forced me to consider the impacts of a virus like this occurring again. Accordingly, these entities hold risks we are unwilling to bear.
To be sure, there is a very reasonable possibility we sold “too cheap.” However, Bill Miller’s firm wrote a letter last year that made a lasting impression on me. In the letter they commented that their biggest mistakes came from holding stocks whose fundamentals deteriorated below their expectations at underwriting. In those situations, they held because they thought intrinsic value declined less than price. The results were poor.
Warren Buffett summarized his thoughts on the issue slightly differently when he said “Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.” AB InBev has been leaking for a while and I suspect Phillip Morris will prove leakier than I originally underwrote. Thus, we are sidestepping the current risks given the facts as I understand them today.
Again, these may have been poor risks to take in the first place. There is no way to replay the hand dealt. Regardless, after seeing more cards, I’ve decided to fold our hand.
The Current Portfolio
I will not discuss our current holdings here as it makes my job tougher at the moment. That said, I am very happy to be partnered with Berkshire, Dr. Malone and Mr. Maffei, Mr. Roberts, and the team at Markel. I have very limited concerns about whether we will be wealthier in 5 years than we are now. Unless the entire system collapses. This update won’t matter much if that’s the outcome.
The Correct Investment Question, As I Perceive It
As discussed, we are at war with COVID-19. The world economy has ground to a halt in an effort to contain and fight the virus. A time may come where we have to make a collective choice to sacrifice the old and unhealthy to save the economy. Thankfully we are not there yet.
Consequently, I am contemplating three scenarios:
Success – Humans band together, stay inside/socially distanced, and bend the curve of COVID-19. We could come out of this current state in 2-3 months. The mood would likely be celebratory and it’s possible pent up demand results in a spending spree. However, supply chains have ground to a halt so there’s minimal chance of a “V shaped” recovery in the manufacturing sector. This is because there will be a lag between when supply can ramp up to meet demand.
Malaise – The news trickles and trickles out and we stay in this state for longer than 3 months. It’s hard to see how this state of the world could possibly be good for equities over the medium term. Layoffs would almost certainly begin en masse and a deep recession is in the cards.
Failure – We lose the fight against the virus and decide to go on with our lives, albeit with immense pain of human loss. From an investment perspective, that may be OK as the wealth the older generation accumulated and is saving would be passed to people in peak spending years. From a human perspective, it would be devastating and we would probably lose some of the older members of this family.
The situations contemplated above clearly under represent the total spectrum of outcomes. That said, those are the mental buckets I have. It’s noteworthy that the combination of situations 1 and 3 exceed the probability of situation 2 in my mind.
In closing, these are unprecedented times. It’s possible, though unlikely, a drug is developed to kill this virus. Let’s hope so.
I apologize for any imprudent risks I may have taken. I can assure you that I care deeply about not repeating the same mistakes; if they actually were mistakes.
If life were a golf game then COVID-19 is a huge “duck hook” that put everyone behind the trees. Given the circumstances, I think it’s best to chip the ball back into the fairway rather than try to blast it through the trees to hit the green.
There will undoubtedly be a time to second guess these decisions. As stated above, my goal is to make sure we financially survive.
Running a concentrated portfolio is one of the surest ways to win. It’s also the surest way to lose. Moreover, the difference between winning and losing may not be much.
It’s been an interesting two weeks at SCG. Your manager has been public about liking the risk/reward offered on many airline equity investments. It’s only right to acknowledge those public declarations created additional emotional pressure when inevitable uncertainty materialized.
Owning an asset is far different from researching an asset. It’s easy to contemplate a recession, terrorist attack, or outbreak while researching an investment opportunity. For airlines and travel, a researcher would find that even after 9/11 and The Great Recession air travel proved resilient. As shown below, travel demand bounces back pretty quickly.
It’s hard to imagine scenarios worse for passenger demand than 9/11 and/or 2008-2009. That’s easy to wrap one’s head around. Right? Sure, until you own the position and see this:
Or, God forbid you decided to own one of the riskier stocks in the sector and stare at a 40% drawdown in under a month?
How does that historical data feel now that IATA projects $27.8Bn of revenues lost in 2020 just in Asia? See https://www.iata.org/en/pressroom/pr/2020-02-20-01/ . How does it feel to watch conferences get canceled? How does it feel to have anyone with a shorter term time horizon say you’re an idiot for remaining long?
None of that feels like the underwriting felt. It feels scary. It is scary. It’s also not rational. Making matters worse, an investor is able to cut the current pain, and avoid further pain, with just one click of a button. All he/she has to do is sell. That feels so much safer. It’s also a great way to donate profits to Mr. Market.
Fundamentally, an investor is entitled to earn the returns of the business he/she chooses to purchase only when that investor is willing to own the crappy times for the business. An investor is not entitled to return while avoiding risk. Instead, that investor is only entitled to donate return to those willing to suffer.
As Tom Russo has summed up, both the investor and the business must have the capacity to suffer. Running a concentrated portfolio substantially increases the need for an investor to have the capacity to suffer. As a quick aside, Joel Greenblatt mentioned he found letting his winners run to be as, or more, difficult than watching his positions go against him. SCG would have benefited from letting certain winners run longer. That said, we’ve also been fortunate to make some timely exits so the jury is still out on our long term selling record.
If not now,when is this thesis wrong?
One major reason to own airline stocks is a bet that consolidation enables relatively fast responses to demand shocks. COVID-19 has certainly created a demand shock; or at least the perception of one in the US. It’s undeniable that the current quantity of seats demanded will be lower than projected, and will almost certainly see year over year declines. But have the demand and supply curves actually moved to create an industry doomed for failure? Doubtful.
As of today, a bad case scenario would result in 2% of the population dying. That is a lot of people. It’s also approximately less than one year of anticipated seat mile growth. Recently, airlines have managed to keep load factors reasonably stable, which is evidence of rational growth.
Equity owners of the entities controlling the planes could see a permanent impairment without the industry stopping. All you need to do is look at the time period between 2000-2012 to see the potential devastation. That said, airlines, specifically US airlines, are in a much healthier position going into this potential crisis.
An incredibly bearish argument would say the airlines have 2 months of liquidity before things get really scary.
However, that assumes there are zero revenues, the costs stay almost totally constant, and the airlines cannot mitigate any of the damage. That scenario is highly unlikely. Moreover, if demand falls to zero there are going to be way bigger things to worry about than the health of airlines.
The Most Likely Outcome
SCG is positioning itself to take advantage of further pain. Please note, we hope none happens and pray the human toll is minimal. However, thinking rationally about the current situation, it’s hard to see permanent long term consequences.
Yes, the short term could be painful. Yes, things are scary right now. Yes, it sucks to have a drawdown in a big position. All that said, our view is this virus is here to stay. Accordingly, sheltering in place won’t do anything for most of us. Moreover, most of us will not have our lives impaired. Thus, the probability that Americans decide to incur pain for a meaningful amount of time is low to quite low.
Therefore, we will continue to hold our airline positions and earn the reward liquidity tempts us to sell out of. As stated, the pain is likely to get worse. Potentially much worse. Buckle your seatbelts and put your seatback in the upright position.
A key component of Marathon’s investment theory is based on the inverse correlation between profitability and levels of competition. Capital Account at 45. Their thinking goes something like this: if competition declines, then future profitability is likely to increase, which should result in higher stock market values. Id. Often, investment analysts miss how competition (the supply side) drives profitability and shareholder returns. Id at 47.
If, during the course of a business cycle, the competitive environment of an industry changes dramatically, then we can expect peak to trough profits to change correspondingly. Id. at 48. The actions of management are extremely important as well. When a mature company operates from a smaller asset base (ie: ROIC improves), it can boost shareholder value even if cyclically adjusted profits stay the same. Id.
What might determine the direction of normalized profits? “The first important factor is the change in competition between one cycle and another. This needs to be tempered by an assessment of the firm’s position in the corporate life cycle and whether its product life cycles are lengthening or shortening. The latter is particularly important because shortening product lives are rarely caught by reported earnings. Indeed, the appearance of rising profits from a new product may be offset by a shorter product life.” Id.
In order to get clues into management behavior, look to proxies and incentives. As far as valuation in concerned, be mindful of market value to replacement costs. (NOTE – Market value to replacement costs applies to most companies. However, the types of companies Bruce Greenwald refers to as franchise companies are likely untethered from replacement costs. In those instances, an investor should think more about yield on cost than replacement values). Long periods of companies trading at discounts to replacement cost tends to result in profitability improving. Id. at 49. This is because sustained low valuations exert downward pressure on capital spending. Id. Eventually, some form of underinvestment leads to product shortages and improved profitability. Id. (NOTE – Be mindful to analyze this on a geographic basis. For instance, the US steel industry could be rational but foreign companies could expand production and ruin the benefits of US rationality).
Conversely, when companies are valued in the stock market at premiums to replacement costs there is a strong incentive to increase capital spending. Id. at 50. This is a form of multiple arbitrage where the company can spend $1 and have it valued at far more than $1. “All too often this encourages undisciplined expansion, which in turn leads to excess capacity and falling profitability. Id. Generally speaking, industry capex to depreciation is a decent clue for determining whether an industry is over or under investing. Id.
Be mindful of the impact asset lives can have on capital cycle analysis. For instance, paper processing plants have longer lives than semiconductor fab facilities. Id. at 57. Therefore, it can take a longer time for capital cycle analysis to flow through the paper processing industry. Id. It’s equally important to study the extent to which new technologies can wreak havoc on capital cycle analysis. Id. In today’s terms, be mindful of potentially disruptive technologies and how quickly they can enter the market.
Chapter 2 Takeaways
“When we examine a company as a prospective investment, we analyse both the industry in which it operates from a capital cycle perspective and make an assessment of the individual firm’s management. We attempt to judge whether the sector is attractive, whether our prospective portfolio company is positioned favorably within its sector and what are the likely returns a company will earn from reinvesting its profits. Since by definition half of all companies must be reinvesting at below average returns, they should ideally be retrenching. However, by our estimate, around 90 per cent of firms continue to invest for growth, regardless of their profitability.” Id. at 65.
Although not news, remember to be mindful of growth for growth’s sake. Moreover, pay some attention to where the company is located. In Chapter 2.3, Marathon highlights France (in 1994) as a country housing corporations with particularly egregious corporate structures and incentives. Perhaps today’s version is the energy MLP industry in Texas.
Throughout Chapter 2, Marathon argues that management compensation via long term options is a good thing. At least up to a point. In short, options compensation, while not a one for one incentive structure, does focus management on share price. Thus, management teams are more willing to make reasonable capital allocation decisions.
With respect to buybacks, Marathon argues a number of conditions should be met:
The company must be able to afford the buyback without putting itself in jeopardy. Watch leverage and liquidity.
Buybacks are most suitable for businesses that are mature and generating plenty of cash.
Generally it’s the adoption of new performance measurement systems, rather than share repurchases themselves, that benefit investors.
Be very wary of buybacks that drive EPS targets. According to Marathon, buying in shares to improve ROIC or another rational investment metric is a far superior capital allocation decision than driving EPS.
Share repurchases should be done below intrinsic value. Above intrinsic value repurchases are no better than cash dividends.
Consistent share repurchases instill discipline.
Chapter 3 Takeaways
The more things change, the more they stay the same. Much like today, the 1990s saw extreme outperformance in the “growth” segment of the stock market.
In 1998 Marathon wrote:
“Enthusiasm for highly profitable businesses has been a striking characteristic of the stock market over the last few years. Yet in theory there is no reason why growth stocks should outperform value shares, since the market is capable of adjusting share prices to reflect each individual companies’ prospects. In other words, as the share price should reflect the net present value of the cash flow a business is likely to generate over its life cycle, it matters little whether this is a modest amount, in the case of a steel company, for example, or a much greater amount, say in the case of Coca Cola.” Id. at 87-88.
Later in the year they revisited their growth vs. value observations:
“We have felt that price-earnings mutliples of 50x earnings might be a little rich for firms whose profits might be overstated and whose main investment strategy is acquisition of their own shares, regardless of price. Furthermore, the high levels of current profitability, from which further enhancements are already discounted, increases our concern…Shares defined by Wall Street as growth stocks have a high probability of failure. Over the last 33 years, only 19% of growth stocks have maintained that elevated status for a decade or more. For most of this period, growth stocks were not as highly rated or as profitable as they are today.” Id. at 91.
They go on to analyze whether growth stocks can grow into current valuations and propose the following decision tree:
In the decision tree above the business model is riskiest at the top of the tree. Id at 93. Importantly, companies with long runways and low risk growth paths are worth a higher multiple than those lacking those characteristics. However, just as oaks don’t grow to the sky, multiples eventually reflect unrealistic expectations. The investor’s job is to avoid the pitfall of believing hype at exactly the wrong time. Watch out for leading indicators of falling profitability, industry expansion, lower returns on capital, and accounting gimmicks that keep earnings elevated. These are all warning signs and demanding valuations require few warning signs.
Interestingly, Marathon bucks conventional wisdom saying they operate under the philosophy that the range of investment outcomes is characterized by “fat tails.” Id at 99. Most market participants assume there is a normal distribution of returns. Marathon, however, argues shares spend relatively little time at “fair value.” Id. Instead, shares spend lengthy periods of overvaluation followed by lengthy periods of undervaluation. Id.
That thesis carries important conclusions. First, it implies short term mean reversion is not likely. Id. Second, it implies extreme periods of misvaluation are not short lived and/or rare. Id.
Given what’s going on within the market, it’s interesting to revisit Marathon’s thoughts in the late 1990s. A couple excerpts:
“We believe the capitulation of the investment community [to chase high flying shares]…will have economic consequences long after the current trend is reversed. This is because valuations affect behavior. For instance, among firms in the value universe which fail to earn their cost of capital even the most diehard optimists in senior management now accept that asset expansion destroys value.” Id at 103-104.
On investor’s behaviors: “The high valuation of growth stocks might leave investors dangerously exposed should growth disappoint at any time. This has induced investors to buy shares in companies they believe will maintain growth. In the last few years, as growth slowed, the list of potential growth companies has narrowed considerably…Growth now has a scarcity premium attached to it.” Id. at 106.“
The more things change, the more they stay the same…
Chapter 5 Takeaways
Chapter 4 didn’t have much. So, here’s chapter 5.
In 1994 Marathon saw the market capitalization of telecom stocks as a signal that competition would likely enter the market. Moreover, Europe was deregulating many telecom markets and transitioning from state run to private enterprise telecom companies. Signals included the following:
“Equity market valuations [of telecom companies] have sky-rocketed. The market capitalization of the telecoms service sector in Europe now…represent[s] 13 per cent of the MSCI Europe Index. Compare this with the modest 2 to 3 percent of national income spent on telecom services in the major European economies. The challenge for investors in such a rapidly changing an complex industry is to understand the assumptions underpinning current valuations and identify those companies with sustainable competitive advantages...That the market values of telecoms firms are currently at a huge premium relative to invested capital reflects an expectation that the prices [economic profits will remain] long into the future.” Id. at 130.
They shared this image of industries beginning deregulation.
That framework appears applicable to industries in the midst of disruption as well. Such as media distribution in 2020.
An important quote to remember: “The laws of the capital cycle are such that in a [competitive] environment, the price of goods and services will drop to the marginal cost of production and even below for a while.’ Id. at 129. This is extremely important to remember. There must be a very good reason if underwriting deviates from this thesis. Don’t find “moats” where none exist if you want to protect capital for the long run.
On network effects: “Many segments of the telecom market [in 1999] display network effects, i.e., the value that a customer derives from a product or service is dependent on how many other customers also use the product. For the network operator, the more businesses a network connects to, the greater the value of being plugged into it. There are also more subtle network effects: advertising is attracted by high levels of subscription, which funds investment in improving quality to attract more subscribers, thereby completing the virtuous circle. However, the first mover advantage will probably be sustainable only when customer turnover is low.” Id. at 134. It’s important to remember that being first, in and of itself, is not a durable advantage. Companies and management teams must combine that with customer lockin.
Throughout the chapter Marathon demonstrates a strong understanding of competitive advantages. Where those advantages begin and end, to whom the real customer relationship belongs to, and whether the growth spend that telecoms underwent in the 1990s would prove economic. The firm also consistently focused on share turnover as an indication of whether a company like Level 3 had long term oriented shareholders (they didn’t and turnover was quite high).
On over indebtedness creating opportunity: “Just as during the technology bubble the ability to raise cheap capital led to ludicrously overvalued companies, the viscous cycle in the debt markets (in May 2002) is creating the opposite phenomenon. Many indebted companies now have share prices that are significantly below our assessment of a ‘clean balance sheet’ valuation. As the price of debt falls in tandem with the market value of the equity, the likelihood of debt-for-equity swaps rises to the point where distressed debt can often be viewed as equity in waiting. While traditionally, the upside for debt securities has been limited to face value, under the debt-for-equity swap model, distressed debt is beginning to look more like equity, both with regard to risk and potential rewards.” Id. at 147. Note – Remember that carnage creates opportunity and look across the capital structure for potential opportunities.
In June 2002 Marathon was following the tech and telecom industry closely. They tend to like situations where shares are trading below replacement cost because management teams have the option to purchase shares rather than spend on capex. They also look for firms in an industry buying debt back at discounts to par because that is another example of capital buying a part of the business in cheaply. However, the industry remained too fragmented for Marathon’s liking and they decided to watch and wait for consolidation.
Chapter 6 Takeaways
On why IPOs tend to be poor investments: Id at 157.
First, new issued tend to be concentrated in fashionable sectors where a great deal of money has already been made.
Second, insiders only sell at attractive valuations. Since shares tend to trade around intrinsic value in cyclical fashion, they are likely to be undervalued in the future if they are overvalued today.
Third, investment banks are paid handsomely to sell a good story.
Fourth, the company knows a lot more than the equity buyers.
“Despite the favourable reception accorded new flotations in 1995, it would be foolhardy to adopt anything other than a skeptical approach to new issues. We continue to prefer a policy of investing where the supply of equity is shrinking rather than rising, as such a situation is more likely to be consistent with reasonable valuations. Unfortunately, this means our portfolios will be disproportionately invested in the mundane rather than the glamorous. Over the long run, this may be no bad thing.” Id. at 159.
On investment banks and bankers: “An understanding of ‘how the game works’ provides us with an edge over the competition. We believe investment banks exploit weak CEOs; that fads and fashions are hyped to drive deals; that the power of investment banks is sustained by an industry cartel; that skulduggery is rampant; and that banks’ research encourages momentum strategies which produce ultimately futile stock trading.” Id. at 166. Note, that was written in 2000 and some things may have changed. Overall, the incentives identified are more likely to endure than not.
Chapter 7 Takeaways
Marathon is extremely good at focusing on incentives. In discussing economic value added (EVA) as a concept they question whether the incentives are actually counter to long term growth. Id. at 184. They are also extremely focused on looking at what is going to happen, not what happened. For instance:
“Proponents of EVA-type systems agree that it is not the level of profitability that’s most important but the direction in which it is heading. For this reason, we continue to believe that the best investment opportunities lie among companies in the value universe. Not only is it easier to improve corporate profitability from a low level, but expectations for value stocks are now extremely pessimistic, especially compared with so-called growth companies. The new corporate metrics (such as EVA) will surely be applied in the value universe…[which could prove quite profitable for investors].” Id. at 186.
On share repurchases: “Contrary to the widespread belief that highly-profitable and highly-valued businesses have all the opportunities, when it comes to share repurchases it is among the lowly valued business where returns are potentially highest. An out-of-favor company pays a low price for its shares (compared to assets and cash flow), and the size of its buyback can be meaningful relative to the number of shares in circulation. The opposite case is the case for the “nifty fifty” companies whose shares may be trading above intrinsic value. For these companies, the typical share repurchase is so small, relative to market capitalization, that it is largely offset by dilution from share options issued to employees. In some sectors, especially technology, share repurchases are only a drop in the ocean compared to the number of options outstanding.” Id. at 190. That was written in 1999 and remains true today. Tomorrow’s headlines are history’s stories.
They go on to say: “The future returns from repurchasing shares, seventeen years into the greatest bull market of all time, are likely to disappoint shareholders. In our view, the money would be better spent on doubling the research budget, or preferably on special dividends to shareholders…The looking glass world of buybacks is largely ignored by the investment community. At a recent company presentation, analysts bombarded Merck’s management with questions about the R&D pipeline, but none asked about the considerably larger sum being spent on share repurchase. If we capitalized as an investment the cost of company buybacks, then assets at Merck would rise by nearly 40% and return on capital decline proportionally. In our opinion, this represents a truer picture of the trend in returns at the company.”
On turnarounds: Look for businesses that have hit a temporary bump, but did so following big investments in R&D and/or marketing. Those businesses likely have good things going on under the surface.
Ollie’s Bargain Outlet Holdings is setting up to be an interesting situation. The company buys “end of run” goods and sells them at deeply discounted prices. Grant’s Interest Rate Observer described Ollie’s business as follows:
“The closeout business is off-price retailing without the frills. Like the cigar-butt investor, the closeout merchant finds stock where it’s cheapest: in discontinued merchandise, canceled orders, modified orders, liquidations. He buys low, sells a little higher.”
The average Ollie’s store produces roughly $475k of unlevered earnings. Those stores grow earnings at roughly 2% per year IF you look at 2 year comps. Given where assets trade, it’s not unreasonable to assume a required return of 8% for owning the unlevered equity of the stabilized store base. Therefore, each existing store could be worth ~$8.1mm.
Today, there are 332 existing stores. Thus, the value of the equity of the business as it exists today could be ~$2.7Bn IF the assumptions above are valid. The current offered price of Ollie’s equity is $3.5Bn. Why might that be a reasonable price to pay?
Ollie’s believes they can grow the store count to 950 stores. Their strategy involves entering adjacent markets. They are expanding West as they started on the East Coast. The current store footprint appears to be as far West as Indiana down to just West of Jackson, Mississippi. Importantly, the company has a history of successful store openings.
Each store costs approximately $1.0mm to open. Assuming the $8.1mm value cited above is correct, each store opening creates ~$7.1mm of value. They believe they can open 45-50 stores per year. Therefore, the present value of the growth could be anywhere up to $2.0Bn (assuming a 12% discount rate).
Accordingly, the offered price of the Ollie’s equity is ~75% of the present value of the equity. Not a screaming bargain, but also reasonably cheap given the environment today. Why? First, Ollie’s had a bad quarter. Second, key man risk materialized.
Missed earnings (and a demanding valuation) caused the sell off during the week of August 26, 2019. As the company tells it, accelerating store openings and odd box sizes caused some disruption to the company’s growth formula.
The pace of store openings allegedly stressed the entire system and resulted in SG&A deleveraging (meaning SG&A as a percentage of sales increased). This is a plausible explanation because Ollie’s took advantage of the Toys ‘R Us (“TRU”) bankruptcy and acquired some good real estate. On one hand this was an opportunistic way to open stores in good locations. On the other, the store acquisitions complicated Ollie’s growth formula.
First, Ollie’s accelerated its store opening cadence because they wanted to get the TRU stores open. Second, the TRU real estate introduced a different store footprint/layout. Mr. Butler attributed some of the operating hiccups to those factors. Mr. Butler’s track record warrants some deference. Therefore, this appears to be one of those situations where the reality of operating a growth company comes in direct conflict with Wall Street’s Excel models.
Further hurting Ollie’s quarterly results was Ollie’s inventory consisted of lower margin products. This is meaningless to a long term investor. What matters, long term, is whether Ollie’s is satisfying its customers. A skeptic would argue Ollie’s margins came down due to inventory quality. Again, Mark Butler’s record warrants deference.
The Potential Opportunity
To summarize, Ollie’s had a pretty poor quarter and the stock was priced for perfection; not a good combination. Below is a screenshot illustrating Ollie’s multiple compression as market participants realize (a) growth isn’t painless and (b) margins occasionally compress.
At the time Mark Butler tried to settle investors by saying:
Thinking long term, the case for buying Ollie’s shares rests on the power of the business model, increased scale resulting in more inbound calls from companies looking to liquidate end of run goods (and excess inventory), and store openings driving efficiencies through the business (by absorbing the recent distribution center costs, for instance). Scale resulting in better buying opportunities is a particularly compelling thesis. As the barriers to new product discovery continue to erode CPG companies, set up for longer production runs and pushing demand, may have more frequent forecasting misses. Accordingly they could need to sell through a channel that is (a) discrete and (b) can actually move the excess product quickly. Ollie’s appears to have a high probability of solving that need.
The Short Story
In March of 2019 Grant’s Interest Rate Observer wrote negatively of Ollie’s shares. A prescient call, Grant’s rested some of it’s thesis on valuation. But, valuation wasn’t all:
“As no proper bear case rests on valuation alone, our bill of particulars goes well beyond that FAANG-like multiple. Among its highlights: rising competition, operational shortcomings, low inventory turnover, high exposure to financially vulnerable consumers and accounting problems.”
The first accounting claim Grant’s alleges is Ollie’s free cash flow and net income diverge substantially. While this is true, it’s also somewhat explainable by store growth. Ollie’s inventory is growing at ~14-16% per year, which is in line with store count growth. Comparing Ollie’s to another high growth retailer, Five Below, its unclear the free cash flow conversion is a concern.
The second, and more compelling, accounting claim Grant’s discusses relates to Ollie’s irregularities pertaining to inventory and pre-opening expenses (oddly these include store closure costs). Grant’s discussion is concerning given the outdated inventory systems Ollie’s allegedly uses. To summarize the concern, if it is true that Ollies has terrible inventory systems, its possible that reported gross margin overstates actual gross margins. That said, it’s tough to overstate cash generation. And Ollie’s generates cash. Enough cash to retire $200mm+ of borrowings since 1/30/16 while investing in growth.
Grant’s concludes by mentioning the internet may increase competition for closeout sellers. While that may be true, Mark Butler contended that Ollie’s offers a preferred liquidation channel because there are no prices found on the internet. Therefore, a company like P&G can sell Tide through Ollie’s without upsetting the brand’s image in most consumer’s minds. Both thesis have merit but again, Mark Butler’s argument seems more likely.
More Fodder For Short Sellers
On December 1, 2019, Mark Butler, Ollie’s CEO and founder, died. Turn on an earnings call and listen to his enthusiasm. The man is irreplaceable.
One example of Mr. Butler’s genius was buying wedding dresses on closeout. No one sells wedding dresses at a closeout store. Consequently, Ollie’s got a fair amount of publicity from selling deeply discounted dresses. It’s unclear whether the remaining buying (and management) team will be willing to take those types of risks.
Mr. Butler’s replacement, John Swygert, has been with Ollie’s for a long time but is untested as a CEO. So, this would be an opportune time for a short seller to test him and/or shareholders. It appears as though that is going on as the side by side shown below is making the rounds.
The implication of that side by side seems to be that Mark Butler talked about toy sales when they were good and John Swygert is not talking about toy sales when they are bad. That conclusion appears tenuous given Swygert’s comments that “we are pleased with what we’re seeing right now.” Further, Mr. Butler and Mr. Swygert have different styles. Some of the language change may be attributable to who delivers the message. Long term investors should be way more concerned with the accuracy of these statements:
The Shorts May Have a Real Argument
Mark Butler’s death is a potentially derailing event. He had a reputation as an extremely sharp buyer and a one-of-a-kind charisma. It’s quite plausible that Ollie’s dependent on one man; that story isn’t uncommon in retail. That said, Ollie’s team has been there for a while. They’ve thought about succession planning as evidenced by elevating John Swygert’s position in the company a few years ago.
Importantly, based on a conversation with a very trusted source, we find it likely that there is institutional knowledge within these types of organizations. Coordinating purchases, store openings, inventory management, and logistics is probably more than one man can handle. JP Morgan has this to say about Ollie’s bench strength:
Going forward, it’s almost inhuman to expect Ollie’s to hit their short term plan. Those people lost a leader. But, if the team can focus on execution, maintain buying relationships, and continue to open stores then Ollie’s should have a very good future. Parsing short term issues from fundamental long term business erosion probably won’t be easy.
The Balance Sheet: A Potential Asset
Ollie’s doesn’t own its real estate. Therefore, the business doesn’t need to carry the leverage it would need to if it owned it’s real estate. Instead, they have ~330mm of lease assets on the balance sheet. Accordingly, Ollie’s cost of real estate flows through the income statement (and operating cash flows) as rent rather than through interest expense, changes in PP&E, and net financing cash flows. The average lease term is 7.2 years so there could be some liability if certain store results erode quickly.
Other than leases, there is no debt at the company. Many retailers would fund at least a part of their inventory carrying costs with a revolving credit line. While Ollie’s has a $100.0mm revolving credit line, that line is undrawn. If the share price sells off too much, Ollie’s could use it’s $10.1mm of cash and some of its credit line to retire shares. They opportunistically bought in shares at ~$58.02/sh last quarter. We expect some more repurchases in the upcoming quarter considering they should be generating seasonal cash and the shares are currently trading at $53.34/sh.
Today’s investor gets paid for taking execution risk and betting on the business model. Whether the odds offered are enticing enough is another matter. There’s currently uncertainty around whether the new team can execute the growth plan.
An under discussed risk is how the new CEO interacts with the Board. Will he be able to take over after a charismatic founder passed away? Will he feel comfortable implementing “risky” and/or unconventional (like the wedding dress sale) promotions/actions? Mark Butler’s shoes are not easy to fill…
This is one to watch. Assuming the discussion above is accurate, the upside offered in the stock is probably not much more than 40% (assuming no share repurchases). The downside could easily be ~30%. Accordingly, an investor needs to be ~43% or more certain that a Mark Butler-less team is up to the task. Therefore, this may be one to watch from the sidelines.
PS. What will Chuck Akre’s firm do? Is Mark Butler’s death sufficient reason to sell or did they bet on the business and team? That will be interesting to see given The Art of (Not) Selling.
Chuck Akre’s firm lives inside my head. “The Art of (Not) Selling” is causing soul searching, confusion, and even a bit of anger. That anger is self directed.
For the longest time I searched for The Answer. Immersed in “value investing” books, praying to the alter of Buffett and Graham, and searching for The Formula. Here’s the problem: The Formula doesn’t exist. Only models and theories.
The past year was a good one for SCG. Given some of our large holdings, it’s remarkable that we kept pace with the index. That said, our performance was catapulted by a large position in Charter Communications, which is not a “value investment” as defined by deciles of valuation. Other meaningful contributors to performance included Apple, Netflix, and J.W. Nordstrom. Our portfolio continues to own J.W. Nordstrom and Charter as of this writing.
Going forward, the portfolio will look different from last year’s portfolio. Much of the change is attributable to our firing of a manager, which brought a substantial percentage of the portfolio “in house.” The decision to part with our previous manager was not easy, but it was the right decision. From hereafter, we completely eat what we kill.
Our strategy is to accumulate minority interests, in businesses we understand, at values that make the risk of permanent capital impairment minimal. As stated before, in the past year, the portfolio benefited from churn. Unfortunately, your manager is concerned he “learned” the wrong lessons.
Focusing on entry price has been a worthwhile pursuit. However, would it not have been better to be invested in quality companies with long runways? Sure, the entry multiples would have been higher, but the tax drag on the portfolio would be lower and we’d still own the businesses. See Charter as an example of a business that wouldn’t screen cheap but almost certainly was when we acquired our interest.
One could reasonably argue that worrying about not focusing enough on terminal values is a great “late cycle” indicator. Maybe, but also maybe not. Two quotes come to mind (thank you to @tsoh_investing on Twitter):
“The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks saltwater, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.” https://microcapclub.com/2015/05/i-passed-on-berkshire-hathaway-at-97-per-share/
“Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high … That’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth. But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.” – Warren Buffett, 1997 Shareholder Meeting, Morning Session.
In defense of our strategy, with the exception of Wells Fargo, I think it’s hard to argue our holdings are “poorly managed.” Facebook is one that many would argue should fall into that category. Personally, I might agree. However, that is a judgment call and, to the extent possible, we will invest based on fundamental truths. One of those fundamental truths is Zuckerberg built one of the biggest social networks ever and acquired two more. Thus, management is at least acceptable.
The current contemplation of whether our focus on entry price is misguided stems from a different framing of math. On one hand, it is very hard to lose when you are purchasing a $1.00 for $0.50. However, it’s also very hard to win big and IRRs will depend on how quickly the market realizes that $1.00.
On the other hand, investing is one of the few games where winners can run for a very, very long time. Importantly, strong organizations attract strong people. Those strong people tend to win. Consequently, while there is momentum in stock prices there is also business momentum. Thus, $1.00 can turn into $5.00 over time. Has a focus on entry price undervalued the momentum benefiting truly great organizations? Perhaps. To not at least contemplate that question is to remain stupid. We will not do that.
To be clear, we own our perception of good businesses. Each serves an important function in its customer’s lives. Many of these businesses are mature and cannibalizing shares. Therefore, on a per share basis, we are quite comfortable with our existing portfolio’s growth rate. Moreover, the portfolio is reasonably priced. As of this writing the Top 10 holdings, accounting for 64% of the portfolio are as follows:
Of the businesses listed above, Phillip Morris (PM) appears to be the one at greatest risk of deterioration. That said, we own the company because it sells an addictive product, has room to take prices, and is a low cost producer. Longer term, it’s plausible that PM acquires other cigarette makers (it recently tried to acquire Altria) and the volume deterioration is slower than anticipated. Phillip Morris rhymes with AB InBev (now a smaller position due to portfolio consolidation) because both entities have dominant positions, are suffering from volume declines, and benefit from raising prices.
Going forward, SCG will probably own fewer of these types of businesses and look to own businesses that are growing volumes as well. Mr. Akre makes a compelling case that it’s better to own a business that can grow its way out of a period of overvaluation. I will put more energy and focus into finding those situations.
Thank you for your continued trust. I commit to taking fewer actions in the future and finding greater long term, durable, investments. For now, our results have been satisfactory. Thus, expect at least some of the same behaviors to recur.
Chuck Akre, one of the most interesting investors in the world, recently had his firm issue a blog post discussing their sell discipline, or lack thereof. The meat of the post was:
“In addition, we try to resist the temptation to sell (or trim, even) on the basis of valuation alone. We are unfazed when our businesses are quoted in the market at prices above what we would pay for them. It might be worth reading that last sentence again for emphasis.
Why? For three reasons…
First, when selling because of valuation, it is often with the idea that there will be an opportunity down the road to buy back in at lower prices. In our experience, it seldom works out this way.
Second, of the thousands of publicly traded companies, there are probably fewer than one hundred that meet our criteria, and opportunities to buy them at attractive prices are few and far between. Unlike average businesses that can be traded like-for-like on the basis of valuation alone, growing and competitively advantaged businesses are just too hard to replace.
Third, the very best businesses tend to exceed expectations. What may seem like a high price today may be proven to be perfectly reasonable in hindsight.”
The post has caused some cognitive dissonance for SCG. For one, our portfolio has benefited from churn. Specifically, churn among one of the greatest companies in the world: Apple. Note: Apple never exceeded a 5% portfolio position at cost, which reflects some concerns cited below.
Our first investment in Apple took place in early 2013, after Steve Jobs died and there were concerns about whether the iPhone would continue to sell in droves. We held that position until 10/22/2018. We repurchased Apple on 12/28/18 to then sell again on 11/19/19. To be sure, our portfolio missed out on another 10% move from 11/19/19 to 12/31/19.
There is a decent chance the churn activity cited above reinforced bad habits. Further, it is only one memorable example so (a) it’s statistically insignificant, (b) increases the chances of memory biases, and (c) could be a great example of “resulting” (measuring success based on results as opposed to process). Further, your manager believed, and still believes, he probably sold too early. So, why sell? The answer is duration risk.
At this valuation, Apple is valued at roughly a 5% free cash flow yield. That valuation implies the company has to exist for 20 years and the company must generate this level of cash flow for an investor to extract the cash flows from the business. Importantly, Apple is repurchasing shares at an impressive pace. However, those repurchases do a lot less for investors at this valuation than they did at our purchase valuation.
Perhaps the error of commission, by Akre standards, was purchasing Apple given some of our business durability concerns. That said, if Apple isn’t quality what is? Ultimately, our read of Apple’s “tea leaves” is less optimistic than our perception of the market’s read. More importantly, we were offered our perception of a healthy price for the business. Thus, we exited the position despite seeing a plausible way for Apple’s price to increase at least another 40%. Note, our strategy does not, and will not, depend on selling shares to buy them at lower valuations. When we sell we intend to move on. Apple presented a unique opportunity in a short amount of time, it was an asset we understand, and we thought the probability of permanent capital impairment was low given the valuation and buy back pace.
Was that a mistake? Perhaps. In retrospect it was definitely a mistake from a tax perspective. That said, selling is a “mistake” we anticipate making over and over again. However, your manager is committed to working harder to find businesses we can hold for the long term regardless of valuation. Said differently, you can expect your portfolio to get more expensive but also more durable over the years to come.
Subscription business models are the future. Or so we are told…
To be sure, subscription businesses have inherent advantages. They “know” how much they are going to sell next month. Therefore, they can plan their cost structures around fairly predictable anticipated sales. Further, they are more durable than many business models because inertia/switching costs tend to result in subscription renewals. Importantly, software subscription services should benefit from operating leverage at scale. Thus, they are potentially desirable investments. Hence the current research project: Zuora.
Zuora provides a software billing solution to companies that are launching subscription services. Scuttlebutt suggests the offering is quite good and customizable. Customers see value in Zuora’s offering because subscription services have billing nuances that most billing systems aren’t equipped to handle.
Think of the NY Times as an example. There are many different customers, all subscribing to a number of products, signing up at different times. Traditional billing solutions, designed for discrete transactions, cannot handle that load. Zuora built its business specifically to address these issues and remains focused on them. As a complimentary offering, Zuora also offers a revenue recognition software solution that helps customers accurately account for the revenues they earn (which isn’t always easy given length of terms, renewals, changes, etc).
The company’s sales strategy involves “landing and expanding.” That means they try to acquire a customer and then (a) sell that customer a more robust billing solution, (b) try to cross sell the revenue recognition solution to customers using Zuora’s billing solutions (or vice versa), or (c) a combination of the two. Importantly, this strategy requires large upfront investments. Sales cycles are lengthy, the product must be designed and tested for specific use cases, and good sales reps cost a lot of money. Therefore, sales efficiency and distribution are key to scaling quickly and obtaining a defensible position in the market. While there are less expensive billing solutions on the market, Zuora’s product has proven to be a good fit in the enterprise market.
Importantly, it seems as if Zuora’s product is sticky among the larger customers they serve. The company consistently increases the amount of customers billing over $100,000 in annual recurring revenue. That said, the company’s sales growth has slowed this year and there are questions around how quickly the product will scale.
Zuora seems to have a realistic, forward looking vision about future business models. Their theory of the case is businesses, enabled by IoT, will collect data on how their products are used. Those businesses will then offer users of their products subscription services as supplements to existing business lines. The theory is supported by a recent Barron’s article featuring Honeywell. See Footnote 1. Zuora will also benefit from increasing subscription businesses such as DAZN, FT.com, the Guardian, etc. See https://www.zuora.com/our-customers/ for a list of customers and case studies. But can Zuora serve these customers profitably?
Historical Financial Results
Zuora’s CEO, Tien Tzuo, recommends benchmarking SaaS businesses by subtracting cost of goods sold, general & administrative, and research and development costs from sales in order to determine “Recurring Profit.” Then, he suggests viewing sales and marketing expenses as “growth.” Using his own suggestion, Zuora’s historical financials don’t show recurring profit margin expansion:
Admittedly, there are timing differences between the costs Zuora incurs and the revenues it recognizes. For instance, the company has been growing revenues in excess of 30% per year until this year. Undoubtedly, they hired expecting more robust growth than they achieved. Therefore, their existing cost base is almost certainly too bloated relative to their revenue base.
Moreover, the company is highly likely to be erring on the side of over hiring so they don’t hinder growth. As of today, the perceived appropriate strategy is to acquire as many customers as fast as possible. Therefore, Zuora would be foolish to forego sales because of insufficient support. That said, it’s not certain that Zuora’s anticipated growth materializes and/or the cost base “right sizes.”
An Accounting Tangent
Accounting under GAAP penalizes enterprise SaaS businesses relative to traditional capital intensive businesses. Traditionally, a growing company in a capital intensive business would capitalize a portion of its growth spending. Only later would that company depreciate the spend on the income statement. Consequently, a traditional income statement did not capture “growth” capital spend.
Conversely, enterprise SaaS businesses have the opposite problem. These business are capital intensive, but they require human, not physical, capital. GAAP does not allow companies to capitalize human capital expenditures. Consequently, the current cost structure is fully captured but the revenue stream associated with these costs is not. SaaS income statements are further penalized because revenues are recognized as they are earned. This puts more pressure on the income statement relative to traditional businesses.
For illustrative purposes, let’s assume Zuora was selling a discrete product for $100 with 70% gross margins. The income statement in the quarter of sale would capture revenues of $100 and gross profit of $70. However, Zuora is actually selling that $100 product for $8.33/month. Thus, a quarterly income statement shows sales of $25 ($8.33 * 3) and gross profit of $17.50. Therefore, the entire cost to support and implement the product sale is in today’s income statement but only a fraction of the product sale is captured.
All that said, the income statement is not useless. At a minimum, it’s a relatively reliable picture of how Zuora’s costs have grown as the business grew. These dynamics have led to a cash flow negative company, despite $19.6mm of stock based compensation over the past 6 months.
The Future, Not The Past, Is What Matters
All of the above is interesting. Zuora’s vision of the world is interesting. It’s interesting to think of the potential business lines a connected world could create. It’s also interesting that a public company, with an allegedly incredible business model, continues to lose cash despite ~7% of its expense base being non cash share based compensation. Further, it’s interesting that the company has generated larger and larger losses as its business grows. But, what’s more interesting is Zuora still trades for $1.5Bn, or ~48.1x “recurring profit” before sales and marketing expense. Why?
The answer lies in the market’s expectation that this business is scaleable, has a long runway, and will generate predictable cash flows over time. If that happens, Zuora is going to be a cash machine in the future. Therefore, Mr. Market is assigning a high valuation because he believes Zuora is on the left side of the image below:
Mr. Market may be correct. That said, it’s difficult to handicap the odds because searching historical transcripts, presentations, and filings for “unit economics” and “contribution margin” returns no results. More importantly, the historical income statement doesn’t show evidence of R&D or G&A leverage. Therefore, Zuora’s ability to scale is more theoretical than tangible.
Further complicating the equation is every period showing “recurring profit” growth (though at a lower margin) corresponds with an even larger increase in sales and marketing costs. Bulls will argue the sales and marketing ramp is rational because this is race to get an installed base. Skeptics will argue it’s a structurally cash flow impaired business model. What is the truth?
Grow Now, Prosper Later
There is merit to the strategy of racing to acquire customers in an enterprise software business. Thus, the bull argument cannot be summarily dismissed. That said, the bear argument also cannot be summarily dismissed; Zuora not only hasn’t generated cash but also supports a healthy valuation. See Footnote 2.
As discussed, enterprise SaaS companies benefit from switching costs. What is the probability that a company is using Zuora to run its billing for a successful subscription business line? In order to make that decision a company like the Financial Times would need to:
(a) have enough pain with the current billing solution to consider switching,
(b) get comfortable with a competitor’s product,
(c) be willing to migrate billing systems and risk some sort of customer disruption (remember, the hypothetical company invested a lot to acquire those customers so disrupting the experience is a serious potential risk); and
(d) actually make the switch.
It’s obviously possible for companies to switch, but it isn’t easy. Moreover, Zuora charges ~50bps on transaction volume. How much savings can a company capture by switching to a competitor? That competitor would need to be able to economically offer savings, guarantee a seamless transition, and close the sale. That is a tall order. So, grow now and harvest later!
Growing now and harvesting later is exactly what Zuora is trying to do. So it continues to aggressively pursue deals that look like:
A problem, however, is Zuora’s “recurring profit” margin, coupled with its sales cycle leads suggests the business economics are closer to the orange line below than the green line. And that matters. A lot.
For illustrative purposes, lets compare the Run Rate 7/31/19 financial results (above) to the year ended 1/31/19. Zuora discloses a net revenue retention rate of ~112%. Therefore, company’s 1/31/19 sales base of $168.8mm would result in $189.1mm of sales. The $100.8mm of sales and marketing exepenses deliver the “growth” of $13.6mm of new business. That $13.6mm generates ~$2.0mm of “recurring profit.” That is not an incredibly exciting return on sales spend. Please note that the actual run rate business at 1/31/20 should be substantially larger than the run rate business at 7/31/19 and this example is very imperfect. However, the example directionally demonstratesthat Zuora’s business is not growing like a weed and realizing incredible unit economics. It must be noted the time period in this example also covers some sales execution issues. But, the example is useful to show this business, while priced like a Ferrari, may actually be a Honda.
Justifying Zuora’s current valuation requires a long time horizon and some creativity. In the words of Shomik Ghosh:
“In enterprise software, valuations are mostly quoted as revenue multiples. Companies are said to be valued at 15x NTM revenue or 10x NTM ARR. These again are proxies for eventual free cash flow generation. However, they’re necessary because building a discounted cash flow analysis early on in many of these company’s lives would have so many assumptions on it that the analysis would effectively be useless.
So what are the proxies commonly used for valuation? They include revenue growth, gross margins, LTV/CAC ratios, S&M efficiency, churn, upsell, runway, TAM, market share, etc. An exact same business with the exact same metrics will be valued more highly if it has 2 years of runway versus 1 year as the longer runway allows more time for growth and eventual higher free cash flow generation at steady state.” See Footnote 3.
Zuora is almost certain to continue growing sales given the business model and infancy of the product offering. As shown below, ~50% of firms with sales between $0-325mm can grow at or above 10% per year for 10 years (note there is some survivorship bias as some firms don’t last 10 years).
That said, other than faith, it’s hard to see how Zuora’s sales growth results in operating leverage. Further, the speed of growth over the long term and capital allocation is questionable. There’s something offensive about an organization spending $75.0mm of run rate R&D to support $202.7mm of run rate sales (regardless of how understated sales are). How does a company with only two real products need that kind of R&D investment? And, with $139.9mm of R&D investment over the past 4 years shouldn’t Zuora have more than 112% revenue retention if their end market is growing so much? While Zuora needs to iterate its product, this R&D spend (a) seems extreme and (b) could be better spent on an even bigger sales team to accelerate scaling.
Conclusion: Too Hard
Given concerns with Zuora’s capital allocation, it’s very difficult to determine the company’s steady state economics and the path to get there. There are so many intertwined variables that a model does more to serve as confirmation bias than an objective forecast of the future. Moreover, there’s nothing tangible that shows this business and/or management team is scaling.
There’s a strong desire to assume all this spending is rational. After all, very smart people (a) work at Zuora and (b) support the company as investors. Moreover, Zuora has a visionary concept of the future. Further, scuttlebutt suggests the product is good. All that said, investing isn’t rooting for a sports team. There is real money on the line. Given the lack of visibility into terminal economics, this business is better to let others wager on. Some bets are best observing from the sideline.
According to Bloomberg there are 4,371 companies in the US and Canada that are classified as communications, consumer discretionary, consumer staples, and technology. Of those only 731 have a market cap in excess of $1.5Bn. Of that 731, 602 are free cash flow positive. Those sectors were chosen because they have reasonably good businesses in them (as opposed to energy and materials). Within the technology subset, there are 1,530 companies, of which 272 have market caps equal to or greater than Zuoras. Of those 272, 221 are cash flow positive. None of these numbers mean anything, per se. However, they do demonstrate that Zuora is among the most highly valued companies in the investable universe. That said, this is a pond worth fishing in because successful tech companies tend to produce the preponderance of value within the sector.