Some thoughts on risk arbitrage

I promised a new post within 3 weeks of the last one. It’s here…but is different than originally planned! Several recent M&A events have motivated me to try to explain some basics on what happens to associated stocks in such a situation, the most recent being the Zoom acquisition of Five9. If the acquisition is a stock for stock transaction (as the Zoom one is), the acquirors stock will usually decline in price right after the announcement of the deal.  The reason for the inevitable next day decline of the acquirer’s stock can be misunderstood. In this post I will explain why the decline has little to do with investors reaction to the quality of the acquisition.

What happens when a stock for stock acquisition of a public company is announced?

When a public company offers to acquire another, it is quite usual for the offer to be at a premium to the current stock price of the target company. Without a premium there is little motivation for the target company to accept the offer, and it can create a legal issue – as class action attorneys are vigilant to find opportunities to sue and can claim that the target sold out too “cheaply”.

Assuming the number of shares involved is a material amount, then once the deal is made public, the stock of the acquirer will almost always decline the next day while the target’s price rises. The press often interprets this as “The Street” being negative on the acquisition, when in fact it has little to do with a critique of the deal. Instead, it stems from “Risk Arbitrage” where arbitragers will short the acquirer’s stock and buy the target’s stock to create a certain profit if the acquisition is consummated. To illustrate this, I will use an easy-to-understand example:

Suppose Company A is trading at $100/share and then offers to acquire Company B (trading at $60/share). Suppose the offer is one share of Company A stock for each share of Company B stock. At these prices an arbitrager can:

  1. Buy Company B stock at $60/share – this equates to buying Company A stock at a discount if and when the deal closes since each share of B will then convert to one share of A
  2. Short Company A stock and receive $100/share

The net result is a gain of $40/share assuming the deal consummates. This occurs because when the share of B is converted to a share of A it can be used to cover the short position without the arbitrager spending any money. The Arbitrager will continue to do this as long as there is a gap between the prices of the shares. Given the number of shares being sold, A’s stock price will usually fall (the next day) and B’s will rise until it is virtually equal to A’s price on an as converted basis. The difference once this reaches equilibrium is the “risk premium”.

The reason it’s called “Risk Arbitrage” is that if the deal falls apart money could be lost. Therefore, a smart arbitrager will assign a risk premium based on his or her assessment of the probability that the deal will break. Once the 2 stocks are in sync, they will continue to trade in sync with the difference in prices being the risk premium. This will probably mean that the acquirer’s stock will return to around its prior price a few days later plus or minus its normal fluctuation, and the premium or discount assigned by investors to the deal.

Using Zoom Acquisition of Five9 as a Real Example

For an actual example, lets review the Zoom acquisition of Five9 announced on Sunday July 18, 2021. The agreement was to exchange each share of Five9 for 0.5533 shares of Zoom. At the close of the market on Friday, July 16 (just before the announcement):

  1. Zoom shares were at $361.97 and Five9 shares were at $177.60
  2. The theoretic value of a Five9 share based on 0.5533 of a Zoom share was $200.28 a 13% premium to the July 16 Five9 share price.

By the close on Monday July 19, Zoom shares had declined to $354.20 and Five9 shares had increased in price to $188.12. I saw many articles interpreting the Zoom drop in price as investors being negative on the deal. However, I believe it was the result of the volume of Zoom stock shorted by arbitragers.

Since 0.5533 times the Zoom price of $354.20 is $195.98 there was still a discrepancy in the ratio between the two stocks versus the ultimate conversion multiple of 0.5533 since Five9 was trading at 4.01% lower than the exchange ratio implied it was worth. This meant that Arbitragers were initially assigning a 4.01% risk factor based on the odds the deal would close. Once the two stocks settled into the appropriate ratio they have traded in sync since (less the Risk Premium). The risk premium has declined slightly in the two weeks since the deal was announced as arbitragers began to assess a lower risk factor to the odds the deal would break.

This same pattern usually occurs each time a stock for stock transaction is announced. There is too much money to be made from the arbitrage if the two stocks don’t adjust based on the conversion ratio. Any time they get out of sync arbitragers will step in again. When they initiate a pair of transactions the combination of buying stock in the target and shorting stock in the acquirer generates an immediate profit in cash. In our example of Zoom if the stocks were still at the July 16 price a transaction could be:

  1. Buy 10,000 shares of Five9 at $177.60 at a cost of $1,776,000
  2. These shares would convert to 5,533 shares of Zoom when the acquisition closes
  3. Sell short 5,533 shares of Zoom at $361.97/share to receive $2,002,780
  4. Immediate cash to arbitrager = $2,002,780 – $1,776,000 = $226,780
  5. If and when the acquisition closes the arbitrager would net a profit of $226,780
  6. If the deal breaks there could be a loss as the Zoom share short would need to be covered and the Five9 shares sold. This is why there is a risk premium involved.

Of course, the July 16 prices disappeared quickly when the stocks opened on July 19 as the arbitragers begin to execute their transactions. But as long as the difference exceeded the risk premium, they continued to transact to realize an immediate cash return. Once equilibrium was reached arbitragers ceased transacting (unless the stocks were to get out of sync again).

Conclusion

If you own a stock making a major acquisition and its stock price drops the day after the transaction is announced, the drop is likely to be temporary. Of course, there are situations where investors actually are so negative towards the transaction that the acquirer stock does not recover, but the first day drop usually has little to do with that.   

Why spending on branding can be a key to long-term success

A friend called me the other day and inquired as to whether I was ok, as I had not posted in several months. While my goal has been to do about 10 blog posts per year, my frequency has always been erratic, and this year has really been sparse. To make things up, I am going to try for 2 new posts in the next 3 weeks or so that stem from the Azure Marketing Day, held each year for our portfolio companies to gain exposure to advanced techniques across multiple marketing areas. Since the speakers are truly knowledgeable of their arena, using one or two talks as a basis of a post makes me look good!

This post will focus on branding and how to measure whether it is working. The next will delve into direct (snail mail) marketing and how some companies are finding it quite effective.

How to measure the efficacy of brand campaign spend

Spending on branding is quite different than spending for customer acquisition. While many ads serve both purposes, the difference is based on whether there is a direct call for action…usually to buy something. For simplicity, I assume that if there is a call for action, the ad is for customer acquisition, if there is no call for action the ad is for branding.

By improving their brand, a company can experience:

  1. Higher conversion rates on its customer acquisition spend
  2. An increase in the number of people who visit their site
  3. An increase in the LTV (lifetime value) of customers

One method of measuring whether a branding campaign is effective is to determine whether people in the geography where the marketing takes place become more aware of the brand. This is done by measuring the awareness of the brand both before and after the campaign. The most common measure for younger companies is called “Aided Brand Awareness”. Aided brand awareness is determined by conducting a survey of a statistically significant random sample of the population of the geography. In the survey, each person is asked to say which of a list of products/companies they recognize. The percentage that picks the product or company as one they know of is designated as the Aided Brand Awareness.  Most TV ads are for improving brand awareness, whereas a large proportion of online ads are for customer acquisition.

While it may seem surprising now, when I was on Wall Street covering Microsoft (and others), Bob Herbold, Microsoft COO, believed a lack of universal brand awareness was limiting the company. So, Microsoft engaged in a significant spend to raise its brand awareness from well below 50% (as I recall) before the campaign. It was one of the many smart strategies the company used to become what they are today. An improved brand helped drive a massive gain in market share for Microsoft productivity applications.

At the Azure Marketing Day, Chris Bruzzo, EVP Marketing and Commercial at Electronic Arts, provided a session on the importance of branding. He outlined one method of testing the potential effectiveness of a branding campaign without breaking the bank. He suggested, if possible, to start by picking matched geographies for a test. You then conduct the branding campaign in the test location and compare results to the control (the second location). By limiting the test to a few geographies, the cost can be kept reasonable while acquiring information on how much impact a branding campaign could have on your company. EA found advertising to improve its brand was quite effective. While I can’t cite EA data due to a public company’s need for confidentiality, I can say it led to higher customer Life Time Value and an increase in the success of customer acquisition campaigns in the test geographies. I have been given permission to review a similar test conducted by Azure portfolio company Chairish.

Chairish recently conducted a test of whether spending on branding would prove beneficial. They decided to select 3 cities for the test. For confidentiality, I’ll refer to them as Test Cities 1, 2 and 3. Each was measured against a control city where no branding spend was done. The paired cities, control cities 1, 2 and 3, respectively, each had similar population demographics to the test city it was paired with. The first measurement of benefit was the change in Aided Brand Awareness. Pre-campaign the test cities averaged 6% awareness and the control cities 8%. Post campaign the test cities increased to 13% awareness and the control cities to 9%. So, the lift for the test cities was 7% and for the control cities 1%. I believe that the control cities represented the natural gain the company was getting without a branding campaign, while the branding campaign added an additional 6% of the population to those aware of its brand.

Comparing Test Cities to Control Cities for Branding Campaign  

The table shows the average benefit of the marketing campaign across the test cities when compared to their matched control. For example, during the test period the increase in average overall revenue was 23% greater in the test cities than in their paired control locations. A month later, the difference in gain had improved to 25.8%. The reason for such large revenue gains stems from some of the other metrics measured, especially the massive gain in registrations because of the branding campaign.

Given these results, Chairish will be increasing its spend on branding. For those of you who decide to try a branding campaign, it is important to make sure you can measure results. Once the results are in hand, the next step is to compare revenue and gross margin dollar gains to the cost of the campaign. This allows a company conducting a branding campaign to understand the initial incremental cost and the time to recover the investment. Having that in hand allows for a reasonable forecast of the cash flow implications of increasing the spend for branding. One caveat is, while hard to forecast, there is also often the benefit of an increase in customer LTV (life-time value) as greater awareness of the brand also spurs more visits (and spend) from existing customers but this is more difficult to measure in the short run.

While mature companies typically spend a portion of advertising on branding and conduct these types of Aided Brand Awareness measures many younger companies do not consider this. As companies cross the $20-30 million threshold, we believe they should consider experimenting with a brand spend in the manner discussed in this post. Many will find that it is another valuable tool to use as part of marketing spend.

Soundbytes

In our post on September 10, 2020, A Counter Theory to Potential Recession (during week 26 of Shelter in Place), we advocated a counter-theory to widespread predictions that there would be a recession as the pandemic ebbed, stating:

“Much of the public dialogue concerning the economic effect of Covid19 has centered around the large number of people who have lost income, with the conclusion that the US will potentially experience a continued recession going forward. What seems to be lost in the discussion is that the 90% of the labor force that is employed is saving money at an unprecedented rate. This has occurred partly through fear of future loss of income but mostly by a reduction in spending caused by the virus.”

We estimated that consumers would save trillions of incremental dollars if Covid lasted through year end. And that a large portion of it would subsequently be spent on furniture, luxury items, vacations and more. This is now occurring, leading to substantial increased demand for many goods and services and inflationary pressure.

The pressure of this increased spend coupled with continued supply chain issues due to Covid provides the opportunity to keep prices firm (or even increase them) as demand will outstrip supply in many sectors, possibly through year end. 

The Top 10 List for 2021

Professional Sports in a Covid World

I wanted to start this post by repeating something I discussed in my top ten lists in 2017, 2018 and 2020 which I learned while at Sanford Bernstein in my Wall Street days: “Owning companies that have strong competitive advantages and a great business model in a potentially mega-sized market can create the largest performance gains over time (assuming one is correct).” It does make my stock predictions somewhat boring (as they were on Wall Street where my top picks, Dell and Microsoft each appreciated over 100X over the ten years I was recommending them).

In the seven years we have been offering stock picks on this blog this strategy has worked quite well as the cumulative gains for my picks now exceeds 21X and the 7-year IRR is 55%. The two stocks that have been on the list every year, Tesla and Facebook, were at the end of 2020 at 77X and 11X, respectively, of the price I bought them in mid-2013. They both have been on our recommended list every year since but this is about to change.

In last year’s Top 10 list I pointed out that my target is to produce long-term returns at or above 26%. At that rate one would double their money every 3 years. Since the S&P has had compound growth of 10.88%/year for the past 7 years, and Soundbytes has been at 55%, I thought you might find it interesting to see how long a double takes at various levels of IRR and what multiple you would have after 10 years for each one.

Table: Compound Returns at Various Rates

The wonder of compounding is quite apparent in the table, but it also shows that patience is a virtue as holding the stocks of great companies longer can multiply your money significantly over time, while too many investors become inpatient and sell prematurely. In our last post of 2020 we outlined the thinking process to select great companies, but even great companies can have some periods where their returns are below par. Given that our picks were up an average of 259% last year, I’m back to a fearful mode that 2021 might be that period. Of course, I’m always fearful but sticking with great companies has worked out so far and trying to time when to sell and buy back those companies often leads to sub-optimization.

To some extent, over a 5-year period or longer, stock appreciation is correlated with a company’s growth. So, as I go through each of my 6 stock picks, I will discuss what that might mean for each company. With that in mind, as is my tendency (and was stated in my last post), I am continuing to recommend 5 of the 6 stocks from last year: Tesla, Zoom, Amazon, Stitch Fix and DocuSign. I am removing Facebook from the list and adding CrowdStrike. To be clear, I still believe Facebook will outperform the S&P (see Pick 7 below) but I also believe that over the next few years CrowdStrike and the 5 continuing stocks will experience greater appreciation.

2021 Stock Recommendations:

1. Tesla stock appreciation will continue to outperform the market (it closed last year at $706/share)

Tesla is the one stock in the group that is not trading in synch with revenue growth for a variety of reasons. This means it is likely to continue to be an extremely volatile stock, but it has so many positives in front of it that I believe it wise to continue to own it. The upward trend in units and revenue should be strong in 2021 because, in addition to continued high demand for the model 3:

  1. China Expansion: Tesla continues to ramp up production in China, the world’s largest market. In 2020 the company sold about 120,000 cars (which placed it a dominant number 1 in battery powered cars) there as its Giga Factory in Shanghai ramped up production. Trade Group China Passenger Car Association predicts that Tesla will sell as many as 280,000 vehicles there in 2021…an increase of about 133%. While that is significant growth it only would represent 20% of the number of battery powered vehicles forecast to be sold. The limitation appears to be production as the Shanghai factory is just nearing a volume of 5,000 vehicles per week. Tesla believes it can double that during this year. The Model Y has just been introduced in China and early press is calling it a major hit. Together with the Model 3, I believe this positions Tesla to be supply constrained. Should the company increase production earlier in the year, it has the opportunity to sell more than the forecast 280,000 vehicles. What is also important to note, is Tesla seems to be making greater profits on sales of its cars in China than in the U.S so as China becomes a larger portion of the mix Gross Margin could increase.
  • European Factory: Tesla has a cost disadvantage in Europe as its cars are not currently built there. So, while it established an early lead in market share, as others have launched battery powered vehicles at lower prices Tesla lost market share. That should all change when its Berlin Giga Factory begins production in July, 2021. This coupled with the Model Y introduction (it will be built in the Berlin factory) should mean a notable increase in sales as Europe returns to more normal times.
  • Model Y introduction: The Model Y, launched in early 2020 in the U.S., is already selling about 12,000 units a month here. This exceeds sales of crossover vehicles from every major brand (per GCBC which uses VIN reporting to calculate its numbers). It is expected to start being delivered in China in February.
  • Cybertruck: The Cybertruck (see our graphic here) was introduced to extremely mixed reactions. Traditionalists tended to hate it due to its radical departure from what they have come to expect for a pickup truck from companies like Ford, Toyota, etc. But it rang a cord with many and pre-orders are now up to 650,000 units according to Finbold. To give perspective on what this means, it is 30% higher than the total number of vehicles Tesla sold in 2020.  While a portion of these orders could be cancelled as they only required a $100 deposit, the magnitude does imply significant incremental demand when Tesla launches in this category. The launch is expected late this year.
  • Roadster: Tesla has plans to re-introduce a Roadster in 2021. You may recall that the first Tesla’s were sports cars and are now collectors’ cars mostly valued between $50,000 and $70,000 but now the last one built, having about 200 miles on it is up for sale at $1.5 million. This time around it will make it an ultra-premium vehicle in specifications and in price. The base price Tesla has indicated starts at $200,000. A “Founders Series” will be $50,000 higher (with only 1,000 of those available). At those prices, gross margins should be quite high.  The range Tesla initially indicated for this car was 620 miles and the speed from 0 to 60 of 1.9 seconds which would be much quicker than the McLaren 570S gas powered auto.
  • Tesla Semi: of all the vehicle categories that would benefit from being battery powered I believe the Semi is on top. That is because cost of ownership is one of the highest priorities for vehicles used in commerce. And Tesla claims that their semi will offer the lowest cost of ownership due to economic cost of fuel, less maintenance required as it has fewer parts, and easier repairs. According to Green Car Reports Musk has said it will begin being produced in 2021. Even assuming that Elon’s optimism is off, it appears that it could hit the market in early 2022. Once a definite date and specs are public, sales forecasts for Tesla could rise in 2022.

I’ve taken more time than usual to review my thoughts on Tesla as its astounding stock appreciation in 2020 make it vulnerable to stock pullbacks of some magnitude from time to time. But, its potential to achieve meaningful share of overall auto sales as various geographies shift to battery powered vehicles gives it the potential to achieve high growth in revenue for many years to come.  

2. DocuSign stock appreciation will continue to outperform the market (it closed last year at $222/share)

DocuSign is the runaway leader in e-signatures facilitating multiple parties signing documents in a secure, reliable way for board resolutions, mortgages, investment documents, etc. Being the early leader creates a network effect, as hundreds of millions of people are in the DocuSign e-signature database. The company has worked hard to expand its scope of usage for both enterprise and smaller companies by adding software for full life-cycle management of agreements. This includes the process of generating, redlining, and negotiating agreements in a multi-user environment, all under secure conditions. On the small business side, the DocuSign product is called DocuSign Negotiate and is integrated with Salesforce.

DocuSign was another beneficiary of the pandemic as it helped speed the use of eSignature technology. The acceleration boosted revenue growth to 53% YoY in Q3, 2021 (the quarter ended on October 31, 2020) from 39% in Fiscal 2020.  Total customers expanded by 46% to 822,000. At the same time Net Retention (dollars spent by year-ago customers in Q3 FY21 vs dollars spent by the same customers a year earlier) was 122% in the quarter. Non-GAAP gross margin remained at 79% as increased usage per customer (due to the pandemic) had minimal impact on cost. Given DocuSign’s strong Contribution Margin, operating profits increase faster than revenue and were up to $49 million from $17 million in the year ago quarter. What has happened represents an acceleration of the migration to eSignature technology which will be the base for DocuSign going forward. Once a company becomes a customer, they are likely to increase their spend, as evidenced by 122% Net Revenue growth. Finally, competition appeared to weaken as its biggest competitor, Adobe, lost considerable ground. This all led to a sizable stock gain of 200% to $222/share at year end.  In my view, the primary risk is around valuation but at 50% growth this gets mitigated as earnings should grow much faster than revenue. I continue to believe the stock will appreciate faster than the S&P.

3. Stitch Fix Stock appreciation will continue to outperform the market (it closed last year at $58.72/share)

Stitch Fix offers customers, who are primarily women (although its sales in Men’s clothing is rising), the ability to shop from home by sending them a box with several items selected based on sophisticated analysis of their profile and prior purchases. The customer pays a $20 “styling fee” for the box which can be applied towards purchasing anything in the box. The company is the strong leader in the space with revenue at nearly a $2 billion run rate. The stock had a strong finish to 2020 after declining substantially earlier in the year due to Covid negatively impacting performance. This occurred despite gaining market share as people simply weren’t buying a normal amount of clothes at the onset of the pandemic. When revenue growth rebounded in the October quarter to 10% YoY and 7% sequentially the stock gained significant ground and closed the year up 129%.

Stitch Fix continues to add higher-end brands and to increase its reach into men, plus sizes and kids. Its algorithms to personalize each box of clothes it ships keeps improving. It appears to be beyond the worst days of the pandemic and expects revenue growth to return to a more normal 20-25% for fiscal 2021 (ending in July). This is partially due to easy comps in Q3 and Q4 and partly due to clothing purchase behavior improving. The company will also be a beneficiary of a number of closures of retail stores.

Assuming it is a 20-25% growth company that is slightly profitable, it still appears under-valued at roughly 3X expected Q2 annualized revenue. As a result, I continue to recommend it.

4. Amazon stock will outpace the market (it closed last year at $3257/share).

Amazon shares increased by 76% last year while revenue in Q3 was up 37% year over year (versus 21% in 2019). This meant the stock performance exceeded revenue growth as its multiple of revenue expanded in concert with the increased revenue growth rate. Net Income grew 197% YoY in the quarter as the leverage in Amazon’s model became apparent despite the company continuing to have “above normal” expenditures related to Covid. We expect the company to continue at elevated revenue and earnings growth rates in Q4 and Q1 before reaching comps with last year’s Covid quarters. Once that happens growth will begin to decline towards the 20-25% level in the latter half of 2021.

What will remain in place post-Covid is Amazon’s dominance in retail, leading share in Web Services and control of the book industry. Additionally, Amazon now has a much larger number of customers for its Food Services than prior to the pandemic. All in all, it will likely mean that the company will have another strong year in 2021 with overall growth in the 25-30% range for the year and earnings growing much faster. But remember, the degree earnings grow is completely under Amazon’s control as they often increase spend at faster rates than expected, especially in R&D.

5. Zoom Video Communications will continue to outperform the market (it closed last year at $337/share)

When I began highlighting Zoom in my post on June 24, 2019, it was a relatively unknown company. Now, it is a household name. I’d like to be able to say I predicted that, but it came as a surprise. It was the pandemic that accelerated the move to video conferencing as people wanted more “personal contact” than a normal phone call and businesses found it enhanced communications in a “work at home world”. Let me remind you what I saw in Zoom when I added it to the list last year, while adding some updated comments in bold:

  1. At the time, Revenue retention of business customers with at least 10 employees was about 140%. In Q3, FY 2021 revenue retention of business customers was still 130% despite pandemic caused layoffs.
  2. It acquires customers very efficiently with a payback period of 7 months as the host of a Zoom call invites various people to participate in the call and those who are not already Zoom users can be readily targeted by the company at little cost. Now that Zoom is a household name, acquiring customers should be even less costly.
  3. At the time, Gross Margins were over 80% and I believed they could increase. In Q3, GM had declined to 68% as usage increased dramatically and Zoom made its products available to K-12 schools for free. Given that students were all mostly attending school virtually, this is a major increase in COGs without associated revenue. When the pandemic ends gross margins should return close to historic levels – adding to Zoom profits. 
  4. The product has been rated best in class numerous times
  5. Its compression technology (the key ingredient in making video high quality) appears to have a multi-year lead over the competition
  6. Adding to those reasons I noted at the time that ZM was improving earnings and was slightly profitable in its then most recent reported quarter. With the enormous growth Zoom experienced it has moved to significant profitability and multiplied its positive cash flow.

While ZM stock appreciated 369% in 2020, it actually was about equal to its revenue growth rate in Q3 2020, meaning that the price to revenue was the same as a year earlier before despite:

  • Moving to significant profitability
    • Becoming a Household name  
    • Having a huge built-in multiplier of earnings as schools re-open

6. CrowdStrike will outperform the market (it closed 2020 at $211/share and is now at 217.93)

When I evaluate companies, one of the first criteria is whether their sector has the wind behind its back. I expect the online security industry to not only grow at an accelerated pace but also face an upheaval as more modern technology will be used to detect increased attacks from those deploying viruses, spam, intrusions and identity theft. I suspect all of you have become increasingly aware of this as virus after virus makes the news and company after company reports “breaches” into their data on customers/users.

The U.S. cyber security market was about $67 billion in 2019 and is forecast to grow to about $111 billion by 2025 (per the Business Research Company’s report). Yet Cloud Security spend remains at only about 1.1% of total Cloud IT spend (per IDC who expects that percent to more than double). CrowdStrike is the player poised to take the most advantage of the shift to the cloud and the accompanying need for best-in-class cloud security. It is the first Cloud-Native Endpoint Security platform. As such it is able to monitor over 4 trillion signals across its base of over 8500 subscription customers. The companies leading technology for modern corporate systems has led to substantial growth (86% YoY in its October quarter). It now counts among its customers 49 of the Fortune 100 and 40 of the top global 100 companies.

Tactically, the company continues to add modules to its suite of products and 61% of its customers pay for 4 or more, driving solid revenue retention. The company targets exceeding 120% of the prior year’s revenue from last year’s cohort of customers. They have succeeded in this for 8 quarters in a row through upselling customers combined with retaining 97% – 98% of them. Because of its cloud approach, growing also has helped gross margins grow from 55% in FY 18 to 66% in FY 19 to 72% in FY 20 and further up to 76% in its most recent quarter. This, combined with substantial improvement in the cost of sales and marketing (as a % of revenue) has in turn led to the company going from a -100% operating margin in Fiscal 2018 to +8% in Q3, FY21. It seems clear to me that the profit percentage will increase dramatically in FY22 given the leverage in its model.  

Non-Stock Picks for 2021

7. Online Advertising Companies will Experience a Spike in Growth in the Second Half of 2021

The pandemic hit was devastating for the travel industry, in-person events and associated ticket sellers, brick and mortar retailers and clothing brands.  Rational behavior necessitated a dramatic reduction of advertising spend for all those impacted. U.S. advertising revenue declined by 4.3% to $213 billion, or around 17% according to MagnaGlobal, if one excludes the jump in political advertising (discussed in our last post), with Global spend down 7.2%. That firm believes digital formats grew revenue about 1% in 2020 (with TV, radio and print declining more than average). Digital formats would normally be up substantially as they continue to gain share, so the way to think about this is that they experienced 10-20% less revenue than would have occurred without Covid.

Assuming things return to normal in H2 2021, digital advertising will continue to gain share, total industry revenue will be higher than it would have been without Covid (even without the increased political spending in 2020) and comps will be easy ones in H2 of 2021.  While there will not be major political spending there could be Olympic games which typically boost ad spend. So, while we removed Facebook from our 6 stock picks, it and other online players should be beneficiaries.

8. Real Estate will Show Surprising Resiliency in 2021

The story lines for Real Estate during the pandemic have been:

  1. The flight to larger outside space has caved urban pricing while driving up suburban values
  2. Commercial real estate pricing (and profits) is collapsing, creating permanent impairment in their value for property owners with post-pandemic demand expected to continue to fall

My son Matthew is a real estate guru who has consulted to cities like New York and Austin, to entities like Burning Man and is also a Professor of Real Estate Economics at NYU. I asked him to share his thoughts on the real estate market.

Both Matthew (quoted below) and I disagree with the story lines. I believe a portion of the thinking regarding commercial real estate pricing relates to the collapse of WeWork. That company, once the darling of the temporary rental space, had a broken IPO followed by a decline in value of nearly 95%. But the truth is that WeWork had a model of committing to long term leases (or purchasing property without regard to obtaining lowest cost possible) and renting monthly. Such a company has extreme risk as it is exposed to downturns in the business cycle where much of their business can disappear. Traditional commercial property owners lease for terms of 5 to 25 years, with 10-15 years being most common, thus reducing or even eliminating that risk as leases tend to be across business cycles. The one area where both Matthew and I do believe real estate could be impacted, at least temporarily, is in Suburban Malls and retail outlets where Covid has already led to acceleration of bankruptcies of retailers a trend I expect to continue (see prediction 10).

The rest of this prediction is a direct quote from Matthew (which I agree with).

“Real estate in 2021 will go down as the year that those who do not study history will be doomed to repeat it. The vastly overblown sentiments of the “death of the city” and the flight to the suburbs of households and firms will be overshadowed by the facts. 

In the residential world, while the market for rentals may have somewhat softened, no urban owners have been quick to give up their places, in fact, they turned to rent them even as they buy or rent roomier locations within the city or additional places outside the cities, driving up suburban prices more quickly. In fact, even in markets such as NYC, per square foot housing sale prices are stable or rising. US homebuilding sentiment is the highest in 35 years, with several Y/Y growth statistics breaking decades long records leading up to a recent temporary fizzle due to political turmoil. 

The commercial office world, which many decry as imminently bust due to the work at home boom, has seen a slowdown of new leases signed in some areas. But because most commercial office leases are of a 10–15-year term, a single bad year has little effect. While some landlords will give concessions today for an extended term tomorrow, their overall NPV may remain stable or even rise. In the meantime, tech giants like Amazon are gobbling up available space in the Seattle and Bellevue markets, and Facebook announced a 730,000 square foot lease in midtown Manhattan late in the year. In the end, the persistence of cities as clusters of activity that provide productivity advantages to firms and exceptional quality of life, entertainment options, restaurants and mating markets to individuals will not diminish. The story of cities is the story of pandemic after pandemic, each predicting the death of the city and each resulting in a larger, denser, more successful one. 

The big story of real estate in 2021 will be the meteoric rise of industrial, which began pre-COVID and was super charged as former in-person sales moved to online and an entire holiday season was run from “dark stores” and warehouses. The continual build out of the last mile supply chain will continue to lower the cost of entry for retailers to accelerate cheaper delivery options. This rising demand for industrial will continue the trend of the creation of “dark stores” which exist solely as shopping locations for couriers, Instacart, Whole Foods and Amazon. Industrial is on the rise and the vaccine distribution problems will only accelerate that in 2021.”

9. Large Brick and Mortar Retailers will continue their downward trend with numerous bankruptcies and acquisitions by PE Firms as consumer behavior has permanently shifted

While bankruptcies are commonplace in the retail world, 2020 saw an acceleration and there was a notable demise of several iconic B&M (Brick & Mortar) brands, including:

It is important to understand that a bankruptcy does not necessarily mean the elimination of the entity, but instead often is a reorganization that allows it to try to survive. Remember many airlines and auto manufacturers went through a bankruptcy process and then returned stronger than before. Often, as part of the process, a PE firm will buy the company out of bankruptcy or buy the brand during the bankruptcy process. For example, JC Penny filed for bankruptcy protection in May, 2020 and was later acquired by the Simon Property Group and Brookfield Property Partners in September, 2020. Nieman Marcus was able to emerge from bankruptcy protection without being acquired. However, in both cases, reorganizing meant closing numerous stores.

There are many who believe things will: “go back to normal” once the pandemic ends. I believe this could not be further from the truth as consumer behavior has been permanently impacted. During the pandemic, 150 million consumers shopped online for the first time and learned that it should now be part of how they buy. But, even more importantly, those who had shopped online previously became much more frequent purchasers as they came to rely on its advantages:

  1. Immediate accessibility to what you want (unlike out of stock issues in Brick and Mortar retail)
  2. Fast and Free shipping in most cases
  3. A more personalized experience than in store purchasing

As older Brick & Mortar brands add online shopping to their distribution strategy, most are unable to offer the same experience as online brands. For example, when you receive a package from Peloton the unboxing experience is an absolute delight, when you receive one from Amazon it is perfectly wrapped. On the other hand, I have bought products online from Nieman Marcus, an extremely high-end retailer, and the clothes seemed to be tossed into the box, were creased and somewhat unappealing when I opened the box. Additionally, a company like Amazon completely understands the importance of customer retention and its support is extraordinary, while those like Best Buy that offer online purchasing fall far of the bar set by Amazon.

What that all means is that many Brick and Mortar retailers will not solve their issues:

  • Adding more of an online push will not be enough
    • Customers that have experienced the benefits of online purchasing will continue to use it in much greater amounts than before the pandemic
    • Ecommerce will continue to take share from Brick and Mortar stores
    •  

As a result, we believe that in 2021 the strain on physical retail will continue, resulting in many more well-known (and lesser known) store chains and manufacturing brands filing for bankruptcy as the dual issues of eCommerce and of the pandemic keeping stores closed and/or operating at greatly diminished customer traction throughout most of the year. Coming on the heels of a disastrous 2020 it will be harder for many of them to even emerge from bankruptcy after reorganizing (including closing many stores). 

10. The Warriors will make the playoffs this Year

I couldn’t resist including one fun pick. We did speak about this in our last post but wanted to include it as an actual 2021 pick. Many pundits had the Warriors as dead before this season began once Klay Thompson was injured. And, of course, more piled on when the team lost its first 2 games by large margins. But they were mis-analyzing several significant factors:

  • Steph Curry is still Steph Curry at his peak no matter who the supporting cast
  • Andrew Wiggins is a superior talent who has the ability to shine on both offense and defense now that he is no longer in a sub-optimal Minnesota environment
  • Kelly Oubre Jr is also talented enough to be a great defender. His offense, while poor so far, is well above average and over the course of the season that should show well
  • Draymond Green is in his prime and remains one of the top defenders in the league. He is also a great facilitator on the offensive end of the floor.
  • James Wiseman is a phenomenon with the talent to be a star. As the season progresses, I expect him to continue to get better and become a major factor in Warrior success
  • Eric Pascal was on the all-rookie team last year and has gotten better

It is clear that the team needs more games to get Curry and Green back into peak playing condition, Wiseman to gain experience and the Warriors to become acclimated to playing together. They have started to show improved defense but still need time to develop offensive rhythm. I expect them to be a major surprise this year and make the playoffs.

SoundBytes

  • Please Wear A Mask: I recently read a terrific book describing the 1918 flu pandemic called The Great Influenza by John Barry. That pandemic was much deadlier than the current one, with estimates of the number of people it killed ranging from 35 million to 100 million when the world population was less than 25% of what it is today. What is so interesting is how much the current situation has replicated the progress of that one. One of the most important conclusions Barry draws from his extensive study of the past is that wearing a mask is a key weapon for reducing the spread.

Recap of 2020 Top Ten Predictions

Tesla’s new pickup truck due out late 2021

Bull Markets have Tended to Favor My Stock Picks

This may seem like a repeat of what you have heard from me in the past, but I enter each year with some trepidation as my favored stocks are high beta and usually had increased in value the prior year (in 2019 they were up about 46% or nearly double the S&P which also had a strong year). The fact is: I’m typically nervous that somehow my “luck” will run out. But, in 2020 I was actually pretty confident that my stock picks would perform well and would beat the market. I felt this confidence because the companies I liked were poised for another very strong growth year, had appreciated well under their growth over the prior 2-year period and were dominant players in each of their sub-sectors. Of course, no one could foresee the crazy year we would all face in 2020 as the worldwide pandemic radically changed society’s activities, purchasing behavior, and means of communication. As it turns out, of the 6 stocks I included in my top ten list 3 were beneficiaries of the pandemic, 2 were hurt by it and one was close to neutral. The pandemic beneficiaries experienced above normal revenue growth and each of the others faired reasonably well despite Covid’s impact. The market, after a major decline in March closed the year with double digit gains. Having said all that, I may never replicate my outperformance in 2020 as the 6 stocks had an average gain of an astounding 259% and every one of them outperformed the S&P gain of 14.6% quite handily.

Before reviewing each of my top ten from last year, I would like to once again reveal long term performance of the stock pick portion of the top ten list. I assume equal weighting for each stock in each year to come up with performance and then compound the yearly gains (or losses) to provide the 7-year performance. I’m comparing the S&P index at December 31 of each year to determine annual performance.  Soundbyte’s compound gain for the 7-year period is 2049% which equates to an IRR of 55.0%. The S&P was up 106.1% during the same 7-year period, an IRR of 10.9%.

2020 Non-Stock Top Ten Predictions also Impacted by Covid

The pandemic not only affected stock performance, it had serious impact on my non-stock predictions. In the extreme, my prediction regarding the Warriors 2020-2021 season essentially became moot as the season was postponed to start in late December…so had barely over a week of games in the current year! My other 3 predictions were all affected as well. I’ll discuss each after reviewing the stock picks.

The 2020 Stocks Picked to Outperform the Market (S&P 500)

  1. Tesla Stock which closed 2019 at $418/share and split 5 for 1 subsequently
  2. Facebook which closed 2019 at $205/share
  3. DocuSign which closed 2019 at $74/share
  4. Stitch Fix which closed 2019 at $25.66/share
  5. Amazon which closed 2019 at $1848/share
  6. Zoom Video Communications which closed 2019 at $72.20/share

In last year’s recap I noted 3 of my picks had “amazing performance” as they were up between 51% and 72%. That is indeed amazing in any year. However, 2020 was not “any year”. The 6 picks made 2019 gains look like chopped liver as 4 of my 6 picks were up well over 100%, a 5th was up over 70% and the last had gains of double the S&P. In the discussion below, I’ve listed in bold each of my ten predictions and give an evaluation of how I fared on each.

1. Tesla stock appreciation will continue to outperform the market (it closed last year at $418/share). Note that after the 5 for 1 split this adjusts to $84.50/share.

In 2020, Tesla provided one of the wildest rides I’ve ever seen. By all appearances, it was negatively impacted by the pandemic for three reasons: people reduced the amount they drove thereby lessening demand for buying a new vehicle, supply chains were disrupted, and Tesla’s Fremont plant was forced to be closed for seven weeks thereby limiting supply. Yet the company continued to establish itself as the dominant player in electronic, self-driving vehicles. It may have increased its lead in user software in its cars and it continued to maintain substantial advantages in battery technology. The environment was also quite favorable for a market share increase of eco-friendly vehicles.

Additionally, several other factors helped create demand for the stock. The 5 for 1 stock split, announced in August was clearly a factor in a 75% gain over a 3-week period. Inclusion in the S&P 500 helped cause an additional spike in the latter part of the year. Tesla expanded its product line into 2 new categories by launching the Model Y, a compact SUV, to rave reviews and demonstrating its planned pickup truck (due in late 2021) as well. While the truck demo had some snags, orders for it (with a small deposit) are currently over 650,000 units.

All in all, these factors led to Tesla closing the year at $706/share, post-split, an astounding gain of 744% making this the largest one year gain I’ve had in the 7 years of Soundbytes.

2. Facebook Stock will outpace the market (it closed 2019 at $205 per share)

Facebook was one of the companies that was hurt by the pandemic as major categories of advertising essentially disappeared for months. Among these were live events of any kind and associated ticketing company advertising, airlines and cruise lines, off-line retail, hotels, and much more. Combine this with the company’s continued issues with regulatory bodies, its stock faced an uphill battle in 2020. What enabled it to close the year at $273 per share, up 33% (over 2x the S&P), is that its valuation remains low by straight financial metrics.

3. DocuSign stock appreciation will continue to outperform the market (it closed 2019 at $74/share)

DocuSign was another beneficiary of the pandemic as it helped speed the use of eSignature technology. The acceleration boosted revenue growth to 53% YoY in Q3, 2021 (the quarter ended on October 31, 2020) from 39% in Fiscal 2020.  Since growth typically declines for high-growth companies this was significant. Investors also seemed to agree with me that the company would not lose the gains when the pandemic ends. Further, DocuSign expanded its product range into contract life-cycle management and several other categories thereby growing its TAM (total available market). Despite increased usage, DocuSign COGs did not rise (Gross Margin was 79% in Q3). Finally, competition appeared to weaken as its biggest competitor, Adobe, lost considerable ground. This all led to a sizable stock gain of 200% to $222/share at year end.

4. Stitch Fix stock appreciation will continue to outperform the market (it closed 2019 at $25.66/share)

Stitch Fix had a roller coaster year mostly due to the pandemic driving people to work from home, which led to a decline in purchasing of clothes. I’m guessing many of you, like me, wear jeans and a fleece or sweatshirt most days so our need for new clothes is reduced. This caused Stitch Fix to have negative growth earlier in the year and for its stock to drop in price over 50% by early April. But, the other side of the equation is that brick and mortar stores lost meaningful share to eMerchants like Stitch Fix. So, in the October quarter, Stitch Fix returned to growth after 2 weak quarters caused by the pandemic. The growth of revenue at 10% YoY was below their pre-pandemic level but represented a dramatic turn in its fortunes. Additionally, the CEO guided to 20-25% growth going forward. The stock reacted very positively and closed the year at $58.72/share up 129% for the year.

5. Amazon stock strategy will outpace the market (it closed last year at $1848/share)

Amazon had a banner year in 2020 with a jump in growth driven by the pandemic. Net sales grew 37% YoY in Q3 as compared to an approximate 20% level, pre-pandemic. Their gains were in every category and every geography but certainly eCommerce led the way as consumers shifted more of their buying to the web. Of course, such a shift also meant increased growth for AWS as well. Net Income in Q3 was up 197% YoY to over $6.3 billion. Given the increase in its growth rate and strong earnings the stock performed quite well in 2020 and was up 76% to $3257/share.

In our post we also recommended selling puts with a strike price of $1750 as an augmented strategy to boost returns. Had someone done that the return would have increased to 89%. For the purposes of blog performance, I will continue to use the stock price increase for performance. Regardless, this pick was another winner.

6. I added Zoom Media to the list of recommended stocks. It closed 2019 at $72.20

When I put Zoom on my list of recommended stocks, I had no idea we’d be going through a pandemic that would turn it into a household name. Instead, I was confident that the migration from audio calls to video conference calls would continue to accelerate and Zoom has the best product and pricing in the category. For its fiscal 2020-year (ending in January, 2020) Zoom grew revenue 78% with the final sequential quarter of the year growth at 13.0%. Once the pandemic hit, Zoom sales accelerated greatly with the April quarter up 74% sequentially and 169% YoY. The April quarter only had 5 weeks of pandemic benefit. The July quarter had a full 3 months of benefit and increased an astounding 102% sequentially and 355% YoY.  Q3, the October quarter continued the upward trend but now had a full quarter of the pandemic as a sequential compare. So, while the YoY growth was 367%, the sequential quarterly growth began to normalize. At over 17% it still exceeded what it was averaging for the quarters preceding the pandemic but was a disappointment to investors and the stock has been trading off since reporting Q3 numbers. Regardless of the pullback, the stock is ahead 369% in 2020, closing the year at $337/share .

In the post we also outlined a strategy that combined selling both put and call options with purchasing the stock. Later in the year we pointed out that buying back the calls and selling the stock made sense mid-year if one wanted to maximize IRR. If one had followed the strategy (including the buyback we suggested) the return would still have been well over a 100% IRR but clearly lower than the return without the options. As with Amazon, for blog performance, we are only focused on the straight stock strategy. And this recommendation turned out to be stellar.

Unusual Year for the Non-Stock Predictions

7. The major election year will cause a substantial increase in advertising dollars spent

This forecast proved quite valid. Michael Bloomberg alone spent over $1 billion during his primary run. The Center for Responsive Politics reported that they projected just under $11 billion in spending would take place between candidates for president, the Senate and the House in the general election. This was about 50% higher than in 2016. Additionally, there will be incremental dollars devoted to the runoff Senate races in Georgia. This increase helped advertising companies offset some of the lost revenue discussed above.

8. Automation of Retail will continue to gain momentum

Given the pandemic, most projects were suspended so this did not take place. And it may be a while before we have enough normalization for this trend to resume, but I am confident it will. However, the pandemic also caused an acceleration in eCommerce for brick and mortar supermarkets and restaurants. I’m guessing almost everyone reading this post has increased their use of one or more of: Instacart, Amazon Fresh, Walmart delivery, Safeway delivery, Uber Eats, GrubHub, Doordash, etc. My wife and I even started ordering specialty foods (like lox) from New York through either Goldbelly or Zabars. Restaurants that would not have dreamed of focusing on takeout through eCommerce are now immersed in it. While this was not the automation that I had contemplated it still represents a radical change.

9. The Warriors will come back strong in the 2020/2021 season

This was my fun prediction. Unfortunately, the combination of injuries and Covid eliminated fun for sports fans. I expected that there would be enough games in 2020 to evaluate whether my forecast was correct or not. Since the season started in late December its premature to evaluate it. Also, I pointed out that the team had to stay relatively healthy for the prediction to work. Guess what? The Warriors have already had 2 devastating injuries (Thompson the critical one, and Chriss, who I expected would help the second team as well).

Yet, several things I predicted in the post have occurred:

  1. The younger players did develop last season, especially Pascal
  2.  The Warriors did get a very high draft choice and at first blush he seems like a winner
  3. The Warriors did use the Iguodala cap space to sign a strong veteran, Oubre.

Given the absence of Thompson, the team will be successful if they make the playoffs. So, let’s suspend evaluating the forecast to see if that occurs in a packed Western Conference despite losing Thompson. Last year they started 4 and 16. For the 2020-2021 season  (as of January 3) they are 3 and 3 and appear to be a much better team that needs time to jell. But the jury is out as to how good (or bad) they will be. 

10. At least one of the major Unicorns will be acquired by a larger player

There were 9 Unicorns listed in the post. Eight are still going at it by themselves but the 9th, Slack, has recently been acquired by SalesForce making this an accurate prediction.

2021 Predictions coming soon

Stay tuned for my top ten predictions for 2021… but please note most of the 6 stocks from 2020 will continue on the list and as usual, for these stocks, we will use their 2020 closing prices as the start price for 2021. For any new stock we add, we will use the price of the stock as we are writing the post.

Soundbytes

I thought I would share something I saw elsewhere regarding New Year’s wishes. In the past most people wished for things like success for themselves and/or family members in one form or another. The pandemic has even transformed this. Today, I believe most people are more focused on wishing for health for them, their family, friends, and an end to this terrible pandemic. Please take care of yourselves, stay safe. We are getting closer to the end as vaccines are here and will get rolled out to all of us over the next 4-6 months.

My approach on public market investing

I have always taken a research driven, multi-pronged approach to identifying attractive publicly traded equity investments, and after reflecting on this approach with a new fund that I am starting, I figured that it would make for an interesting blog post to share this with a broader audience. The companies that I have covered through previous blog posts have been identified through this process. As you likely know if you made some investments based off of my suggestions in the past, they have performed very well!

My Screening Process

I begin with a screening process as follows:

  1. Discover trends that are disruptive to entrenched market participants, expected to continue for over five years, and relate to very large markets
  2. Identify companies that are strong beneficiaries of these trends; and
  3. Evaluate these companies’ competitive advantages that stem from one or more of:
    • superior technology often protected by patents,
    • strong emerging brand,
    • network effect of having built a massive connected audience,
    • high quality leadership,
    • products that are very difficult to replicate, and/or
    • advantageous business model

Companies are identified that pass the above screening. Then I apply a filter to reduce these matches to ones that also are already generating or have an ability to generate strong profits. I believe that the most important metric to evaluate companies that have yet to develop mature business models is contribution margin, i.e.: gross margin minus customer acquisition cost. We have covered contribution margin in past blog posts. Check our post in January 2020 which contains our discussion of sophisticated valuation methodology for more background on how I see this as a key metric for evaluating business models.

Companies passing the above screen are rare and, thus, are both difficult and time-consuming to identify. Each company selected from those that passed the screening will also need to have well above average revenue growth for their respective stages.

My experience indicates that great returns will be realized over a long period of time from companies that have the key attributes described above and, therefore, I expect, generally, to hold the core of each of my positions for an average period of five years or more. This doesn’t mean never selling any shares, but rather holding the majority of shares for that period. I augment my equity investments in portfolio companies by writing both call and put options or other derivatives (we covered an example of this recently with Zoom in my 2020 predictions). Doing this hedges risk of short-term market fluctuation and generates income from option premiums going to zero over the life of the option. Given my concentration on relatively few securities of high growth companies, it is expected that volatility in my portfolio could often exceed that of the overall market. Therefore, I believe it’s important to avoid margin borrowing as this would increase risk and volatility beyond what I think is an acceptable level.

Applying the Strategy to Investing

The first step in my strategy is to identify longer term trends that are disruptive to entrenched leaders of large markets. I believe the following qualify:

  1. Growth of eCommerce: Online purchasing will gain share for another 10 years or more
  2. Shift of services from physical, in-person to virtual: This reduces cost and adds convenience and should persist for many years
  3. Use of video conferencing in place of older audio conferencing: Will continue to further penetrate businesses and also emerge as a “must have” for individual households
  4. Online advertising: It will continue to gain share from other forms as it allows for more precise measurement of effectiveness and promotes immediate ability to purchase
  5. Shift from old generation autos to eco-friendlier (i.e. electric) with software capabilities tightly integrated: It is in its early stages and will gain increasing traction for several decades to come
  6. The entire online security industry will not only grow at an accelerated pace but also face an upheaval as more modern technology will be used to detect increased attacks from those deploying viruses, spam, intrusions and identity theft
  7. Web Services will continue to experience double digit growth: Since its directly tied to Internet traffic driven by increased eCommerce, escalation of video, social and virtual services

Several companies that I have selected (and outlined in the past) benefit from more than one of the 7 identified trends and all are one of the dominant players in their particular arena. It should be noted that the arena may be more specific than the trend.

For example, Online advertising has distinct leaders in overall social (Facebook), search advertising (Google), Visual advertising (Pinterest), eCommerce ads (Amazon) and programmatic (The Trade Desk). So, while these 5 companies compete for advertising budget, they each are the dominant brands in their sub-sector with massive networks of users that are difficult to replicate.

Picking the winners

In the first section of this blog, I highlighted six different types of competitive advantages I look for. The companies that I have recently invested in have three or more of these advantages, and on average qualifies for roughly 4.5. On the leadership side not only do all have very strong leadership but virtually all are led by their founder who is an early innovator in their sector.

One other major consideration recently has been the impact of the pandemic. There are three companies that I have previously covered in the blog that I feel benefit strongly: Amazon, DocuSign, and Zoom. Both Peloton and Shopify would be major additional beneficiaries. When the pandemic ends there is widespread views on how such companies will be impacted. On the one hand, many analysts believe some or all of these will experience a reduction in revenue against strong comps. Others, including myself, think that behavior has changed, so while massive growth experienced during the pandemic won’t be replicated, most, if not all of them will continue to grow at a more “normal” rate. The four advertising companies I mentioned previously: Facebook, Google, Pinterest and The Trade Desk have all been impacted by the loss of advertising from major business segments like travel, live events (and associated ticket sellers) and brick and mortar retail. Since Amazon advertising revenue is limited to online sellers it is not affected by loss of ads from these sectors. My expectation is that when the Shelter-in-Place requirements are substantially eased, all four of these companies will experience a jump in advertising revenue. As we reach April of 2021 this jump will be compared to depressed comps and all four should experience above normal growth.

Of companies that are in my 2020 stock pics, surprisingly, Tesla has appreciated well over 600% despite its revenue being lower than pre-pandemic expectations. I believe this is mostly because of the certain shift taking place towards software enabled electronic cars but the stock has also been helped by inclusion in the S&P index. The other company negatively impacted by the pandemic is Stitch Fix. On the one hand, it has undoubtedly gained share as it offers a modern online method of shopping to its very large base of customers, but it is also obvious that people are just not buying that many items of clothes during the pandemic. I expected Stitch Fix to be a substantial beneficiary when Shelter-in-Place is eased, but the market is already anticipating this as we’ve seen it’s begin year value of $25.66, which fell dramatically earlier in the pandemic, rebound nicely to a price of $69 in December 2020…a 170% appreciation year-to-date.

I have also been examining several companies that had recently IPO’d as younger public companies tend to have higher growth rates which in turn creates greater potential future appreciation. So, I considered the various companies that had come public in 2019 to see which ones met my screens. Investing in Lyft and Uber, post IPO, had little interest for me. On the positive side, Lyft revenue growth was 95% in Q1, 2019, but it had a negative contribution margin in 2018 and Q1 2019. Uber’s growth was a much lower 20% in Q1, but it appeared to have slightly better contribution margin than Lyft, possibly even as high as 5%. I expected Uber and Lyft to improve their contribution margin, but it is difficult to see either of them delivering a reasonable level of profitability in the near term as scaling revenue does not help profitability until contribution margin improves. So, I passed on both which proved the right decision as Lyft is still well below the first day’s closing price of $78.29 post-IPO. Uber is now up 27% vs its first day closing price (roughly the same as the S&P index) as food delivery has proven a great business for them during the pandemic. The first of the 2019 IPO class that I bought was Zoom Video, which had a contribution margin of roughly 25% coupled with over 100% revenue growth. It also seemed on the verge of moving to profitability. Four others piqued my interest: Pinterest, Peloton, Slack and CrowdStrike. All of these were growing revenue at a 40% or higher rate, had solid business models and met my other criteria. I’ll discuss these in more detail in my following posts but, on average, they are up well over 300% this year …stay tuned for my 2021 predictions!

A Counter Theory to Potential Recession (during week 26 of Shelter in Place)

Consumers have more money available to spend – not less

Much of the public dialogue concerning the economic effect of Covid19 has centered around the large number of people who have lost income, with the conclusion that the US will potentially experience a continued recession going forward. What seems to be lost in the discussion is that the 90% of the labor force that is employed is saving money at an unprecedented rate. This has occurred partly through fear of future loss of income but mostly by a reduction in spending caused by the virus. For myself and my family, our spending has been involuntarily reduced in the following areas:

  1. Personal care: haircuts, beauty parlor, nail treatments, massages, etc.
  2. Cleaning services: we are wearing very casual clothes that get washed instead of going to the cleaner (who has mostly been unavailable anyway).
  3. Vacations: our last vacation was in December. We haven’t been on a plane since the pandemic started and cancelled two vacation trips.
  4. Purchasing clothes: I have bought some items online for future use (because they were at major discounts) but being at home means I don’t really need any new clothes.
  5. Restaurants: before the pandemic I was eating breakfast and lunch out every weekday at or near my office and my wife and I ate out lunch and dinner on weekends. Additionally, I normally have additional business dinners several times a month. Instead, we are ordering food in on weekends from local restaurants we wish to support, but the cost is much lower than when we ate at the restaurant. Many of the people we know haven’t even ordered in from a restaurant.
  6. Transportation: these expenses have been virtually eliminated as I am not commuting to my office, take no Ubers and rarely drive anywhere other than to pick up local takeout food.
  7. Entertainment: such expenses have been close to eliminated other than occasionally purchasing a movie for home consumption.
  8. Medical/Dental/Optical Services: In my case medical and dental expenses have remained the same but many others have seen them reduced as access to doctors and dentists has been curtailed.

The only expenses that have increased are paying for delivery of food instead of picking it up ourselves at a supermarket and our new Zoom subscription…but at $12/month that hardly counts. I believe my family is representative of the 90% of people who still have their jobs at no reduction of pay.  In fact, according to Statista, the savings rate in March through June increased to an average of 22% versus 7.9% in 2019. Using this data, I estimate that by the end of August this amounted to approximately $1.2 trillion in above normal savings as compared to last year’s “normal” savings rate. Since stay at home is unlikely to end in many places by the end of August, this number is likely to grow.

Post Pandemic: will some areas of savings persist?

Survey data of companies indicates that there is likely to be an increase in the number of people who work from home once the pandemic ends A recent survey by Global Workplace Analytics estimates that the U.S. will see between 25-30% of the workforce working from home multiple days a week by the end of 2021, up from less than 5% who were working from home at least half-time or more before the pandemic. Since working from home will continue to offer some savings in spending this could add to the “pot” of available dollars to be redeployed. There also may be some people who remain reluctant to fly or go on a cruise. We don’t expect these incremental cost savings to be removed from commerce but rather to be redeployed.

What I believe will occur post-pandemic

While some people will take advantage of their lower cost during the pandemic to pad their savings, it seems likely to me that a substantial portion of the “above normal” accumulated savings will be spent. I believe that such spending will be divided between satisfying pent up demand for items like clothing and vacations and new demand for luxury items. The pent-up demand will start with numerous parties as people are able to once again have human contact, but it also is likely to consist of increased purchases of clothes, more visits to restaurants and rescheduling of missed vacations.

I think that some portion of these savings will also be used on furniture (and perhaps even full remodels), art, and increased purchases of luxury items. After all, people can easily feel they deserve a reward for all these months of suffering. It is apparent that many people are already adding to their online budgets for furniture, décor and art as Wayfair has seen a large spike in revenue. While Wayfair results may be due to increased marketing spend, Azure portfolio company Chairish, has also had a very large spike in revenue without such an increase in marketing.

Has the pandemic caused temporary changes in buying habits or merely accelerated trends that were already in place?

The pandemic caused a number of radical changes in behavior, including:

  1. Most people working from home and rarely, if ever, going to their office.
  2. The vast majority of people ordering almost everything online instead of visiting a store.
  3. Shifting to video calls with coworkers, friends and relatives as opposed to regular phone calls or face to face interactions.
  4. Working out at home instead of at a gym, where possible.
  5. Education moving to at home via Zoom.

These shifts favored eCommerce sites, delivery services, providers of video conferencing, home equipment providers, Telemedicine, web services providers, and many others. They devastated physical stores, especially large department stores, restaurants, local transportation services (like subway systems, busses, ride services), service providers like cleaners, beauty parlors, spas, and gyms, airlines, hotels, theaters and arenas, and sports leagues (including college sports). There was also a lesser negative secondary impact on the advertising and marketing sectors as companies with major demand losses curtailed their spend.

How Ya Gonna Keep ‘em Down on the Farm After They’ve Seen Paree?

This was a song in the aftermath of World War I highlighting the fact that farm boys, once experiencing a more sophisticated life and culture would find it hard to return to their old way of life. It could not be more appropriate for the current situation. The leap in how much nearly everyone in society is using eCommerce, video conferencing, schooling and working at home is accelerating trends that were already in place. In fact, for me:

  • Phone calls to friends that used to be audio calls are often Zoom video calls;
  • While my wife and I already were buying a great deal online, its now pretty much everything and when the pandemic ends our portion of purchases online will remain at an elevated level given the convenience and the availability of a larger choice of items
  • While I already had a home gym, many others are now substituting this for a gym membership
  • In the 25+ weeks I’ve been “sheltering in place” I visited my Menlo office for 2-3 hours on about 5 separate occasions. While I look forward to more in person meetings once we are back to normal, working at home is an option that I expect to continue to use with some frequency once the pandemic ends. I also believe that several Azure portfolio companies can reduce the number of in-person board meetings by alternating them with Zoom board meetings.

I honestly find it hard to believe that our society will not shift behavior in the same way as my wife, myself and companies in the Azure portfolio. After all, while most of us have suffered from lack of interaction with others, the pandemic has introduced many shifts that people find positive. With this, and keeping the larger available funds mentioned earlier in mind, here are some of my post pandemic predictions:

  1. Ecommerce share of the consumer wallet will be much higher than before Covid, but not as high as currently.
  2. Consumer spending for the near term will grow to a much larger amount than pre-pandemic days (by perhaps as much as 15-20%).
  3. Online Advertising Companies will have a banner year in 2021 as Ad spending resumes for industries that were impacted by Stay at Home. These include airlines, cruise lines, hotels, live events (sports, concerts, etc.), ticket sellers, physical retailers. As their spend resumes, players like Facebook, Google, Pinterest, Twitter and Snapchat will have elevated revenue versus comps from the depressed 2020 numbers.
  4. Video calls will INCREASE SHARE even compared to during the pandemic as the people who have experienced its benefits will find it hard to go back to plain audio, companies will see the economics of reducing travel by increasing the number of video meetings and about 25-30% of the workforce will continue to spend 2 or more days working at home. Additionally, companies will be more comfortable hiring IT staff in less expensive locations as they have seen the effectiveness of video vs in-person communication, and some colleges that previously only offered in-person education will augment their income by adding students that are taught remotely using video conferencing.
  5. Home remodels will have a renaissance from simply buying a new couch to completely redoing rooms or even the entire house.
  6. Suburban homes will increase in value (this appears to be already happening) as people value having outside space in case of a pandemic recurrence.
  7. Working from home will be at an elevated level vs pre-Covid but demand for office space will resume as workplaces will require more space per employee.
  8. More shopping malls will close as Big Box retailers close more stores (or in some cases cease to exist).
  9. The ability to sign and even notarize documents using the web will continue to see high growth in demand
  10. Vacations will resume, but for about a year or more there will be an increase in driving vacations
  11. More people than pre-Covid will take to wearing masks on a regular basis
  12. There will be a one year above normal bump in purchasing of luxury items like more expensive cars, expensive watches, new state of the art TVs

The Stock Market is already at Least Partly Discounting a Number of the Above Items

Many have been surprised at the resilience of the stock market during this crisis. It is important to remember that the Market discounts future results rather than past ones. So, I believe, many investors are looking at some of the above and factoring it into how to value stocks. The trickier issues involve stocks that have been beneficiaries of the pandemic but I’ll leave that for another time.

Soundbytes

  • In our January post of the top ten for the year we included Zoom as a stock buy in 2 ways. One was to simply buy the stock and the other was to buy the stock and sell both calls and puts. By June 30 the stock was at $253.54 per share and the call options (with a strike price of $80) was at $175 per share. Since the option premium was down to sub $2, I would have bought back the stock and the call options as there was little benefit to letting them ride as the IRR could not increase. But since I didn’t publish that then we can just assume I did that on September 1 where the premium was down to about $0.50. I can also buy back the puts at $0.40. That would mean I initially spent a net of $50.70 and received back $79.10, 8 months later. This translates to an annualized IRR of about 100% (on June 30 it would have been over 120%). Make no mistake, if you bought the stock and did not sell calls, I would continue to hold it as I expect another very strong (above analyst consensus forecast) quarter in Q3 which will be reported in early December.

Week Seven of Sheltering in Place

As hard as it would have been to believe back in the olden days (like in February) my wife and I are now in the 7th week of “Sheltering in Place” and it has just been extended another 4 weeks. The questions constantly being discussed among my colleagues, friends and family are:

  1. How long will this last?
  2. What will life be like at the beginning of the end of this initiative?
  3. When will things go back to normal?
  4. Who will the Warriors draft with their high pick this year (OK not everyone brings this one up)?

I’m not going to try to answer any of these as I’m sure you are all bombarded with potential answers and there are many who know more than I do regarding a pandemic. In this post I’ll try to grapple with 3 different questions, each of which deserves a section below.

Question 1: How will the long-term ramifications of Covid-19 impact success for companies and what can they do to enhance their opportunity?

This is a long-winded question and will get a long-winded answer. To begin, I believe this will only accelerate several trends that are already in place: online commerce gaining share, the use of video conferencing and the virtual workplace, as well as increased emphasis of companies being economically efficient. The pandemic has forced most people to be much more cautious at venturing out to accomplish such everyday tasks as shopping, eating in restaurants and going to the movies. Instead, they are learning that almost everything can be bought online (including food from some top restaurants), conferencing with Zoom provides a great experience at a low cost, and business efficiency will be correlated with survival.

My wife and I have long been online shoppers but as we shelter at home, we have increased the volume of purchases quite significantly. Department stores that were previously experiencing loss of share to online merchants but were resistant to devoting sufficient effort to their own online stores are in deep trouble. It appears likely that a number of well-known and not so well-known retailers will file for bankruptcy within the next few months. The combination of people becoming more comfortable with buying just about everything online and a major reduction in the number of physical outlets will open up more share for online players and for the online stores of multi-channel merchants.

During the current environment my board meetings (as well as everyone else’s) are being held as Zoom conference calls. For many companies, having such a meeting eliminates travel and hotel expenses for employees, board members and advisors. Replacing this with a Zoom conference call can mean lowering the cost to hundreds of dollars, from tens to hundreds of thousands of dollars, per meeting. While I am a big fan of the value of face to face, many companies will be re-evaluating whether having more of their meetings through video conferencing makes sense in an era when the technology has emerged as very viable and extremely cost effective. I’m not suggesting that all board meeting will be executed as video conference calls as face-face remains important, but perhaps companies will decide to do half of their meetings as a Zoom call. An interesting example is the NFL draft, where it was conducted through use of Zoom instead of renting a large stadium and paying for  travel expenses. Reviews have suggested that it was actually a better event than the prior year. I suspect the cost savings between all parties involved ran into the millions of dollars.

For many companies the pandemic has weakened revenue, putting pressure on survival. The government “bailout” PPP program helps, but by itself can prove insufficient to prop up companies with weak business models unless they have a very large cash reserve. The investment community was already shifting to focus more on efficient business models prior to Covid-19 but its disruption has helped to highlight the importance of building a profitable business.

Question 2: What should Companies do in the current environment?

What Azure has been suggesting for its portfolio companies is the following series of steps:

  1. If you are eligible, apply for government assistance through the PPP, SBA emergency loan or other programs.
  2. Create multiple models for your business under different scenarios (different dates that people will be back to normal, whether consumer spending will be reduced even after being back, whether customers will delay payments, etc.)
  3. If one or more of credible scenarios indicate that you will run out of cash, then cut costs as quickly as possible. For employees making over $100,000 per year (including founders) cutting them back to some amount that is still at $100,000 or more will have no impact on the forgiveness offered on the PPP loan.
  4. Make every attempt to extend any bank lines coming due as banks have been asked to cooperate with their customers.
  5. If you can afford it, be as kind as possible to your customers by extending terms, etc. Not all, but many, will remember your help and repay you with increased loyalty.
  6. While advertising seems an easy area to cut costs, make sure you evaluate the payback period for customer acquisition marketing as costs may be lower and online conversion may be higher (we have seen that with a number of our companies). In fact, if the payback is reasonably quick it may pay to play offense by being aggressive!
  7. If you have a strong cash position it may be a time to consider acquisitions as many companies will be struggling.
  8. If you have a product that customers are opting to purchase in this environment, think about trying to convert as many as possible to a subscription so that you can extend the relationship beyond the current situation. This can be done by offering attractive discounts for signing up for one or more years rather than month to month. For example, Zoom offers 2 months free if you opt for an annual plan versus a monthly plan. My wife and I decided the cost savings made it worth signing up for a full year.

Question 3: Who are the current and longer-term winners and losers as a result of Covid-19?

Winners

The biggest winners appear to be those that can leverage working at home, educating at home, buying at home, supplying infrastructure for increased online usage, and supplying products for increased cleanliness of surfaces and one’s self. In the public markets, I fortunately have 3 of my annual Blog recommendations included in these categories:

  • Zoom is the most obvious example of a beneficiary of people working and educating at home. It has reported that daily usage is up an astounding 30X between December and April. Its stock performance is just as astounding, up well over 100% year to date from the time of my pick in early January. The question for the company is whether they can harness this to make us permanently change how we communicate. For my wife and I, the number of Zoom calls we are on is now running between 5 and 10 per week. When I add my business calls the number is quite a bit higher. As they say: “How ya gonna keep ’em down on the farm after they’ve seen Paree?” That is, we are permanent customers as are many of our friends and colleagues.

 

  • DocuSign is another of my blog picks that should benefit in both the near term and longer term from the impact of the virus and sheltering at home. Its stock reflects higher expectation as it has increased in value by 41% year-to-date. If more meetings are going to be virtual then more documents will require esignatures and DocuSign is the runaway leader in the category

 

  • There are many other pure play beneficiaries of a future where more people entertain themselves, work and educate at home. This includes Netflix (stock up over 25%) who has seen a large spike in usage, Slack (stock up 30% since January 27), and online educational plays (our former company Education.com has seen a large spike in traffic and revenue as has our existing portfolio company Showbie)

 

  • Amazon is the poster child for purchasing online. It has announced hiring of 175,000 employees for increased warehouse and logistics operations which Wall Street interpreted as a massive increase in demand driving the stock to new highs (its currently up over 25% YTD). It should also benefit from increased purchases of eBooks and increased online usage of its Web Services (I haven’t seen much chatter about AWS benefit but it should be very large and is highly profitable). Azure portfolio company, Open Road is seeing a significant increase in its sales of eBooks since sheltering-at-home began.

 

  • Infrastructure Companies whose revenue varies with web usage should also benefit as volumes are increasing massively: Zoom announced that daily usage is up 3,000%; many others I’ve heard have ranged from 50% to 700% or more. Schools are converting to online classes with student usage increasing to 4-7 hours per day. Gaming companies are also beneficiaries and users. I believe that total web traffic is up at least 50% and perhaps a lot more versus where it would have been.

 

  • Clorox is one of the major beneficiaries of our new emphasis on cleanliness through disinfecting our environment and washing our hands many times a day, as recommended by the new folk hero Dr. Fauci. While its stock is up 20% year-to-date, the question is whether the increased demand for disinfectants is a permanent change. I’m guessing that increased usage is permanent… but not to the extent we are seeing today.

Long-Term Losers

Losers span several industries and the question for many of the companies in these industries is how permanent the loss of demand will be. Let’s look at them sector by sector.

  • Department Stores are currently shut down in most of the United States. Companies already struggling are now experiencing substantial losses every week. Those that have a pharmacy or grocery area (like Walmart) can stay open, but the real key to reducing the losses is the effectiveness of their online offering. In most cases this is pretty weak, both in percentage of the retailer’s sales and the level of profitability given inefficient distribution and high levels of returns. I expect multiple brand name players to file for bankruptcy before the year is over.

 

  • The Travel Industry is being hit very hard by the shelter-in-place requirements. Airlines are flying planes that are nearly empty but trying to maintain their cash by not cancelling flights until close to the date of departure so that passengers cancelling will get credits rather than rebates. One hotel I spoke to when cancelling my reservation told me that occupancy was down 90%. Many have already closed their properties. While I expect business to improve greatly for both of these arenas when we are back to normal, they are both accumulating massive losses which might pressure viability. Further, when we are back to normal (whatever that becomes) I suspect that airline traffic will be down through at least mid-2021 as fears are elevated and will take some time to subside. Cruise lines may be in worse shape as the publicity around the various ships that had large portions of passengers and crew get Covid-19 has definitely caused many to reconsider vacationing this way. I expect this sector to be impacted at least through the end of 2021. Also, cruises have had to refund most fares as opposed to providing a credit for future travel.

 

  • Arena Entertainment providers and entertainers have been hurt badly by the closure of their venues during this time period. This includes movie theaters as well as complexes like the Chase Center and other arenas. The question becomes when will they be able to be open for full occupancy? And when they are will people stay away for some time. I expect many of them to be at full occupancy by early 2021 as younger people (who make up the majority who attend concerts) will drive renewal of demand for concerts.

Short-term Losers that can Return to Success

  • Advertising Platforms (TV, Web, etc) have seen demand drop as the travel industry, live events and brick and mortar retailers have little reason to maintain prior spending. Additionally, those companies looking to cut cost view advertising (especially brand building advertising) as a prime candidate for cuts. However, I believe that demand will return to normal as stores reopen and travel is permitted. As of now this appears to be sometime in Q3. While many companies in sectors that take longer to return to normal will still have reduced budgets, online players will likely increase spend, as will those seeing this as an opportunity to gain share.

 

  • The Sports Industry consists of teams, leagues, arenas, ticket sellers (like Stubhub), equipment providers and betting. All of these are experiencing close to zero revenue (with the exception of some equipment being sold for home use). Leagues (and teams) with large TV contracts are likely to reinitiate games without live audiences by July as participants can be restricted to those having tested for no virus immediately before a game. Even without an audience the TV money will make this profitable to do. Once these are back in play, betting will resume. Equipment providers can still sell T-shirts and other paraphernalia online, but once games resume their sales will increase. By as early as the fall, but no later than early 2021, I expect that many states will allow live audiences for games and that arenas will be back to normal capacity for them. This would allow ticket sellers and sports betting to be at normal capacity. Equipment suppliers also depend on school purchases as well as little league, etc. So, while revenue will begin growing in the fall it may not be back to normal before early 2021.  A noted exception will be providers of at home equipment, like Peloton, which will lose business from gyms in the short run but should see a large increase in at-home purchases.

 

  • Non-Internet Service Providers (other than delivery services) have a particularly hard time as physical services cannot be provided online. Things like the Geek Squad, physician checkups and procedures, elective surgeries, automotive services, personal care like haircuts and manicures, massages, and more have been suspended. But as long as the entities survive this period, I believe there will be no permanent impairment of their businesses.

 

Conclusion

Coming back to where this post began, I’m still wondering who the Warriors will draft! But more importantly, I hope all of you and your families are safe and healthy. We will get through this!

Random Thoughts as I Shelter in Place

This post will be more of a stream of consciousness rather than one of focus on a topic.

Sheltering in Place

My wife, Michelle, and I have obeyed the order to “shelter in place” by staying at home except for walks outside (avoiding going within 6 feet of anyone). The order started in San Mateo County at 12:01 AM on March 17.  Our last time being in close proximity with anyone was Friday March 13, so we’re getting close to knowing we are virus free. We stocked up on food a day before the order began and have already had one “Instacart” delivery as well. Not sure what you are all doing but we have called a number of family members and friends to make sure they are ok – times like this make you want to verify the health of others! We also had to cancel vacation plans – which happened in steps as fear of the virus increased. We had scheduled a trip that included visiting Cabo followed by some time with good friends/cousins in Arizona.

I was scheduled to have my annual checkup before the trip, but 2 days before my doctor called to tell me not to come. It seems that the building he is located in is a center for virus testing and he thought it made no sense to have unneeded exposure. During the course of the conversation I mentioned we would be leaving for Cabo on Thursday, March 19 and he immediately warned me not to go. While I don’t want to be compared to the premier of Italy who initially told people to ignore the risk, at the time I felt the risk was overblown (as long as I was careful in Cabo). My doctor made an impossible to refute point saying: “What if you couldn’t get back because of a lockdown. Wouldn’t you rather be in the vicinity of Stanford Hospital if anything happened instead of in Mexico?” Hard to argue with that, so we decided to fly directly to Arizona instead. As flying became a risky option, we next thought we might drive to Arizona. Finally, we decided it was best to postpone the vacation. I’m guessing some of you went through a similar gradual awakening to the degree of risk.

Still Partying

Michelle and I truly enjoy the company of others. Staying at home precludes that, at least in the normal way…but then Zoom came to the rescue! We have had two “Zoom cocktail parties.” The first was more formal so everyone dressed up (I wore a wild Shinesty tuxedo and Michelle a matching outfit). Each couple at this virtual party had their drink of choice in front of them as well as appetizers. A few days later, Michelle and I hosted a similar party after becoming paying subscribers for Zoom. At our party we asked people to dress business casual. The benefit of requiring some higher level of dress than jeans is that it makes one feel (almost) like they are out partying.  Each party lasted a little over one hour and the conversation was pretty lively. Of course, the first 10-15 minutes were all about the impact of the virus, but then the conversation rotated through a number of less depressing subjects.

We now have been invited to a virtual dinner party by the first group host and we are planning a winery hosted party for the second group. Not sure, but in all likelihood, we’ll also work on setting up a third group. If we are still in this situation when Passover arrives, we will have our traditional seder (for 20 people) via Zoom.

 

Our Crossword Puzzle Tradition Continues

My family has been jointly solving the NY Times crossword puzzles for many years. More recently our grandson has not only joined in but become pretty prolific. On a typical Sunday we meet our daughter, son-in-law and their two kids for brunch and do the famous NY Times Sunday puzzle. If our son is in town, he also joins us. The only difficulty is that we each have our own copy, either on an iPhone or physical printout, so coordinating is a bit more difficult. This past weekend that tradition was replaced by doing it together over brunch at each of our homes. Once again, a Zoom conference call was the method of joining together. An added benefit was that, using Zoom, the puzzle was up on each of our large screens for all of us to share one version, and we actually finished in one of our fastest times ever!

The Wild Stock Market

As you know, at the beginning of each year I select stocks to invest in. One point I continue to make is that my picks tend to be high beta stocks so they might depreciate disproportionately in a down market. With the S&P down about 25%, this is certainly bear territory, but this is not your ordinary down market as the virus impacts different companies in different ways. I have been most fortunate in that 3 of my 6 selections, Zoom, Amazon and Docusign, should benefit from the virus. Zoom is the most obvious and this has not been lost on investors, as the stock as of this writing (March 24) is up almost 90% year to date. Of course, given the substantial day to day fluctuations this might not be the case by the time this blog is posted. Docusign should also be a major beneficiary of an increase in the number of people who work at home as its electronic document signing technology increases in importance (I’ve already had a major increase in e-signing in this past week at home). Amazon is having trouble keeping up with demand since most people have decided to rely on home delivery for fulfilling their needs. A fourth stock, Tesla is also ahead 21% year to date, but its stock has been impacted by the virus as it was up over 100% before the virus impact was felt. The other 2 stocks in my picks, Facebook and Stitch Fix, are down quite a bit but I still expect them to recover by year end despite the fact that Facebook should have lower revenue than previously forecast (advertising budgets will be cut) and Stitch Fix likely will also miss prior forecasts since people not leaving their homes are less likely to be buying a lot of new clothes – but whatever they do buy will be online (partly offsetting a reduction of total spending on new clothes).

Is it a good time to be buying stocks and/or munis?

In my last post I reminded you that the best strategy for making money in the stock market is to “Buy Low Sell High”. While this seems silly to even say, people have difficulty buying low as that is when the most fear exists (or the market wouldn’t be low). While there is danger that the impact of the virus could trigger a weak economy for at least this year, I still believe this is now mostly factored into the market and have been buying after days of large market declines. Don’t do this indiscriminately, as some companies (think physical retailers for example) may be permanently impaired, but others may also benefit from what is taking place. Still others will recover and their stocks are now trading at attractive prices. What has surprised me is there has also been an opportunity to buy munis at good rates of return (3.8% to over 4% for A or better rated bonds with 8 or more years to call/maturity). But this was only available to me on Schwab (not on several large well-known brokerage houses I use). It seems the panic for liquidity has led to better than expected returns despite 10-year Treasuries dropping to 1.02% from 2.41% a year ago. However, it also seems that several of the larger brokerage firms are not passing these returns through to their customers. Once the current “panic” situation passes (say 3 months from now) tax-free bonds with 10 years or less to call should be yielding under 2% annualized return to call leading to substantial appreciation of munis acquired at a much higher rate.

We need a Sports Interlude

Since sports are at a standstill my usual analysis of performance seems out of context. Instead I wanted to suggest something I have been thinking about for the last few months – how to punish the Houston Astros for their cheating. Given the mounting disapproval of the Baseball Commissioners lack of action perhaps he will even adopt my suggestion (of course he may never even hear of it). It’s a simple one that is the mirror image of the advantage the Astros created by stealing signs (through use of technology) in their home playoff games for about 3 years. My answer is to take away at least one home game from them in every playoff series they are in (including the World Series) for the next 3 years. If it’s a one game series, they would always play at the other team’s park. If it’s a 5-game series, they would at most have one home game, and in a 7-game series at most 2 home games. While this would not totally make up for what they did, it would at least somewhat even the playing field (no pun intended).

Back to the Virus

Given all the sacrifices many are making by sheltering in place, it should be easy to expect an immediate decline in the number of new cases. Unfortunately, the incubation period for the virus is estimated to be up to 14 days. We also have under-tested so there are more people who have it than the statistics show. With increased testing more of the actual cases will be detected. When these two factoids are combined, even if there was zero spread of the virus once the stringent asks were put in place, we would still continue to see many new cases during the 14-day period and the number would be further increased by improved testing. Unfortunately, not everyone is behaving perfectly so while I would expect (hope) that in each geography we would see substantial reduction in the number of new cases after 2 weeks of sheltering in place, the number won’t get to zero. It should take a drop but getting to zero could take much longer especially considering that part of the process to fix things still exposes medical professionals, delivery people, and more to becoming carriers of the virus.

What should Companies do to Protect their Futures?

There are a number of steps every company needs to consider in reacting to the threat posed by the virus to both health and the economy. At Azure we have been advising our portfolio companies to consider all of them. They include:

  1. First and foremost, make sure you protect your employee’s health by having them work remotely if at all possible.
  2. Draw down bank lines completely to increase liquidity in the face of potential reduced revenue and earnings.
  3. Create new forecast models based on at least 3 scenarios of reduced revenue for varying periods of time. If you were anticipating a fundraise assume it will take longer to close.
  4. If modeling indicates additional risk, consider cutting whatever costs you possibly can including:
    1. A potential reduction in workforce – while this is unpleasant you need to think about insuring survival which means the remaining employees will have jobs
    2. Reduced compensation for founders and top executives possibly in exchange for additional options
    3. Negotiating with your landlord (for reduced or delayed rent) as well as other vendors
    4. Eliminating any unnecessary discretionary spending
    5. Evaluating the near-term ROAS (return on advertising spend). On the one hand, preserving capital may mean the need to cut if the payback period is more than a few months. On the other hand, since advertising cost is likely to be lower given reduced demand (for example the travel industry likely will completely shut down advertising as will physical retail) it is possible you may find that increasing marketing adds to cash flow!
  5. Think about how you might play offense – are there things you can offer new and/or existing customers to induce them to spend more time on your site or app (and perhaps increase buying) in this environment?

Stay Safe

While I was a sceptic regarding how pandemic this pandemic would be, I eventually realized that there was little downside in being more cautious. So please follow the guidelines in your area. It is easy to order just about anything online so going out to shop is an unnecessary risk. As they said in the Hunger Games: “May the odds be ever in your favor!” But, unlike the Hunger Games you can improve the odds.

The Impact of Gen Z on Marketing

Azure Marketing Day

Each year, Azure hosts a marketing day for CMOs and CEOs of its consumer-facing portfolio companies. This year, on February 27th, we had sessions on the following topics:

  • Refreshing Your Brand as the Business Grows
  • Metrics for Evaluating Successful Marketing
  • Leveraging Comedy to Lower Customer Acquisition Cost
  • Know the Next Generation: An introduction to Gen Z
  • The Benefits and Drawbacks of a Multi-Channel Strategy
  • Influencer Strategies
  • Optimizing Pinterest

I presented the one on Metrics, but the other sessions are conducted by a combination of portfolio executives and outside speakers, each a leading thinker on the topic. Since I invariably learn quite a lot from other speakers, it seems only fair to borrow from their talks for a few blog posts so that I can share these benefits.

Much of this post will be based on concepts that I found especially enlightening from the session by Chris Bruzzo, the current CMO of Electronic Arts, on knowing Generation Z. I won’t cite each place I am using something from Chris versus my own thoughts; but you can assume much of the content emanates from Chris. Since Chris is one of the most creative thinkers in marketing, I’m hoping this will make me look good!

Marketers have Defined Generational Characteristics

Marketers often use personas to help understand what they need to do to address different types of customers. A persona may be:

  • A married woman 35 years old with a job and 2 children aged 6 and 9;
  • A 16-year-old male who is a sophomore in high school;
  • A non-working woman aged 50

A great deal of research has been done on the characteristics of particular “personas” to better enable a company to create and market products that meet their needs. One categorization of people is by age, with 5 different generations being profiled. The youngest group to emerge as important is Gen Z, roughly defined as those born between 1995 and 2012. Currently the U.S. population over 12 years old is distributed as follows:

What this means is that Gen Z has become a significant portion of the population to consider when creating and marketing products. With that in mind, let’s compare several characteristics of the youngest three of these groups.

Source: EA Research

Gen Z is the first generation that are digital natives. They are profiled as having cautious optimism, wanting to be connected, seeking community and wanting to create and control things. Earlier generations, including Millennials, watched TV an increasing number of hours, often multi-tasking while they did. Gen Z has replaced much of TV watching with device “screen time”, including visiting YouTube (72% of Gen Z visit it daily). When asked “What device would you pick if you could have only one?”, GenZers chose the TV less than 5% of the time. Prior generations respond well to email marketing while Gen Z needs to be reached through social media. Gen Z has little tolerance for barriers of entry for reaching a site and will just move on (I feel the same way and think many members of other generations do as well).  So, when targeting new customers (especially Gen Z) remove barriers to entry like requiring registration before a user becomes a customer. It is important to demonstrate value to them first.

Gen Z grew up in an era where the Internet was part of life and smart phones were viewed as essential… rather than a luxury. On average they spend 40% of their free time on screens. What is even more eye opening is that 91% go to bed with their devices. Advertisers have responded to these trends by gradually shifting more of their spend online. This has been difficult for newspapers and magazines for quite a while, but now it is also having a major impact on flattening out the use of TV as an advertising medium.

There are several implications from the numbers shown in the above chart. First, it is very clear to see that newspapers and magazines as we know them are not viable. This has led to iconic players like the New York Times and Fortune monetizing their brands through conferences, trips, wine clubs, and more. Lesser known brands have simply disappeared. In 2018, TV revenue continued to grow slightly despite losing share as the smaller share was of a larger pie. But in 2019, TV advertising dollars declined, and the decline is forecast to continue going forward. Several factors can be attributed to this but certainly one is that brands targeting Gen Z are aware that TV is not their medium of choice. One unintended consequence of major brands shifting spend to the Internet is that because they are less price sensitive to cost than eCommerce companies, this has led to higher pricing by Facebook and Google.

Personalization is Becoming “Table Stakes” and Offering Co-Creation is a Major Plus

Consumers, in general, and especially Gen Z, are demanding that brands do more to personalize products to their needs and interests. In fact, Gen Z even wants to participate in product creation. One example involves Azure portfolio company Le Tote. The company, much like Stitch Fix, uses algorithms to personalize the clothing it sends based on specifics about each customer. When the company added the ability for consumers to personalize their box (from the already personalized box suggested by the algorithm) there was a sizeable spike in satisfaction…despite the fact that the items the consumer substituted led to a decline in how well the clothes fit! This example shows that using customer data to select new items is only a first step in personalization. Letting the customer have more of a say (be a co-creator) is even more important. 

Conclusions

  1. Startups need to diversify their marketing spend away from Facebook and Google as the ROI on these channels has contracted. At the Azure marketing day, we highlighted testing whether Pinterest, influencers, brick and mortar distribution and/or comedy might be sources that drive a higher ROI.
  2. If Gen Zers are being targeted, YouTube, Snap, Instagram, and Twitch are likely better places to market
  3. When targeting new customers (especially Gen Z) remove barriers to entry like requiring registration before a user becomes a customer. It is important to demonstrate value to them first.
  4. Build great apps for iPhones and Android phones but what is becoming most important is making sure that smart phones work well on your site without requiring an app, as most Gen Zers will use their phones for access. When they do, the mobile web version needs to be strong so that they don’t need to download your app before discovering the value you offer.
  5. Involve customers as much as possible in the design/selection/creation of your products as this extends personalization to “co-creation” and will increase satisfaction.

Soundbytes

  • Readers are aware that I invest in growth stocks (some of which I suggest to you) to achieve superior performance. What you may not be aware of is that over the past 25 years my strategy for investing has been to put the majority of capital in A or better rated municipal bonds (Munis) to generate income in a relatively safe way (and I believe everyone should diversify how they apportion capital). I use a complex strategy to generate superior returns and in the past 25 years I have earned, on average, between 4% and 5% tax free annually.  But in the current environment new investments in Munis will have much lower yields so I have started to look at “safe” alternatives to generate income. This type of investment is for income generation and involves a different category of stocks than the growth stocks I target for high returns through stock appreciation.
  • Given the recent downturn in the stock market I did my first “bond alternative” investment earlier this week. My goal is to generate income of over 5% on an after-tax basis in stocks that are “safe” investments from the point of view of continuing to deliver dividends at or above current levels.
  • My first set of transactions was in Bristol Myers Squibb:
    • I bought the stock at $56.48 where the dividend is 3.2% per year
    • I sold Jan 21 calls at a strike price of 60 and received $4.95
    • If the stock is not called my cash yield, including $1.80 in dividends, would be $6.75 over less than one year which would equal 12% before taxes
    • I also sold Jan 21 puts at a strike price of $55 and received $6.46. If the stock is not put to me and is not called that would increase my one-year yield to over 23% of the $56.48 stock price and I would repeat the sale of calls and puts next year. Since my net cost was $43.27 the percentage yield would be over 30% of my cash outlay.
    • If the stock was called my net gain would equal the profit on the stock, the dividends for one year plus the premiums on the options and would exceed 30%
    • If the stock went below $55 and was put to me at that price I would be ok with that as the new shares would have a net cost of just over $49 with a dividend yield of close to 4.0% (assuming the company follows past practice of raising dividends each year) and I could sell new puts at a lower strike price.  
  • The second stock I invested in for income is AT&T.
    • I bought the stock at $34.60 where the dividend is 6.0% per year
    • I sold Jan 21 calls at a strike price of $37 and received $2.05 per share
    • If the stock is not called my year 1 cash yield would be $4.13 per share over less than a year or about 12% before taxes
    • I also sold Jan 21 puts with a strike of $32 and received $3.30 per share. If the stock is not put to me and is not called, that would increase my one-year yield to over 20% of the stock price and over 25% of the net cash outlay
    • If the stock was called, I would only have 3 quarters of dividends, but the gain would be over 30% of my net original cash outlay
    • If the stock was put to me my cost of the new shares, after subtracting the put premium would be $28.70 and the dividend alone would provide a 7.2% pre-tax yield and I could sell new puts at a lower price.
  • We shall see how this works out but unless they cut the dividends, I won’t worry if the stock is lower a year from now as that would only increase my yield on new stock purchased due to the puts. The chance of either company cutting dividends seems quite low which is why I view this as a “safe” alternative to generate income as I won’t sell either stock unless they are called at the higher strike price.
  • I also began reserving capital starting about a month ago as I expected the virus to impact the market. These purchases used about 10% of what I had put aside. I put another 15% to work on Friday, March 13 as the market had fallen further and valuations have become quite attractive – remember the secret is to “buy low, sell high”. When the market is low its always scary or it wouldn’t be low! I do confess that I didn’t sell much when it was high as I tend to be a long-term holder of stocks I view as game changers…so I missed the opportunity to sell high and then repurchase low.

Discussion of Sophisticated Valuation Methodology

In the long run, companies should be valued based on future earnings flows. Since this is often nearly impossible to calculate, proxies are often used instead. I find it difficult to competently determine what proxies should be used for cyclical companies, so will ignore them as they are not in my universe in venture or public investing. The focus of this post will be on exploring valuation for high-growth companies.

Companies that are already at or near their long-term model for profitability are often valued based on a multiple of earnings. If they are still in their high growth phase, they are likely to have increasing earnings over time and should therefore command a higher multiple than those that are growing slowly or not at all. Much analysis has been done to compare various such entities based on how their multiple of earnings varies depending on their level of growth. There will be a strong correlation between their multiple of earnings and level of growth, but other factors such as the “dependability of growth and earnings” can lead to wide variations in valuations.  For example, a company that has a SaaS business model with greater than 100% revenue retention would usually be viewed as one where growth is “safer” … thus commanding a higher multiple than those with different models.

What about companies that are not near their long-term profit model?   

Many of the companies that have recently gone public are a long way from reaching their long-term business model, and so other methods of valuing them must be used. Often, Investment Bankers suggest a multiple of revenue as one method. By considering how “comparable” companies trade based on revenue and growth a suggested valuation can be derived:

Table 1 Valuation of Comparable Companies

Table 1 shows a sample of what an investment banker might use as one method of determining potential valuation. However, there are many weaknesses to this approach. The biggest of which is: “what makes a company a comparable?” Usually companies selected are in the same sector. But, within a sector, business models can vary widely. For example, a sector like eCommerce has companies that:

  1. Sell physical goods which are not their own brands
  2. Sell physical goods that are their own brands
  3. Are a marketplace in which sellers list their goods and the company facilitates sales, collects the money and pays the seller (e.g., eBay).  Such a company’s revenue is not the sales of the goods but instead the marketplace commission.
  4. Sell virtual goods that are their own

There can be wide variation in gross margin among the four categories, but in general, gross margins are higher as we go from 1 to 2 to 3 to 4. In fact, companies in category 1 often have gross margins in the 20% to 40% range, those in category 2 in the 40% to 70% range, those in category 3 in the 70% to 90% range and those in category 4 in the 85% to 95% range. What this means is that all other things being equal the potential earnings at scale for these will depend more on its business model than on the sector.  

To test our theory of whether using a multiple of Gross Margin was a better measure of value than a multiple of revenue, we plotted the relationship between growth and valuation using each of these methods.  It turns out there is a correlation between valuation as a multiple of revenue based on revenue growth regardless of industry. We found the correlation coefficient for it to be 0.36, an indication of a moderate relationship. This was still far better than the correlation between slow growth and high growth plays that just happen to be in the same industry. So, I believe (based on evidence) that growth is a better indicator of multiple than industry sector.

In that same post we plotted the relationship between revenue growth and valuation as a multiple of gross margin dollars (GMD). For the remainder of this post I’ll use multiple to mean the multiple of GMD. Since it seemed obvious that GM% is a better indicator of future earnings than revenue, I wasn’t surprised that the correlation coefficient was a much higher 0.62, an indication of a much stronger relationship. While other factors like dependability of revenue, market size, perceived competitive advantage and more will affect the multiple, I decided that this method of assessing valuation was strong enough that I use the resulting least square regression formula as a way of getting a starting approximation for the value of a company that has yet to reach “business model maturity”.

Why Contribution Margin is a better indicator than Gross Margin of future earnings.

The reason the correlation coefficient between GMD multiples and revenue growth is 0.62 rather than a number much closer to 1.0 is that a number of other factors play a role in determining future earnings. For me, the most important one is Contribution Margin, which considers the marketing/sales cost spent each month to help drive revenue (think of it as GMD minus marketing/sales cost). Contribution Margin indicates how quickly the benefits of scaling the business will enable reaching mature earnings. When I look at a company that has low contribution margins it is difficult to see how it can generate substantial profits unless it can improve gross margin and/or reduce marketing spend as a percentage of sales. That is why the bull story on Spotify is that it will get the music labels to substantially reduce their royalty level (from close to 80%), or for Uber is that it will go to self-driving vehicles or why Blue Apron keeps reducing its marketing spend in an effort to increase contribution margin. The argument then becomes a speculation on why the multiple should be of a “theoretically” higher amount.  I would like to plot revenue growth versus the multiple of Contribution Margin to obtain a new least square formula, which I am confident would have a higher correlation coefficient.  Unfortunately, many companies do not readily identify variable marketing/sales cost so instead I analyze where it is likely to be, and factor that into how I view valuation.

Other Factors to Consider for Understanding a Company’s Valuation

  1. Recurring revenue models should have a higher multiple: Business to Business SaaS (Software as a Service) companies usually trade at higher multiples than those with other models that are growing at the same rate. The reason is simple: their customers are likely to stay on their platforms for a decade or more and often increase what they spend over time. This creates a situation where a portion of revenue growth can be sustained even before adding the marketing spend to acquire future customers which in turn should lead to higher Contribution Margins.
  2. Companies that are in markets that are likely to grow at a high rate for 5 years or more should have higher multiples: If the market a company plays in is growing quickly there is more opportunity to sustain high growth levels for a longer time, leading to a likelihood of greater future earnings.
  3. Companies with substantial competitive advantage should have higher multiples: Any company that has a product that it is difficult to replicate can elevate its margins and earnings for a long period of time. One of the best examples of this is pharmaceutical companies, where their drug patents last for 20 years. Even after the patent expires the original holder will continue to sell the drug at a much higher price than its generic alternatives and still maintain strong market share.
  4. Companies that are farther away from generating actual earnings should trade at lower multiples than those that are close or already generating some earnings: The reason for this is obvious to me but it is often not the case … especially for newly minted IPOs. I believe there is considerable risk that such companies will take many years to reach profitability (if they do at all) and that when they do it will only be a modest portion of revenue. I started this post by saying that eventually valuations should reflect the present value of future earnings flows. The longer it takes to get to mature earnings, the lower its present value (see table 2). If tangible earnings started 7 years out (vs immediately) the discounted value of the flow would be reduced by more than half – reflecting that the valuation of the company should be half that of a company with a similar earnings flow that started immediately.

Table 2: Present value of future dollars using a 12% discount rate

How I bet on my Valuation Methodology.

Consider the three recommendations in my last post that have had their IPO between November of 2017 and mid-2019: DocuSign, Stitch fix and Zoom. They all are profitable already. Two are B to B SaaS companies with greater than 100% revenue retention (that means that the cohort of customers they had a year ago, including those that churned, are spending more today than when they started). The third has existing customers increasing their year over spend as well. They are all growing at a strong pace.

SoundBytes

  • While I did not include it in my recommended stocks for 2020, I recently purchased shares in Pinterest (at $19.50 per share), one of the three 2019 Unicorn IPOs (of the nine I highlighted in my last post) that was already profitable. Based on my valuation methods it is at a reasonable valuation, grew 47% year over year in its last reported quarter, and appears well positioned to grow at a high level for many years. What I find surprising is the comparison to the valuation of Snap. Snap is growing at roughly the same pace (50% in the last reported quarter), had an adjusted EBITDA loss of nearly 10% in Q3 and yet was trading at nearly double the multiple of GMD. 
  • I can’t help mentioning that we predicted that Tesla was likely to have a great Q4 in our post in November, based on the long wait time for my getting a model 3 I had ordered, coupled with manufacturing cranking out more expensive model S and X versions for most of the quarter, and that the Chinese factory was starting to produce cars. At the time the stock was $333 per share. Now, after it has risen over 200 points a number of analysts are saying the same thing.

2020 Top Ten Predictions

I wanted to start this post by repeating something I discussed in my top ten lists in 2017 and 2018 which I learned while at Sanford Bernstein in my Wall Street days: “Owning companies that have strong competitive advantages and a great business model in a potentially mega-sized market can create the largest performance gains over time (assuming one is correct).” It does make my stock predictions somewhat boring (as they were on Wall Street where my top picks, Dell and Microsoft each appreciated over 100X over the ten years I was recommending them).

Let’s do a little simple math. Suppose one can generate an IRR of 26% per year (my target is to be over 25%) over a long period of time.  The wonder of compounding is that at 26% per year your assets will double every 3 years. In 6 years, this would mean 4X your original investment dollars and in 12 years the result would be 16X. For comparison purposes, at 5% per year your assets would only be 1.8X in 12 years and at 10% IRR 3.1X.  While 25%+ IRR represents very high performance, I have been fortunate enough to consistently exceed it (but always am worried that it can’t keep up)! For my recommendations of the past 6 years, the IRR is 34.8% and since this exceeds 26%, the 6-year performance  is roughly 6X rather than 4X.

What is the trick to achieving 25% plus IRR? Here are a few of my basic rules:

  1. Start with companies growing revenue 20% or more, where those closer to 20% also have opportunity to expand income faster than revenue
  2. Make sure the market they are attacking is large enough to support continued high growth for at least 5 years forward
  3. Stay away from companies that don’t have profitability in sight as companies eventually should trade at a multiple of earnings.
  4. Only choose companies with competitive advantages in their space
  5. Re-evaluate your choices periodically but don’t be consumed by short term movement

As I go through each of my 6 stock picks I have also considered where the stock currently trades relative to its growth and other performance metrics. With that in mind, as is my tendency (and was stated in my last post), I am continuing to recommend Tesla, Facebook, Amazon, Stitch Fix and DocuSign. I am adding Zoom Video Communications (ZM) to the list. For Zoom and Amazon I will recommend a more complex transaction to achieve my target return.

2020 Stock Recommendations:

1. Tesla stock appreciation will continue to outperform the market (it closed last year at $418/share)

Tesla is likely to continue to be a volatile stock, but it has so many positives in front of it that I believe it wise to continue to own it. The upward trend in units and revenue should be strong in 2020 because:

  • The model 3 continues to be one of the most attractive cars on the market. Electric Car Reviews has come out with a report stating that Model 3 cost of ownership not only blows away the Audi AS but is also lower than a Toyota Camry! The analysis is that the 5-year cost of ownership of the Tesla is $0.46 per mile while the Audi AS comes in 70% higher at $0.80 per mile. While Audi being more expensive is no surprise, what is shocking is how much more expensive it is. The report also determined that Toyota Camry has a higher cost as well ($0.49/mile)! Given the fact that the Tesla is a luxury vehicle and the Camry is far from that, why would anyone with this knowledge decide to buy a low-end car like a Camry over a Model 3 when the Camry costs more to own?  What gets the Tesla to a lower cost than the Camry is much lower fuel cost, virtually no maintenance cost and high resale value. While the Camry purchase price is lower, these factors more than make up for the initial price difference
  • China, the largest market for electronic vehicles, is about to take off in sales. With the new production facility in China going live, Tesla will be able to significantly increase production in 2020 and will benefit from the car no longer being subject to import duties in China.  
  • European demand for Teslas is increasing dramatically. With its Chinese plant going live, Tesla will be able to partly meet European demand which could be as high as the U.S. in the future. The company is building another factory in Europe in anticipation. The earliest indicator of just how much market share Tesla can reach has occurred in Norway where electric cars receive numerous incentives. Tesla is now the best selling car in that country and demand for electric cars there now exceeds gas driven vehicles.

While 2020 is shaping up as a stairstep uptick in sales for Tesla given increased capacity and demand, various factors augur continued growth well beyond 2020. For example, Tesla is only partway towards having a full lineup of vehicles. In the future it will add:

  • Pickup trucks – where pre-orders and recent surveys indicate it will acquire 10-20% of that market
  • A lower priced SUV – at Model 3 type pricing this will be attacking a much larger market than the Model X
  • A sports car – early specifications indicate that it could rival Ferrari in performance but at pricing more like a Porsche
  • A refreshed version of the Model S
  • A semi – where the lower cost of fuel and maintenance could mean strong market share.

2. Facebook stock appreciation will continue to outperform the market (it closed last year at $205/share)

Facebook, like Tesla, continues to have a great deal of controversy surrounding it and therefore may sometimes have price drops that its financial metrics do not warrant. This was the case in 2018 when the stock dropped 28% in value during that year. While 2019 partly recovered from what I believe was an excessive reaction, it’s important to note that the 2019 year-end price of $205/share was only 16% higher than at the end of 2017 while trailing revenue will have grown by about 75% in the 2-year period. The EPS run rate should be up in a similar way after a few quarters of lower earnings in early 2019. My point is that the stock remains at a low price given its metrics. I expect Q4 to be quite strong and believe 2020 will continue to show solid growth.

The Facebook platform is still increasing the number of active users, albeit by only about 5%-6%. Additionally, Facebook continues to increase inventory utilization and pricing. In fact, given what I anticipate will be added advertising spend due to the heated elections for president, senate seats, governorships etc., Facebook advertising inventory usage and rates could increase faster (see prediction 7 on election spending).  

Facebook should also benefit by an acceleration of commerce and increased monetization of advertising on Instagram. Facebook started monetizing that platform in 2017 and Instagram revenue has been growing exponentially and is likely to close out 2019 at well over $10 billion. A wild card for growth is potential monetization of WhatsApp. That platform now has over 1.5 billion active users with over 300 million active every day. It appears close to beginning monetization.

The factors discussed could enable Facebook to continue to grow revenue at 20% – 30% annually for another 3-5 years making it a sound longer term investment.

3. DocuSign stock appreciation will continue to outperform the market (it closed last year at $74/share)

DocuSign is the runaway leader in e-signatures facilitating multiple parties signing documents in a secure, reliable way for board resolutions, mortgages, investment documents, etc. Being the early leader creates a network effect, as hundreds of millions of people are in the DocuSign e-signature database. The company has worked hard to expand its scope of usage for both enterprise and smaller companies by adding software for full life-cycle management of agreements. This includes the process of generating, redlining, and negotiating agreements in a multi-user environment, all under secure conditions. On the small business side, the DocuSign product is called DocuSign Negotiate and is integrated with Salesforce.

The company is a SaaS company with a stable revenue base of over 560,000 customers at the end of October, up well over 20% from a year earlier. Its strategy is one of land and expand with revenue from existing customers increasing each year leading to a roughly 40% year over year revenue increase in the most recent quarter (fiscal Q3). SaaS products account for over 95% of revenue with professional services providing the rest. As a SaaS company, gross margins are high at 79% (on a non-GAAP basis).

The company has now reached positive earnings on a non-GAAP basis of $0.11/share versus $0.00 a year ago. I use non-GAAP as GAAP financials distort actual results by creating extra cost on the P&L if the company’s stock appreciates. These costs are theoretic rather than real.

My only concern with this recommendation is that the stock has had a 72% runup in 2019 but given its growth, move to positive earnings and the fact that SaaS companies trade at higher multiples of revenue than others I still believe it can outperform this year.

4. Stitch Fix Stock appreciation will continue to outperform the market (it closed last year at $25.66/share)

Stitch Fix offers customers, who are primarily women, the ability to shop from home by sending them a box with several items selected based on sophisticated analysis of her profile and prior purchases. The customer pays a $20 “styling fee” for the box which can be applied towards purchasing anything in the box. The company is the strong leader in the space with revenue approaching a $2 billion run rate. Unlike many of the recent IPO companies, it has shown an ability to balance growth and earnings. The stock had a strong 2019 ending the year at $25.66 per share up 51% over the 2018 closing price. Despite this, our valuation methodology continues to show it to be substantially under valued and it remains one of my picks for 2020. The likely cause of what I believe is a low valuation is a fear of Amazon making it difficult for Stitch Fix to succeed. As the company gets larger this fear should recede helping the multiple to expand.  

Stitch Fix continues to add higher-end brands and to increase its reach into men, plus sizes and kids. Its algorithms to personalize each box of clothes it ships keeps improving. Therefore, the company can spend less on acquiring new customers as it has increased its ability to get existing customers to spend more and come back more often. Stitch Fix can continue to grow its revenue from women in the U.S. with expansion opportunities in international markets over time. I believe the company can continue to grow by roughly 20% or more in 2020 and beyond.

Stitch Fix revenue growth (of over 21% in the latest reported quarter) comes from a combination of increasing the number of active clients by 17% to 3.4 million, coupled with driving higher revenue per active client. The company accomplished this while generating profits on a non-GAAP basis.

5. Amazon stock strategy will outpace the market (it closed last year at $1848/share).

Amazon shares increased by 23% last year while revenue in Q3 was up 24% year over year. This meant the stock performance mirrored revenue growth. Growth in the core commerce business has slowed but Amazon’s cloud and echo/Alexa businesses are strong enough to help the company maintain roughly 20% growth in 2020. The company continues to invest heavily in R&D with a push to create automated retail stores one of its latest initiatives. If that proves successful, Amazon can greatly expand its physical presence and potentially increase growth through the rollout of numerous brick and mortar locations. But at its current size, it will be difficult for the company to maintain over 20% revenue growth for many years (excluding acquisitions) so I am suggesting a more complex investment in this stock:

  1. Buy X shares of the stock (or keep the ones you have)
  2. Sell Amazon puts for the same number of shares with the puts expiring on January 15, 2021 and having a strike price of $1750. The most recent sale of these puts was for over $126
  3. So, net out of pocket cost would be reduced to $1722
  4. A 20% increase in the stock price (roughly Amazon’s growth rate) would mean 29% growth in value since the puts would expire worthless
  5. If the stock declined 226 points the option sale would be a break-even. Any decline beyond that and you would lose additional dollars.
  6. If the options still have a premium on December 31, I will measure their value on January 15, 2021 for the purposes of performance.

6. I’m adding Zoom Video Communications to the list but with an even more complex investment strategy (the stock is currently at $72.20)

I discussed Zoom Video Communications (ZM) in my post on June 24, 2019. In that post I described the reasons I liked Zoom for the long term:

  1. Revenue retention of a cohort was about 140%
  2. It acquires customers very efficiently with a payback period of 7 months as the host of a Zoom call invites various people to participate in the call and those who are not already Zoom users can be readily targeted by the company at little cost
  3. Gross Margins are over 80% and could increase
  4. The product has been rated best in class numerous times
  5. Its compression technology (the key ingredient in making video high quality) appears to have a multi-year lead over the competition
  6. Adding to those reasons it’s important to note that ZM is improving earnings and was slightly profitable in its most recent reported quarter

The fly in the ointment was that my valuation technology showed that it was overvalued. However, I came up with a way of “future pricing” the stock. Since I expected revenue to grow by about 150% over the next 7 quarters (at the time it was growing over 100% year over year) “future pricing” would make it an attractive stock. This was possible due to the extremely high premiums for options in the stock. So far that call is working out. Despite the company growing revenue in the 3 quarters subsequent to my post by over 57%, my concern about valuation has proven correct and the stock has declined from $76.92 to $72.20. If I closed out the position today by selling the stock and buying back the options (see Table 1) my return for less than 7.5 months would be a 42% profit. This has occurred despite the stock declining slightly due to shrinkage in the premiums.

Table 1: Previous Zoom trade and proposed trade

I typically prefer using longer term options for doing this type of trade as revenue growth of this magnitude should eventually cause the stock to rise, plus the premiums on options that are further out are much higher, reducing the risk profile, but I will construct this trade so that the options expire on January 15, 2021 to be able to evaluate it in one year. In measuring my performance we’ll use the closing stock price on the option expiration date, January 15, 2021 since premiums in options persist until their expiration date so the extra 2 weeks leads to better optimization of the trade.

So, here is the proposed trade (see table 1):

  1. Buy X shares of the stock at $72.20 (today’s price)
  2. Sell Calls for X shares expiring January 15, 2021 at a strike of $80/share for $11.50 (same as last price it traded)
  3. Sell puts for X shares expiring January 15, 2021 with strike of $65/share for $10.00 (same as last price it traded)

I expect revenue growth of 60% or more 4 quarters out. I also expect the stock to rise some portion of that, as it is now closer to its value than when I did the earlier transaction on May 31, 2019. Check my prior post for further analysis on Zoom, but here are 3 cases that matter at December 31, 2020:

  • Stock closes over $80/share (up 11% or more) at end of the year: the profit would be 58% of the net cost of the transaction
    • This would happen because the stock would be called, and you would get $80/share
    • The put would expire worthless
    • Since you paid a net cost of $50.70, net profit would be $29.30
  • Stock closes flat at $72.20:  your profit would be $21.50 (42%)
    • The put and the call would each expire worthless, so you would earn the original premiums you received when you sold them
    • The stock would be worth the same as what you paid
  • Stock closes at $57.85 on December 31: you would be at break even. If it closed lower, then losses would accumulate twice as quickly:
    • The put holder would require you to buy the stock at the put exercise price of $65, $7.15 more than it would be worth
    • The call would expire worthless
    • The original stock would have declined from $72.20 to $57.85, a loss of $14.35
    • The loss on the stock and put together would equal $21.50, the original premiums you received for those options

Outside of my stock picks, I always like to make a few non-stock predictions for the year ahead.

7. The major election year will cause a substantial increase in advertising dollars spent

According to Advertising Analytics political spending has grown an average of 27% per year since 2012. Both the rise of Super PACs and the launch of online donation tools such as ActBlue have substantially contributed to this growth. While much of the spend is targeted at TV, online platforms have seen an increasing share of the dollars, especially Facebook and Google. The spend is primarily in even years, as those are the ones with senate, house and gubernatorial races (except for minor exceptions). Of course, every 4th year this is boosted by the added spend from presidential candidates. The Wall Street Journal projects the 2020 amount will be about $9.9 billion…up nearly 60% from the 2016 election year. It should be noted that the forecast was prior to Bloomberg entering the race and if he remains a viable candidate an additional $2 billion or more could be added to this total.

The portion targeted at the digital world is projected to be about $2.8 billion or about 2.2% of total digital ad spending. Much of these dollars will likely go to Facebook and Google. This spend has a dual impact: first it adds to the revenue of each platform in a direct way, but secondly it can also cause the cost of advertising on those platforms to rise for others as well.

8. Automation of Retail will continue to gain momentum

This will happen in multiple ways, including:

  1. More Brick & Mortar locations will offer some or all the SKUs in the store for online purchase through Kiosks (assisted by clerks/sales personnel). By doing this, merchants will be able to offer a larger variety of items, styles, sizes and colors than can be carried in any one outlet. In addition, the consolidation of inventory achieved in this manner will add efficiency to the business model. In the case of clothing, such stores will carry samples of items so the customer can try them on, partly to optimize fit but also to determine whether he or she likes the way it looks and feels on them. If one observes the massive use of Kiosks at airports it becomes obvious that they reduce the number of employees needed and can speed up checking in. One conclusion is this will be the wave of the future for multiple consumer-based industries.
  2. Many more locations will begin incorporating technology to eliminate the number of employees needed in their stores. Amazon will likely be a leader in this, but others will also provide ways to reduce the cost of ordering, picking goods, checking out and receiving information while at the store.

9. The Warriors will come back strong in the 2020/21 season

Let me begin by saying that this prediction is not being made because I have been so humbled by my miss in the July post where I predicted that the Warriors could edge into the 2020 playoffs and then contend for a title if Klay returned in late February/early March. Rather, it is based on analysis of their opportunity for next season and also an attempt to add a little fun to my Top Ten List!  The benefit of this season:

  • Klay and Curry are getting substantial time off after 5 seasons of heavy stress. They should be refreshed at the start of next season
  • Russell, assuming he doesn’t keep missing games with injuries, is learning the Warriors style of play
  • Because of the injuries to Klay, Curry, Looney, and to a lesser extent Green and Russell, several of the younger members of the team are getting experience at a much more rapid rate than would normally be possible and the Warriors are able to have more time to evaluate them as potential long-term assets
  • If the Warriors continue to lose at their current rate, they will be able to get a high draft choice for the first time since 2012 when they drafted Harrison Barnes with the 7th pick. Since then their highest pick has been between the 28th and 30th player chosen (30 is the lowest pick in the first round)
  • The Warriors will have more cap space available to sign a quality veteran
  • Andre Iguodala might re-sign with the team, and while this is not necessary for my prediction it would be great for him and for the team
  • The veterans should be hungry again after several years of almost being bored during the regular season

I am assuming the Warriors will be relatively healthy next season for this to occur.

10. At least one of the major Unicorns will be acquired by a larger player

In 2019, there was a change to the investing environment where most companies that did not show a hint of potential profitability had difficulty maintaining their market price. This was particularly true of highly touted Unicorns, which mostly struggled to increase their share price dramatically from the price each closed on the day of their IPO. Table 2 shows the 9 Unicorns whose IPOs we highlighted in our last post. Other than Beyond Meat, Zoom and Pinterest, they all appear some distance from turning a proforma profit. Five of the other six are below their price on the first day’s close. A 6th, Peloton, is slightly above the IPO price (and further above the first days close). Beyond Meat grew revenue 250% in its latest quarter and moved to profitability as well. Its stock jumped on the first day and is even higher today.  While Pinterest is showing an ability to be profitable it is still between the price of the IPO and its close on the first day of trading.  Zoom, which is one of our recommended buys, was profitable (on a Non-GAAP basis) and grew revenue 85% in its most recent quarter. A 10th player, WeWork, had such substantial losses that it was unable to have a successful IPO.

Table 2: Recent Unicorn IPOs Stock Price & Profitability Comparisons

Something that each of these companies have in common is that they are all growing revenue at 30% or more, are attacking large markets, and are either in the leadership position in that market or are one of two in such a position. Because of this I believe one or more of these (and comparable Unicorns) could be an interesting acquisition for a much larger company who is willing to help make them profitable. For such an acquirer their growth and leadership position could be quite attractive.

Recap of 2019 Top Ten Predictions

Bull Markets have Tended to Favor My Stock Picks

I entered 2019 with some trepidation as my favored stocks are high beta and if the bear market of the latter portion of 2018 continued, I wasn’t sure I would once again beat the market…it was a pretty close call last year. However, I felt the companies I liked would continue to grow their revenue and hoped the market would reward their performance. As it turns out, the 5 stocks I included in my top ten list each showed solid company performance and the market returned to the bull side. The average gain for the stocks was 45.7% (versus the S&P gain of 24.3%).

Before reviewing each of my top ten from last year, I would like to once again reveal long term performance of the stock pick portion of my top ten list. For my picks, I assume equal weighting for each stock in each year to come up with my performance and then compound the yearly gains (or losses) to provide my 6-year performance. For the S&P my source is Multpl.com.  I’m comparing the S&P index at January 2 of each year to determine annual performance.  My compound gain for the 6-year period is 499% which equates to an IRR of 34.8%. The S&P was up 78% during the same 6-year period, an IRR of 10.1%.

The 2019 Top Ten Predictions Recap

One of my New Year’s pledges was to be more humble, so I would like to point out that I wasn’t 10 for 10 on my picks. One of my 5 stocks slightly under-performed the market and one of my non-stock forecasts was a mixed bag. The miss on the non-stock side was the only forecast outside of tech, once again highlighting that I am much better off sticking to the sector I know best (good advice for readers as well). However, I believe I had a pretty solid year in my forecasts as my stock portfolio (5 of the picks) significantly outperformed the market, with two at approximately market performance and three having amazing performance with increases of 51% to 72%. Regarding the 5 non-stock predictions, 4 were right on target and the 5th was very mixed. As a quick reminder, my predictions were:

Stock Portfolio 2019 Picks:

  • Tesla stock will outpace the market (it closed last year at $333/share and opened this year at $310)
  • Facebook Stock will outpace the market (it closed last year at $131/share)
  • Amazon Stock will outpace the market (it opened the year at $1502/share)
  • Stitch Fix stock appreciation will outpace the market (it closed last year at $17/share)
  • DocuSign stock will outpace the market in 2019 (it is currently at $43/share and opened the year at $41)

5 Non-Stock Predictions:

  • Replacing cashiers with technology will be proven out in 2019
  • Replacing cooks, baristas, and waitstaff with robots will begin to be proven in 2019
  • Influencers will be increasingly utilized to directly drive commerce
  • The Cannabis Sector should show substantial gains in 2019
  • 2019 will be the year of the unicorn IPO

In the discussion below, I’ve listed in bold each of my ten predictions and give an evaluation of how I fared on each.

Tesla stock will outpace the market (it closed last year at $333/share and opened this year at $310)

Tesla proved to be a rocky ride through 2019 as detractors of the company created quite a bit of fear towards the middle of the year, driving the stock to a low of $177 in June. A sequence of good news followed, and the stock recovered and reached a high of $379 in front of the truck unveiling. I’m a very simplistic guy when I evaluate success as I use actual success as the measure as opposed to whether I would buy a product. Critics of the truck used Elon’s unsuccessful demonstration of the truck being “bulletproof” and the fact that it was missing mirrors and windshield wipers to criticize it. Since it is not expected to be production ready for about two years this is ridiculous! If the same critics applied a similar level of skepticism to the state of other planned competitive electric vehicles (some of which are two plus years away) one could conclude that none of them will be ready on time. I certainly think the various announced electric vehicles from others will all eventually ship, but do not expect them to match the Tesla battery and software capability given its 3 to 5-year lead. I said I’m a simple guy, so when I evaluate the truck, I look at the 250,000 pre-orders and notice it equates to over $12.5B in incremental revenue for the product! While many of these pre-orders will not convert, others likely will step in. To me that is strong indication that the truck will be an important contributor to Tesla growth once it goes into production.

Tesla stock recovered from the bad press surrounding the truck as orders for it mounted, the Chinese factory launch was on target and back order volume in the U.S. kept factories at maximum production.  Given a late year run the stock was up to $418 by year end, up 34.9% from the January opening price. But for continuing recommendations I use the prior year’s close as the benchmark (for measuring my performance) which places the gain at a lower 25.6% year over year as the January opening price was lower than the December 31 close. Either way this was a successful recommendation.

Facebook Stock will outpace the market (it closed last year at $131/share)

Facebook, like Tesla, has many critics regarding its stock. In 2018 this led to a 28% decline in the stock. The problem for the critics is that it keeps turning out very strong financial numbers and eventually the stock price has to recognize that. It appears that 2019 revenue will be up roughly 30% over 2018. After several quarters of extraordinary expenses, the company returned to “normal” earnings levels of about 35% of revenue in the September quarter. I expect Q4 to be at a similar or even stronger profit level as it is the seasonally strongest quarter of the year given the company’s ability to charge high Christmas season advertising rates. As a result, the stock has had a banner year increasing to $205/share at year-end up 57% over the prior year’s close making this pick one of my three major winners.

Amazon Stock will outpace the market (it opened the year at $1502/share)

Amazon had another very solid growth year and the stock kept pace with its growth. Revenue will be up about 20% over 2018 and gross margins remain in the 40% range. For Amazon, Q4 is a wildly seasonal quarter where revenue could jump by close to 30% sequentially. While the incremental revenue tends to have gross margins in the 25% – 30% range as it is heavily driven by ecommerce, the company could post a solid profit increase over Q3. The stock pretty much followed revenue growth, posting a 23% year over year gain closing the year at $1848 per share. I view this as another winner, but it slightly under-performed the S&P index.

Stitch Fix stock appreciation will outpace the market (it closed last year at $17/share)

Stitch Fix, unlike many of the recent IPO companies, has shown an ability to balance growth and earnings. In its fiscal year ending in July, year over year growth increased from 26% in FY 2018 to over 28% in FY 2019 (although without the extra week in Q4 of FY 2019 year over year growth would have been about the same as the prior year). For fiscal 2020, the company guidance is for 23% – 25% revenue growth after adjusting for the extra week in Q4 of FY 2019. On December 9th, Stitch Fix reported Q1 results that exceeded market expectations. The stock reacted well ending the year at $25.66 per share and the year over year gain in calendar 2019 moved to a stellar level of 51% over the 2018 closing price.

DocuSign stock will outpace the market in 2019 (it is currently at $43/share and opened the year at $41)

DocuSign continued to execute well throughout calendar 2019. On December 5th it reported 40% revenue growth in its October quarter, exceeding analyst expectations. Given this momentum, DocuSign stock was the largest gainer among our 5 picks at 72% for the year ending at just over $74 per share (since this was a new recommendation, I used the higher $43 price at the time of the post to measure performance). The company also gave evidence that it is reducing losses and not burning cash. Since ~95% of its revenue is subscription, the company is able to maintain close to 80% gross margin (on a proforma basis) and is well positioned to continue to drive growth. But, remember that growth declines for very high growth companies so I would expect somewhat slower growth than 40% in 2020.

Replacing cashiers with technology will be proven out in 2019

A year ago, I emphasized that Amazon was in the early experimental phase of its Go Stores which are essentially cashierless using technology to record purchases and to bill for them. The company now has opened or announced 21 of these stores. The pace is slower than I expected as Amazon is still optimizing the experience and lowering the cost of the technology. Now, according to Bloomberg, the company appears ready to:

  • Open larger format supermarkets using the technology
  • Increase the pace of adding smaller format locations
  • Begin licensing the technology to other retailers, replicating the strategy it deployed in rolling out Amazon Web Services to others

Replacing cooks, baristas, and waitstaff with robots will begin to be proven in 2019

The rise of the robots for replacing baristas, cooks and waitstaff did indeed accelerate in 2019. In the coffee arena, Briggo now has robots making coffee in 7 locations (soon to be in SFO and already in the Austin Airport), Café X robotic coffee makers are now in 3 locations, and there are even other robots making coffee in Russia (GBL Robotics), Australia (Aabak) and Japan (HIS Co). There is similar expansion of robotic pizza and burger cooks from players like Zume Pizza and Creator and numerous robots now serving food. This emerging trend has been proven to work. As the cost of robots decline and minimum wage rises there will be further expansion of this usage including franchise approaches that might start in 2020.

Influencers will be increasingly utilized to directly drive commerce

The use of influencers to drive commerce accelerated in 2019. Possibly the most important development in the arena was the April 2019 launch by Instagram of social commerce. Instagram now let’s influencers use the app to tag and sell products directly, that is, their posts can be “shoppable”. Part of the series of steps Instagram took was adding “checkout” which lets customers purchase products without leaving the walls of the app.

A second increase in the trend is for major influencers to own a portion of companies that depend on their influence to drive a large volume of traffic. In that way they can capture more of the value of their immense influence. Using this concept, Rihanna has become the wealthiest female musician in the world at an estimated net worth of $600 million. The vast majority of her wealth is from ownership in companies where she uses her influence to drive revenue. The two primary ones are Fenty Beauty and Fenty Maison. Fenty Beauty was launched in late 2017 and appears to be valued at over $3 billion. Rihanna owns 15% – do the math! Fenty Maison is a partnership between LVMH (the largest luxury brand owner) and Rihanna announced in May of 2019. It is targeting fashion products and marks the first time the luxury conglomerate has launched a fashion brand from scratch since 1987. Rihanna has more than 70 million followers on Instagram and this clearly establishes her as someone who can influence commerce.

The Cannabis Sector should show substantial gains in 2019

The accuracy of this forecast was a mixed bag as the key companies grew revenue at extremely high rates, but their stock valuations declined resulting in poor performance of the cannabis index (which I had said should be a barometer). A few examples of the performance of the largest public companies in the sector are shown in Table 2.

Table 2: Performance of Largest Public Cannabis Companies

*Note: Canopy last quarter was Sept 2019

In each case, the last reported quarter was calendar Q3. For Tilray, I subtracted the revenue from its acquisition of Manitoba Harvest so that the growth shown is organic growth. I consider this forecast a hit and a miss as I was correct regarding revenue (it was up an average of 282%) but the stocks did not follow suit, even modestly, as the average of the three was a decline of 54%. While my forecast was not for any individual company or stock in the sector, it was wrong regarding the stocks but right regarding company growth. The conclusion is humbling as I’m glad that I exercised constraint in not investing in a sector where I do not have solid knowledge of the way the stocks might perform.

2019 will be the year of the unicorn IPO

This proved true as many of the largest unicorns went public in 2019. Some of the most famous ones included on the list are: Beyond Meat, Chewy, Lyft, Peloton, Pinterest, Slack, The Real Real, Uber and Zoom. Of the 9 shown, four had initial valuations between $8 billion and $12 billion, two over $20 billion and Uber was the highest at an $82 billion valuation. Some unicorns found the public markets not as accepting of losses as the private market, with Lyft and Uber stock coming under considerable pressure and WeWork unable to find public buyers of its stock leading to a failed IPO and shakeup of company management. There is more to come in 2020 including another mega one: Airbnb.

2020 Predictions coming soon

Stay tuned for my top ten predictions for 2020…but please note that all 5 of the stocks recommended for 2019 will remain on the list.

Soundbyte

  • Before the basketball season began, I had a post predicting that the Warriors still had a reasonable chance to make the playoffs (if Klay returned in late February). Talk about feeling humble! I guess, counting this I had 3 misses on my predictions.

Calculating and Acting on the Right KPIs is Critical for Success

Advanced metrics for Customer Acquisition Cost (CAC) and Lifetime Value (LTV)

What is the purpose of CAC, LTV and Payback Period?

Often entrepreneurs we meet have a list of their KPI’s, but as we dig deeper, it becomes clear that they don’t fully comprehend the purpose of the KPI or why we think that they are so critical in helping us understand the health of a business. I’m a believer in thoroughly understanding the economics of your business, and the metrics around Customer Acquisition Cost (CAC), Customer Lifetime Revenue (LTR), Customer Lifetime Value (LTV) and Payback Period are important metrics to work on improving. In this post we use the word customer to mean a ‘buyer’, someone who actually orders product and will use customer and buyer interchangeably.

  • LTR (Customer Lifetime Revenue) is the total revenue from a customer over their estimated lifetime (we prefer using 5 years as representing lifetime)
  • MCA (Marketing Spend for Customer Acquisition) is the marketing cost directed towards new customer acquisition
  • CAC (Customer Acquisition Cost) captures the cost of acquiring a new buyer
  • LTV (Customer Lifetime Value) is the estimated lifetime profits on new customers once they have been acquired
  • Net LTV is the estimated lifetime profits on a new customer taking acquisition cost into account or: LTV – CAC
  • Payback Period is the time for a new customer to generate profits that equals his or her CAC

When LTV is compared to CAC a measure of the future health of the business can be seen. Most VCs will be loath to invest in any company where the ratio of LTV/CAC is less than 3X and enthusiastic when it exceeds 5X. I also favor companies with a short payback period especially if the recovery is from the first transaction as this means almost no cash is consumed when acquiring a customer.

I have previously written about Contribution Margin (gross margin less marketing and sales spend) being one of the most important metrics for companies as it tells me how scaling revenue will help cover G&A and R&D costs. Once Contribution Margin exceeds these costs there is operating profit. A company with low Contribution Margin needs much greater scale to be able to reach profitability than one with high Contribution Margin. Both the LTV/CAC ratio and Payback Period are important predictors of future Contribution Margin levels. Table 1 shows two companies with the same revenue, R&D and G&A cost. Assuming R&D and G&A are fixed for both, at 5% Contribution Margin Company A would need to reach $50 million in revenue to break-even while Company B would be at break-even at under $4 million in revenue given its 65% Contribution Margin.

Break Even Revenue = (R&D + G&A)/ (Contribution Margin %)

For Company A = $2,500,000/ (5%) = $50,000,000

For Company B = $2,500,000/ (65%) = $3,846,154

The problem for Company A stems from the fact that for every $40 spent in acquiring a customer the total LTV (or subsequent profits on the customer) is only $76 making Net LTV $36. With such a low ratio of LTV/CAC, Contribution Margin is also quite low. I’ve chosen two extremes in gross margin to better illustrate the impact of gross margin on Contribution Margin. 

Table 1: Illustrative Example on the Importance of Contribution Margin

In a second example, Table 2, we show the impact of much more efficient marketing and remarketing on a company’s results. We assume gross margin, R&D and G&A are the same for Company C and Company D, but that Company D is much more efficient at acquiring and retaining customers, resulting in a lower CAC and a higher LTR and LTV for Company D. This could be due to higher spending on branding and remarketing, but also because they are very focused on the metrics that help them optimize acquisition and LTR. The result is considerably higher LTV/CAC and significantly higher Contribution Margin. 

Table 2: Impact of Efficient Marketing & Remarketing on a Company’s Results

A few rules regarding Contribution Margin

  1. Higher Gross Margin means greater opportunity for high Contribution Margin – for example, Company A at 20% Gross Margin is severely limited in reaching a reasonable Contribution Margin while Company B at 80% Gross Margin has an opportunity for high Contribution Margin and can reach profitability at lower revenue levels
  2. Companies with many new customers acquired through “free” methods like SEO, viral marketing, etc. have higher Contribution Margins than similar companies with a low proportion of free acquisitions.  Notice Company D can spend less on marketing than Company C because it acquires half of its customers from free sources whereas Company C has none from free sources.
  3. Returning buyers contribute heavily to Contribution Margin since they require little if any marketing cost. A high LTV/CAC ratio usually means customers return more often, which in turn should increase future Contribution Margin. Company D with its very high LTV/CAC likely has much lower churn than Company C and therefore most of its marketing spend is for adding incremental customers rather than just replacing those that churn. If a company simply stopped spending on marketing, its revenue would be from existing customers and new customers acquired from free methods making Contribution Margin roughly equal to Gross Margin. Of course, lack of marketing could have a major impact on future growth
  4. All other things being equal, companies with short Payback Periods tend to have higher Contribution Margin than those with longer Payback Periods

Marketing Spend on Branding versus Customer Acquisition

Branding is the communication of characteristics, values and attributes of an organization and its products. What is the purpose of spending on branding?  To create a strong image of the company and its products so that existing customers want to stay and spending on customer acquisition will be more efficient. Great brands should have a lower CAC and higher LTV than weak brands.

Nike’s “Just Do It” campaign worked well in establishing a brand message that resonated. Their more recent campaign centered around Colin Kaepernick was riskier as it had pictures of the quarterback and the slogan: “Believe in something even if it means sacrificing everything”. While Kaepernick is controversial, he appeals to a large part of the Nike existing and potential buying audience. The campaign helped lift sales by 27% in the first 4 days following the ad launch. Karen McFarlane, founder Kaye Media Partners summed up Nike’s strategy: “Nike’s mission is to bring inspiration and innovation to every athlete in the world. Colin Kaepernick, through his advocacy, conviction, and talent on and off the field, exemplifies those values in the strongest of terms. Couple that with Nike’s commitment to diversity and community, particularly against the backdrop of today’s America where politics have amplified cultural divisions, Nike took the opportunity to lean into their mission and values.”

Marketing campaigns that are for direct customer acquisition differ from branding campaigns as their goal is to directly acquire customers. It is not always clear whether marketing dollars should be classified as acquisition or branding. The key point is that branding is building for the future, whereas acquisition campaigns are measured by how efficiently they deliver current customers. This brings us back to measuring CAC, as the question becomes whether branding campaigns are part of the calculation of CAC. I believe they are not, as CAC should represent the direct cost of acquiring a customer so that increasing that spend will allow us to estimate how many more customers will result. So, I conclude that marketing for branding should be excluded from the calculation of CAC but can be an important strategy to improve efficiency in acquiring customers and maximizing their value. It should be part of the Contribution Margin calculation.

Paid CAC vs Blended CAC

If CAC represents what it costs to acquire a customer, what about those customers that are acquired through SEO, viral marketing, or some other free method? If one simply divides the spend on Marketing for Customer Acquisition (or MCA) by the total number of new customers, the result will be deceptive if it is used to estimate how many more customers will be acquired if MCA spend is increased. Instead companies should calculate CAC in two ways:

Blended CAC = MCA/ (total number of new customers)

Acquisition CAC = MCA/ (number of new customers generated from acquisition marketing only)

Attribution Models and how they help understand CAC by Channel

CAC helps predict the impact of different levels of spending on marketing. Companies also need to know where spending has the best impact, and therefore need to calculate a CAC (and LTV) for each channel of marketing. If a company uses multiple channels like Facebook, Google, and Snap they need to assign credit to each channel for the customers generated from that channel as compared to the spend for that channel to determine the channel CAC. The most simplistic way of doing this is to say, for example, that Google advertising gets credit for the customer if the purchase by the customer occurs after clicking to the site from Google. But what if a consumer sees a Facebook ad, goes to the site to look at products, then a week later comes back to the site from a Snap ad, and then visits the site again because the company sent them an email that they click on, and finally buys something after clicking on a Google ad?  Should Google get the entire credit for the customer?

Attribution models from companies like Amplitude and Hive attempt to appropriately credit each channel touchpoint for the role it played in acquiring a customer. For example, a company might assign 50% of the credit to the last touchpoint and divide the other 50% equally among prior touchpoints or use some other formula that is believed to capture how each channel participated in driving that consumer towards a purchase. Attribution models attempt to help companies understand how scaling spend in each channel will impact customer acquisition. For example:

Google CAC = (Google marketing spend)/ (number of customers attributed to Google ads)

One question that arises when using attribution models to credit each channel is whether “free” areas should share the credit when both paid and free touchpoints occur before converting a consumer into a buyer. The issue is whether the free touchpoints would have occurred had the company not spent on paid marketing. In my prior example the customer would never have received an email from the company had they not first seen the Facebook and Snap ads so eliminating these ads would also eliminate the email which in turn probably means they never would have become a customer. In a similar way, someone who clicked on a Google ad but did not buy, might later do a search for the product, and go to the site from SEO and then buy. So, one method of assigning attribution would be to divide the entire attribution among paid channels if a consumer touched both paid and free ones before becoming a customer. If the consumer only went to free channels, then they would count in blended CAC but not as a customer in calculating paid CAC or CAC by paid channel.

Where does Marketing to an existing customer fit in?

CAC is meant to measure new customer acquisition. So, marketing to an existing customer to get them to buy more should not be part of CAC but rather should be subtracted from MCA. I view it as a cost that reduces Lifetime Value (LTV). Many startups ignore the possibility of “reactivating” churned customers through marketing spend. Several Azure portfolio companies have seen success in deploying a reactivation strategy. I consider this spend as marketing to an existing customer and resulting profits an increase in LTV. Revising the definition of LTV (see Table 1):

LTV = LTR – COGS – Marketing Costs to existing customers

MCA (Marketing Cost for Customer Acquisition) = Marketing Costs – branding costs – marketing to existing customers

In Table 1, remarketing expense is 1% of Lifetime revenue for both Company A and Company B or:

Company A LTV = (GM% – remarketing%) X LTR = (20% – 1%) X $400 = $76

Company B LTV = (80%– 1%) X $400 = $316

What about new customers that return the product?

This is a thorny issue. If a consumer buys their first product from a company and then returns it, is she a customer? I think it would not be wrong with interpreting this either way. But I prefer considering her a customer as she was a buyer, and while the return zeros out the revenue from that purchase, she did become a customer. There is ample opportunity for marketing to her again. Considering her a customer lowers CAC as there are more customers for the spend, but it also lowers LTV for the same reason. So, if the interpretation is applied consistently over both CAC and LTV, I believe it would be correct.

More mature companies should apply the methods shown here to better understand their business

By better understanding acquisition CAC and LTV of each channel of customer acquisition a company can direct more spending to the most efficient ones (those with the highest LTV/CAC). By experimenting with “reactivation” spending a company can determine if this improves LTV/CAC. Companies that improve LTV/CAC will likely generate higher Contribution Margin. Those that increase the proportion of customers acquired for “free” can also improve Contribution Margin. Improving CAC and LTV can be accomplished in several ways as described in prior posts:

Optimizing the cost of customer acquisition modeling metrics to drive startup success (March 2014)

How to improve Contribution Margin (Nov 2018)

Without proper metrics a company is essentially flying blind and will be far less likely to succeed. This post provides a blueprint towards a more sophisticated approach to understanding any business.

Defining Key Elements of the New Model for Retail

In our October, 2015 Soundbytes (https://soundbytes2.com/2015/10/)  I predicted that Omnichannel selling would become prevalent over the ensuing years with brick and mortar retailers being forced to offer an online solution, ecommerce companies needing to access buyers at physical locations and online brands (referred to as DTC or direct to consumer) being carried by 3rd party physical stores. Since that post, these trends have accelerated (including Amazon’s announcement last week that it is opening another “4-star store” in the bay area). Having had more time to observe this progression, I have developed several theories regarding this evolving new world that I would like to share in this post.  

Issues for Brick and Mortar Stores when they Create an Online Presence

Physical retailers are not set up to handle volumes of online sales. Their distribution centers are geared towards sending larger volumes of products to their stores rather than having the technology and know-how to deal directly with consumers (a situation which motivated Walmart to buy Jet for $3.3 billion). In general, a retailer starting to sell online will need to create one or more new distribution centers that are geared towards satisfying direct to consumer online demand.  

Another rude awakening for brick and mortar retailers when they go online is a dramatic increase in returns. On average, returns are about 9% of purchases from a retail store and 30% when purchased online. The discrepancy is even greater for clothing (especially shoes) as fit becomes a major issue. Given that consumers expect free shipping, and most want free return shipping, this becomes a cost that can eviscerate margins. The volume of returns also creates the problem of handling reverse logistics, that is tracking the return, crediting the customer, putting it back into the inventory system as available and restocking it into the appropriate bin location. Then there is the question as to whether the item can still be resold. For clothing this may require adding the cost of cleaning and pressing operations to keep the item fresh and having the systems to track movement of the inventory through this process.

Lastly, the question becomes whether a brick and mortar retailers’ online sales will (at least partly) cannibalize their in-store sales. If so, this, coupled with the growth of online buying, can make existing store footprints too large, reducing store profits.

If Brick and Mortar Retailers Struggle with an Omnichannel Approach, why do DTC Brands Want to Create an Offline Presence?

The answer is a pretty simple one: market access and customer acquisition.  Despite a steady gain of share for online sales, brick and mortar still accounts for over 70% of consumer purchases. Not too long ago, Facebook was a pretty efficient channel to acquire customers. For the past 5 years, Azure portfolio companies have experienced a steep rise in CAC (customer acquisition cost) when using Facebook as the acquisition vehicle. There are many theories as to why, but it seems obvious to me that it is simply the law of supply versus demand. Facebook usage growth has slowed but the demand for ad inventory has increased dramatically, driving up prices. For large brands that use advertising for brand building rather than customer acquisition this does not appear to be a problem, especially when comparing its value to ads on television. For brands that use it for customer acquisition, doubling CAC changes the ratio of LTV (lifetime value or lifetime profits on a customer) to CAC making this method of customer acquisition far less effective.

The combination of these factors has led larger (and smaller) online brands to open brick and mortar outlets. Players like Warby Parker, Casper, Bonobos and even Tesla have done it by creating stores that are a different experience than traditional retail. Warby Parker, Bonobos and Tesla do not stock inventory but rather use the presence to attract customers and enable them to try on/test drive their products. I have bought products, essentially online, while at Warby Parker and Tesla physical locations.

I then had to wait between 2 to 6 weeks for the product to be manufactured and delivered (see the soundbite on Tesla below). What this means in each of their cases is that they kept their business models as ones of “manufacture to demand” rather than build to inventory.  It seems clear that for all four of the companies cited above there is a belief that these physical outlets are a cost effective way of attracting customers with a CAC that is competitive to online ads. They also effectively use online follow-up once you have visited their brick and mortar outlet, thus creating a blend of the two methods. Once the customer is acquired, repeat purchases may occur directly online or in a combination of online and offline.

The Future Blend of Online/Offline

While we have seen a steady progression of companies experimenting with Omnichannel whether they started as offline or online players, we have yet to see an optimal solution. Rather, various players have demonstrated parts of that optimization. So, I’d like to outline a few thoughts regarding what steps might lead to more optimization:

  1. To the degree possible, online purchases by consumers should have an in-store pickup and review option at some savings versus shipping to the home. For clothing, there should also be an opportunity to try the online purchased items on before leaving the store. In that way consumers have the ability to buy online, coupled with the convenience of trying products on in a store. This would expose the customer to a broader set of inventory (online) than even a large footprint store might be able to carry. It would improve fit, lower cost to the brand (by lowering returns and reducing shipping cost) while allowing the brand to begin acquiring better information on fit – insuring an improvement for the next online purchase. A secondary benefit would be the increase in store traffic that was created.
  2. Many retailers will add Rental to the mix of options offered to customers to improve profits. Azure portfolio company, Le Tote, is a subscription rental company for everyday women’s clothes. As women give feedback on a large variety of aspects of fit and preferences it can improve the fit dramatically with each successive box. Retailers need to have systems that replicates this knowledge of their customers. The problem for pure brick and mortar retailers is that they have not had a relationship that enables them to get the feedback…and they don’t have software systems to build this knowledge even if they were to get it. Le Tote has also built up strong knowledge of women’s preferences as to style and has created successful house brands that leverage that knowledge based on massive feedback from subscribers. You may have seen the announcement that Le Tote has just acquired Lord & Taylor, the oldest department store in the country. It plans to use the millions of existing Lord & Taylor customers as a source of potential subscribers to its service. It also has a rental vehicle that can be used to improve monetization of items that don’t sell through at the stores.
  3. Successful online brands will be carried by offline retailers. This has already started to occur but will accelerate over time as DTC brands like Le Tote (and perhaps Stitchfix) use their tens of millions of specific customer feedback data points to produce products that meet the needs expressed in the feedback. If they have correctly mined the data, these brands should be quite successful in offline stores, whether it be their own or a third party retailers’ outlet. The benefit to the retailor in carrying online brands is two-fold: first the online brands that have effectively analyzed their data create products they know can sell in each geography; and second carrying online brands will improve the image of the retailor in the eyes of shoppers who view DTC companies as more forward thinking.
  4. Department store footprints will need to shrink or be shared with online players. The issue discussed earlier of overall ecommerce coupled with brick and mortar stores cannibalizing store demand when they start selling online can be dramatically mitigated by having smaller stores. In that way retailers can maintain their brand presence, continue to get foot traffic, and improve store efficiency.  Any larger footprint store may need to take part of its space and either sublet it (as Macys is doing in some locations) or attract online brands that are willing to pay for a presence in those stores in the form of a percentage of revenue generated or rent. The offer to DTC brands may be to have a pop-up for a set period, or to agree to a longer-term relationship. By working with DTC brands in this way retailers can improve gross margin per square foot (a critical KPI for brick and mortar players) for poorly utilized portions of their store footprints. The secondary benefit to the retailer would be that the online brands will generate additional traffic to the stores. There are already a few startups that are creating a store within a store concept that carries DTC brands. They hope to be the middleman between DTC brands and large retailers/shopping malls making it easier for the DTC brands to penetrate more locations, and easier for the retailer to deal with one new player that will install multiple DTC brands in their locations.
  5. There will be more combinations of online and offline companies merging. By doing that the expertise needed for each area of the business can be optimized. The online companies presumably have better software, logistics and more efficient methods of acquiring online customers. The brick and mortar retailers have greater knowledge of running a physical store, an existing footprint to carry the online brands, locations that allow for delivery to their stores, and a customer base to market to online (reducing the CAC and increasing LTV).
  6. For Omnichannel companies, revenue attribution is complex but becomes essential to managing where dollars are spent. Revenue attribution is the tracking, connecting, and crediting marketing efforts to their downstream revenue creation. For example, if a potential customer responds to a Facebook ad by going online to look at items, then visits a store to check them out live, but eventually buys one or more of the items in response to a google ad, the question becomes: which channel should get credit for acquiring the customer? This is important as the answer may impact company strategy and help determine where marketing dollars get spent. Several Azure portfolio companies are now using 3rd party software from companies like Hive to appropriately give attribution to each channel that helped contribute to the eventual sale. This process is important as it helps determine future spending. We expect better run Omnichannel companies to evolve their analysis of marketing to include attribution models.  

Conclusion: The future winners in retail will be those that successfully migrate to the most optimal omnichannel models

What I have described in this post is inevitable. Some large proportion of customers will always want to do some or all of their shopping at a brick & mortar store. By blending the positive attributes of physical retail with the accessibility to the larger number of options that can exist online, companies can move to more optimal models that address all potential customers. But unless this is done in an intelligent way booby traps like inefficient floor space, excessive returns, high shipping costs and more will rear their ugly heads. This post describes steps for retailers/brands to take that are a starting point for optimizing an omnichannel approach.  

Soundbytes

  • When I had just left Wall Street, I received calls from the press and a very large investor in Hewlett Packard regarding my opinion of the proposed acquisition of Compaq Computer. I said: “HP is in 6 business areas with Imaging being their best and PCs their worst. Doubling up on the worst of the 6 does not make sense to me.” When asked what they should do instead, I replied: “Double up on the best business: acquire Xerox.” My how the tide has turned as Xerox was in trouble then and could have been bought at a very low price. Now it appears Xerox may acquire HP. To be clear, Xerox is still a much smaller market cap company…but I’m enjoying seeing how this process will work out.

  • In the last Soundbytes, I mentioned that I had purchased a Tesla Model 3. What is interesting is that 6 weeks later I am being told that it may take as long as 3-4 more weeks before I receive the car.  This means delivery times have extended to at least 9 weeks. I can’t say how reliable this is but the salesperson I am dealing with told me that Tesla has prioritized production of Model S, Model X and shipments to Europe and Asia over even the more expensive versions of Model 3’s (mine cost almost $59,000 before sales tax). One can easily conclude that production must be at full capacity and that the mix this quarter will contain more higher priced cars. So, demand in the quarter appears to be in excess of 100,000 units and price per car appears strong. Assuming the combination of maximum production in the U.S. and some production out of the Chinese factory, supply might also exceed 100,000 units. If the supply is available, then Tesla should have a strong Q4. However, there is the risk that Tesla doesn’t have the parts to supply both factories or that they have somehow become less efficient. The latest thing to drive down the Tesla stock price is the missteps in showcasing the new truck. I’m not sure why a company should be castigated for an esoteric feature not working in a prototype of a product that won’t be in production until sometime in 2021. Remember, Tesla at its core is a technology company producing next gen autos. I’ve seen other technology companies like Microsoft and Oracle have glitches in demos of future products without such a reaction. As for the design of the truck, I believe Tesla is targeting a 10% to 20% share of the truck market with a differentiated product rather than attempting to attract all potential buyers. 10% of the U.S. pickup market would result in 250,000 units per year. The company has announced pre-orders for the vehicle have already reached 200,000. If these orders are real, they have a home run on their hands but since the deposit is only $100 there is no guarantee that all deposits will convert to actual purchases when the truck goes into production.  

Comparing Recent IPO Companies – Should Performance Drive Valuation?

In a past life, while on Wall Street, one of my favorite calls was: “Buy Dell Short Kellogg”. My reasoning behind the call was that while Dell’s revenue and earnings growth was more than 10X that of Kellogg, somehow Kellogg had a much higher PE than Dell. Portfolio managers gave me various reasons they claimed were logical to explain the un-logical situation like: “Kellogg is more reliable at meeting earnings expectations” …. when in truth they had missed estimates 20 straight quarters. What I later came to believe was that the explanation was their overall comfort level with Kellogg because they understood cereal better than they understood a direct marketing PC hardware company at the time. My call worked out well as Dell not only had a revenue CAGR of nearly 50% from January 1995 (FY 95) through January of 2000 (and a 69% EPS CAGR) but also experienced significant multiple expansion while Kellogg revenue grew at just over 1% annually during the ensuing period and its earnings shrunk (as spend was against missed revenue expectations). The success of Dell was a major reason I was subsequently selected as the number one stock picker across Wall Street analysts for 2 years in a row.

I bring up history because history repeats. One of the reasons for my success in investing is that I look at metrics as a basis of long-term valuation. This means ignoring story lines of why the future is much brighter for those with weak metrics or rationales of why disaster will befall a company that has strong results. Of course, I also consider the strength of management, competitive advantages and market size. But one key thesis that comes after studying hundreds of “growth” companies over time is that momentum tends to persist, and strong business models will show solid contribution margin as an indicator of future profitability.

Given this preamble I’ll be comparing two companies that have recently IPO’d. Much like those that supported Kellogg, the supporters of the one with the weaker metrics will have many reasons why it trades at a much higher multiple (of revenue and gross margin dollars) than the one with stronger metrics.  

Based on financial theory, companies should be valued based on future cash flows. When a company is at a relatively mature stage, earnings and earnings growth will tend to be the proxy used and a company with higher growth usually trades at a higher multiple of earnings.   Since many companies that IPO have little or no earnings, many investors use a multiple of revenue to value them but I prefer to use gross margin or contribution margin (where marketing cost is broken out clearly) as a proxy for potential earnings as they are much better indicators of what portion of revenue can potentially translate to future earnings (see our previous post for valuation methodology).

I would like to hold off on naming the companies so readers can look at the metrics with an unbiased view (which is what I try to do). So, let’s refer to them as Company A and Company B. Table 1 shows their recent metrics.

Notes:

  • Growth for Company B included an extra week in the quarter. I estimate growth would have been about 27% year/year without the extra week
  • Disclosures on marketing seem inexact so these are estimates I believe to be materially correct
  • Pre-tax income for Company A is from prior quarter as the June quarter had considerable one-time expenses that would make it appear much worse

Company B is:

  1. Growing 2 -2 ½ times faster
  2. Has over 3X the gross margin percentage
  3. Over 28% contribution margin whereas Company A contribution margin is roughly at 0
  4. Company B is bordering on profitability already whereas Company A appears years away

Yet, Company A is trading at roughly 3.5X the multiple of revenue and almost 11X the multiple of gross margin dollars (I could not use multiple of contribution margin as Company A was too close to zero). In fairness to Company A, its gross margin was much higher in the prior quarter (at 27%). But even giving it the benefit of this higher number, Company B gross margins were still about 65% higher than Company A.

The apparent illogic in this comparison is much like what we saw when comparing Kellogg to Dell many years ago. The reasons for it are similar: investors, in general, feel more comfortable with Company A than they do with Company B. Additionally, Company A has a “story” on why things will change radically in the future. You may have guessed already that Company A is Uber. Company B is Stitchfix, and despite its moving to an industry leading position for buying clothing at home (using data science to customize each offering) there continues to be fear that Amazon will overwhelm it sometime in the future. While Uber stock has declined about 35% since it peaked in late June it still appears out of sync compared to Stitchfix.

I am a believer that, in general, performance should drive valuation, and have profited greatly by investing in companies that are growing at a healthy rate, appear to have a likelihood of continuing to do so in the near future and have metrics that indicate they are undervalued.

Soundbytes

  • It appears that many others are now beginning to focus more closely on gross margins which we have been doing for years. I would encourage a shift to contribution margin, where possible, as this considers the variable cost needed to acquire customers.
  • A few notes about Tesla following our 2019 predictions: My household is about to become a two Tesla family. My wife has owned her second Tesla, a Model S, for over 4 years and I just placed an order to buy a Model 3 as a replacement for my Mercedes 550S. Besides the obvious benefits to the environment, I’m also tired of having to go to gas stations every week. The Model 3 can go 310 miles on a charge, is extremely fast, has a great user interface and has autopilot. I looked at several other cars but found it hard to justify paying twice as much (or more) for a car with less pickup, inferior electronics, etc.
  • If you were wondering why Tesla stock has gone on a run it is because the Chinese Ministry of Industry and Information Technology (MIIT) has added Tesla to its list of approved auto manufacturers (the news of the possibility broke over a week ago). It appears likely that Tesla will begin producing Model 3s out of the new Giga Factory in China some time in Q4. This not only adds capacity for Tesla to increase its unit sales substantially in 2020 but also will save the Company considerable money as it won’t need to ship cars from its US factory. Remember Tesla also is planning on a Giga Factory in Europe to service strong demand there. The company has said that it will choose the location by the end of 2019. Given the intense competition to be the selected location, it is likely that the site chosen will involve substantial incentives to Tesla. While I would not want to predict when it will be in production, Elon Musk expects the date to be sometime in 2021. Various announcements along the way could be positive for Tesla stock.

Why Apple Acquiring Tesla Seems an Obvious Step…

…and why the obvious probably won’t happen!

A Look at Apple history

Apple’s progress from a company in trouble to becoming the first company to reach a trillion dollar market cap meant over 400X appreciation in Apple stock. The metamorphosis began when the company hired Fred Anderson as an Executive VP and CFO in 1996. Tim Cook joined the company as senior VP of worldwide operations in 1998. Fred and Tim improved the company operationally, eliminating wasteful spending that preceded their tenure. Of course, as most of you undoubtedly know, bringing back Steve Jobs by acquiring his company, NeXT Computer in early 1997 added a strategic genius and great marketer to an Apple that now had an improved business model. Virtually every successful current Apple product was conceived while Steve was there. After Fred retired in 2004, Tim Cook assumed even more of a leadership role than before and eventually became CEO shortly before Jobs’ death in 2011.  

Apple post Steve Jobs

Tim Cook is a great operator. In the years following the death of Steve Jobs he squeezed every bit of profit that is possible out of the iPad, iPod, iMacs, music content, app store sales and most of all the iPhone. Because great products have a long life cycle they can increase in sales for many years before flattening out and then declining.

Table 1: Illustrative Sales Lifecycle for Great Tech Product

Cook’s limit is that he cannot conceptualize new products in the way Steve Jobs did. After all, who, besides an Elon Musk, could? The problem for Apple is that if it is to return to double digit growth, it needs a really large, successful new product as the iPhone is flattening in sales and the Apple Watch and other new initiatives have not sufficiently moved the needle to offset it. Assuming Q4 revenue growth in FY 2019 is consistent with the first 9 months, then Apple’s compound growth over the 4 years from FY 15 to FY 19 will be 3.0% (see Table 2) including the benefit of acquisitions like Beats.

iPhone sales have flattened

The problem for Apple is that the iPhone is now in the mature part of its sales life cycle. In fact, unit sales appear to be declining (Graph 1) but Apple’s near monopoly pricing power has allowed it to defy the typical price cycle for technology products where average selling prices decline over time. The iPhone has gone from a price range of $99 to $299 in June 2009 to $999 to $1449 for the iPhoneX, while the older iPhone 7 is still available with minimal storage for $449. That’s a 4.5X price increase at the bottom and nearly 5X at the high end! This defies gravity for technology products.

Graph 1: iPhone Unit Sales (2007-2018)

In the many years I followed the PC market, it kept growing until reaching the following set of conditions (which the iPhone now also faces):

  1. Improvements in features were no longer enough to drive rapid replacement cycles
  2. Pricing was under pressure as component costs declined and it became more difficult to convince buyers to add capacity or capability sufficient to hold prices where they were
  3. The number of first time users available to buy product was no longer increasing each year
  4. Competition from lower priced suppliers created pricing pressure

Prior to that time PC pricing could be maintained by convincing buyers that they needed one or more of:

  1. The next generation of processor
  2. A larger or thinner screen
  3. Next generation storage technology

What is interesting when we contrast this with iPhones is that PC manufacturers struggled to maintain average selling prices (ASPs) until they finally began declining in the early 2000s. Similarly, products like DVD players, VCRs, LCD TVs and almost every other technology driven product had to drop dramatically in price to attract a mass market. In contrast to that, Apple has been able to increase average prices at  the same time that the iPhone became a mass market product. This helped Apple postpone the inevitable revenue flattening and subsequent decline due to lengthening replacement cycles and fewer first time buyers. In the past few years, other then the bump in FY 2018 from the launch of the high priced Model X early that fiscal year, iPhone revenue has essentially been flat to down. Since it is well over 50% of Apple revenue, this puts great pressure on overall revenue growth.

To get back to double digit growth Apple needs to enter a really large market

To be clear, Apple is likely to continue to be a successful, highly profitable company for many years even if it does not make any dramatic acquisitions. While its growth may be slow, its after tax profits has been above 20% for each of the past 5 years. Strong cash flow has enabled the company to buy back stock and to support increasing dividends every year since August 2014.

Despite this, I think Apple would be well served by using a portion of their cash to make an acquisition that enables them to enter a very large market with a product that already has a great brand, traction, and superior technology. This could protect them if the iPhone enters the downside of its revenue generating cycle (and it is starting to feel that will happen sometime in the next few years). Further, Apple would benefit if the company they acquired had a visionary leader who could be the new “Steve Jobs” for Apple.

There is no better opportunity than autos

If Apple laid out criteria for what sector to target, they might want to:

  1. Find a sector that is at least hundreds of billions of dollars in size
  2. Find a sector in the midst of major transition
  3. Find a sector where market share is widely spread
  4. Find a sector ripe for disruption where the vast majority of participants are “old school”

The Automobile industry matches every criterion:

Matching 1.  It is well over $3 trillion in size

Matching 2. Cars are transitioning to electric from gas and are becoming the next technology platform

Matching 3. Eight players have between 5% and 11% market share and 7 more between 2% and 5%

Matching 4. The top ten manufacturers all started well over 50 years ago

And no better fit for Apple than Tesla

Tesla reminds me of Apple in the late 1990s. Its advocates are passionate about the company and its products. It can charge a premium versus others because it has the best battery technology coupled with the smartest software technology. The company also designs its cars from the ground up, rather than retrofitting older models, focusing on what the modern buyer would most want. Like Jobs was at Apple, Musk cares about every detail of the product and insists on ease of use wherever possible. The business model includes owning distribution outlets much like Apple Stores have done for Apple. By owning the outlets, Tesla can control its brand image much better than any other auto manufacturer. While there has been much chatter about Google and Uber in terms of self-driving cars, Tesla is the furthest along at putting product into the market to test this technology.

Tesla may have many advantages over others, but it takes time to build up market share and the company is still around 0.5% of the market (in units). It takes several years to bring a new model to market and Tesla has yet to enter several categories. It also takes time and considerable capital to build out efficient manufacturing capability and Tesla has struggled to keep up with demand. But, the two directions that the market is moving towards are all electric cars and smart, autonomous vehicles. Tesla appears to have a multi-year lead in both. What this means is that with enough capital and strong operational direction Tesla seems poised to gain significant market share.

Apple could accelerate Tesla’s growth

If Apple acquired Tesla it could:

  1. Supply capital to accelerate launch of new models
  2. Supply capital for more factories
  3. Increase distribution by offering Tesla products in Apple Stores (this would be done virtually using large computer screens). An extra benefit from this would be adding buzz to Apple stores
  4. Supply operational knowhow that would increase Tesla efficiency
  5. Add to the luster of the Tesla brand by it being part of Apple
  6. Integrate improved entertainment product (and add subscriptions) into Tesla cars

These steps would likely drive continued high growth for Tesla. If, with this type of support, it could get to 5% share in 3-5 years that would put it around $200 billion in revenue which would be higher than the iPhone is currently. Additionally, Elon Musk is possibly the greatest innovator since Steve Jobs. As a result, Tesla would bring to Apple the best battery technology, the strongest power storage technology, and the leading solar energy company. More importantly, Apple would also gain a great innovator.

The Cost of such an acquisition is well within Apple’s means

At the end of fiscal Q3, Apple had about $95 billion in cash and equivalents plus another $116 billion in marketable securities. It also has averaged over $50 billion in after tax profits annually for the past 5 fiscal years (including the current one). Tesla market cap is about $40 billion. I’m guessing Apple could potentially acquire it for less than $60 billion (which would be a large premium over where it is trading). This would be easy for Apple to afford and would create zero dilution for Apple stockholders.

If the Fit is so strong and the means are there, why won’t it happen?

I can sum up the answer in one word – ego.  I’m not sure Tim Cook is willing to admit that Elon would be a far better strategist for Apple than him. I’m not sure he would be willing to give Elon the role of guiding Apple on the product side. I’m not sure Elon Musk is willing to admit he is not the operator that Tim Cook is (remember Steve Jobs had to find out he needed the right operating/financial partners by getting fired by Apple and essentially failing at NeXT). I’m not sure Elon is willing to give up being the CEO and controlling decision-maker for his companies.

So, this probably will never happen but if it did, I believe it would be the greatest business powerhouse in history!

Soundbytes

  1. USA Today just published a story that agreed with our last Soundbytes analysis of why Klay Thompson is underrated.
  2. I expect Zoom Video to beat revenue estimates of $129 million to $130 million for the July Quarter by about $5 million or more

The Warriors Ain’t Dead Yet!

Why the team is still a contender

My long term readers know that every so often the blog wanders into the sports arena. In doing so, I apply the same type of analysis that I do for public stocks and for VC investments to sports, and usually, basketball. Given all the turmoil that has occurred in the NBA this off-season, including the Warriors losing Durant, Iguodala, Livingston, Cousins and several other players, I thought it would be interesting to evaluate the newly changed team. Both ESPN and CBS power rankings have them 7th in the West and 11th in the NBA. I find that an overreaction as the Warriors may have beaten the Raptors if Klay Thompson not been injured, they swept Portland, and won the last 2 Rockets games without Durant. At the time this drove a lot of chatter that the team might be better off without Durant (I disagree).

But rather then compare the revised roster to last year’s, it seems more closely matched with the 2014-15 team, as that was a championship team that did not include Kevin Durant. I will make 2 key assumptions:

  1. Klay Thompson will return by the end of February and be as effective as he was before his injury
  2. The Warriors will make the playoffs despite missing Thompson for the majority of the season

It all starts with Curry

A third key assumption that has been proven over and over again is that players that come to the Warriors usually perform better as they benefit from the “Curry Effect”, namely, getting more shots without having someone closely guarding them, (The Curry Effect), resulting in an average improved shooting percentage of over 5%. In all fairness, it really is the “Curry plus Thompson Effect” as the extreme focus on preventing the two of them from taking 3 point shots is what frees up others. It helps that Curry is unselfish and readily passes the ball when he is double or triple teamed. Thompson’s passing has improved substantially but since he gets his shot off so quickly, he has less need to pass it. Last year both shot over 40% from 3 despite defensive efforts focused on preventing each of them from taking those shots.

Starting Teams: 2019-20 vs 2014-15

Table 1

Curry, Thompson and Green, the heart and soul of the Warriors, all remain from the 2014-15 roster, and now are at their peaks. In the 2014-15 season when Green first became a starter, Curry was one year away from reaching his peak and Thompson was just coming into his own especially on defense. I believe each of them is better today then they were at that time. At his best, Bogut may have been better than Cauley-Stein, but by 2014 Bogut had been through a number of injuries. Last year Cauley-Stein averaged nearly double the points of 2014 Bogut (11.9 vs 6.3), took slightly more rebounds per game and was a better free throw shooter. Stein, much like Bogut, is also considered a solid pick setter and defender. Russell is someone who should benefit greatly from playing with Curry. Even without that, last season he averaged over twice as many points per game as 2014 Barnes (21.1 vs 10.1) which should take considerable pressure off Curry (and Klay when he returns). However, Barnes was a better defender in 2014 than Russell is today. I give the edge to all 5 starters on the 2019 starting team compared to the 5 that started in 2014-15.

Thompson may be the most underrated player in the league!

It’s unfortunate that Thompson was injured in game 6 of the 2019 finals as he was once again proving just how good he can be. Not only was he playing lockdown defense, but he also drove the offense in what has been referred to as a typical Klay game 6. In just 32 minutes, before getting injured, he scored 30 points on 83% effective shooting percentage (67% on 3s), went 10 for 10 on free throws, and had 5 rebounds and 2 steals. I believe Golden State, even without Durant, would have forced a game 7 if Thompson did not get injured.

It boggles my mind that one of the websites could refer to Thompson as “an average player” who did not merit a max contract. This is bordering on the ridiculous and has a lot to do with the fact that the most important measure of shooting, effective shooting percentage (where each 3 made counts as 1½ 2 point shots made) does not normally get reported (or even noticed). In Table 2, I list the top 31 scorers from last season (everyone who averaged at least 20 points per game) and rank them by effective shooting. Thompson is number 8 in effective shooting and number 3 in 3-point percentage among this group. So, if effective shooting percentage was regularly published, Thompson would show up consistently helping the perception of his value. When this is coupled with his being a third team all-defensive player (i.e., one of the top 15 defenders in the league) it appears clear that he should be considered one of the top 15 players in the league.

Table 2: Top Scorers 2018-2019 Season

6th Man 2019-20 vs 2014-15

Kevon Looney has emerged as a potential star in the works. While he may not yet be the defensive presence of Iguodala, he is getting close. His scoring per minute played was higher than Andre’s 2014-15 numbers and his rebounds per minute were more than twice as much. While Iguodala had greater presence and could run the team as well as assist others in scoring, Looney at least partly makes up for this in his ability to set screens. Looney also has a much higher effective shooting percentage (62.7% vs 54.0%) than Andre had in 2014-15. While Kevon doesn’t shoot 3s he gets many points by putting back offensive rebounds and dunking lob passes. Overall, I give the edge to Iguodala based on the Looney of last season but given Looney’s potential to improve this might be dead even in the coming one.

Rest of the Bench for the 2 teams

It is the bench that is hardest to evaluate. Unlike last year’s bench, the 2014-15 bench was quite strong which spawned the Warrior logo “Strength in Numbers”. It included quality veteran players like Leandro Barbosa, David Lee, Mareese Sprouts and Shaun Livingston, who was playing at a much higher level than last season. The four of these together averaged over 26 points per game.  This coming year’s bench is much younger and more athletic. It includes Alec Burks, Glenn Robinson, Alfonzo McKinnie and Omari Spellman, plus several rookies and Jacob Evans III. The first four are all capable of scoring and are solid 3-point shooters (they could increase to well above average once with the Warriors). I expect that group, coupled with one or two of the others, to exceed the 2014-15 bench in defense…but may not have as much scoring fire power. The team is likely to give one or two of the rookies as well as Evans opportunities to earn minutes as well. The bench is an improvement over last year but may not be as strong as the 2014-15 squads.

Overall Assessment

I believe the 2019-2020 squad is better than the championship team of 2015. The starting lineup features the core 3 players who have improved since then, D’Angelo Russell who was an all-star last year, and a solid center in Willie Cauley-Stein making the edge substantial. Looney as 6th man is already giving evidence of future stardom. While he was not quite the Andre Iguodala of 2014-15, the difference is modest, and Looney continues to improve. The 2014-15 bench appears superior to that of next season, but the edge is not great as the newer group should be stronger defensively and is not far off the older group as scorers – the question will be how well they gel and how much the Curry/Klay factor improves their scoring. Finally, I think Kerr is a better coach today than he was given the last 5 years of experience.

They May Have Improved vs 2014-15, but so has the Competition

ESPN and CBS power rankings reflect the fact that multiple teams have created new “super star” two-somes:

  • Lakers: Lebron and Anthony Davis
  • Clippers: Kawhi Leonard and Paul George
  • Houston: Harden and Westbrook (in place of Chris Paul)
  • Nets: Kyrie Irving and Durant

Contenders also include improving young teams like Boston, Philadelphia, Denver, and Utah plus an improved Portland squad. This makes the landscape much tougher than when the Warriors won their 2015 championship. Yet, none of these teams seem better than the Cleveland team (led by a younger LeBron, Kyrie Irving and Kevin Love) the Warriors beat in 2015. So, assuming Klay returns by late February and is back to par, I believe the Warriors will remain strong contenders given the starting team with four all-stars augmented by Willie Cauley-Stein and an improving Kevon Looney as 6th man. However, it will be much tougher going in the early rounds in the playoffs, making getting to the finals longer odds than in each of the past 5 years.

SoundBytes

  1. An examination of Table 2 reveals several interesting facts:
  2. Curry, once again is the leader among top scorers in effective shooting and the only one over 60%
  3. Antetokounmpo is only slightly behind despite being a very poor 3-point shooter. If he can improve his distance shooting, he may become unstoppable
  4. Russell Westbrook, once again, had the worst effective shooting percent of anyone who averaged 20 points or more. In fact, he was significantly below the league average. Part of the reason is despite being a very poor 3-point shooter he continues to take too many distance shots. Whereas most players find that taking 3s increases their effective shooting percent, for Westbrook it lowers it. I haven’t been able to check this, but one broadcaster stated that he has the lowest 3-point percentage of any player in history that has taken over 2500 3-point shots!
  5. I believe that Westbrook has a diminished chance to accumulate as many triple doubles next season as he has in the past. There is only one ball and both he and Harden tend to hold it most of the time. When Chris Paul came to the Rockets his assists per game decreased by about 15% compared to his prior 3 season average.

My Crazy Investment Technique for Solid Growth Stocks

You should not try it!

Applying Private Investment Analysis to the Rash of Mega-IPOs Occurring

The first half of 2019 saw a steady stream of technology IPOs. First Lyft, then Uber, then Zoom, all with different business models and revenue structures. As an early investor in technology companies, I spend a lot of time evaluating models for Venture Capital, but as a (recovering) investment analyst, I also like to take a view around how to structure a probability weighted investment once these companies have hit the public markets. The following post outlines a recent approach that I took to manage the volatility and return in these growth stocks.

Question: Which of the Recent technology IPOs Stands out as a Winning Business Model?

Investing in Lyft and Uber, post IPO, had little interest for me. On the positive side, Lyft revenue growth was 95% in Q1, 2019, but it had a negative contribution margin in 2018 and Q1 2019.  Uber’s growth was a much lower 20% in Q1, but it appears to have slightly better contribution margin than Lyft, possibly even as high as 5%. I expect Uber and Lyft to improve their contribution margin, but it is difficult to see either of them delivering a reasonable level of profitability in the near term as scaling revenue does not help profitability until contribution margin improves. Zoom Video, on the other hand, had contribution margin of roughly 25% coupled with over 100% revenue growth. It also seems on the verge of moving to profitability, especially if the company is willing to lower its growth target a bit.

Zoom has a Strong Combination of Winning Attributes

There is certainly risk in Zoom but based on the momentum we’re seeing in its usage (including an increasing number of startups who use Zoom for video pitches to Azure), the company looks to be in the midst of a multi-year escalation of revenue. Users have said that it is the easiest product to work with and I believe the quality of its video is best in class. The reasons for Zoom’s high growth include:

  1. Revenue retention of a cohort is currently 140% – meaning that the same set of customers (including those who churn) spend 40% more a year later. While this growth is probably not sustainable over the long term, its subscription model, based on plans that increase with usage, could keep the retention at over 100% for several years.
  2. It is very efficient in acquiring customers – with a payback period of 7 months, which is highly unusual for a SaaS software company. This is partly because of the viral nature of the product – the host of the Zoom call invites various people to participate (who may not be previous Zoom users). When you participate, you download Zoom software and are now in their network at no cost to Zoom. They then offer you a free service while attempting to upgrade you to paid.
  3. Gross Margins (GMs) are Software GMs – about 82% and increasing, making the long-term model likely to be quite profitable
  4. Currently the product has the reputation of being best in class (see here) for a comparison to Webex.
  5. Zoom’s compression technology is well ahead of any competitor according to my friend Mark Leslie (a superb technologist and former CEO of Veritas).

The Fly in the Ointment: My Valuation Technique shows it to be Over Valued

My valuation technique, published in one of our blog posts, provides a method of valuing companies based on revenue growth and gross margin. It helps parse which sub-scale companies are likely to be good investments before they reach the revenue levels needed to achieve long term profitability. For Zoom Video, the method shows that it is currently ahead of itself on valuation, but if it grows close to 100% (in the January quarter it was up 108%) this year it will catch up to the valuation suggested by my method. What this means is that the revenue multiple of the company is likely to compress over time.

Forward Pricing: Constructing a Way of Winning Big on Appreciation of Even 10%

So instead of just buying the stock, I constructed a complex transaction on May 29. Using it, I only required the stock to appreciate 10% in 20 months for me to earn 140% on my investment. I essentially “pre-bought” the stock for January 2021 (or will have the stock called at a large profit). Here is what I did:

  1. Bought shares of stock at $76.92
  2. Sold the same number of shares of call options at $85 strike price for $19.84/share
  3. Sold the same number of shares of put options at $70 strike for $22.08/share
  4. Both sets of options expire in Jan 2021 (20 months)
  5. Net out of pocket was $35/share

Given the momentum I think there is a high probability (75% or so) that the revenue run rate in January 2021 (when options mature) will be over 2.5x where it was in Q1 2019. If that is the case, it seems unlikely that the stock would be at a lower price per share than the day I made the purchase despite a potential for substantial contraction of Price/Revenue.

In January 2021, when the options expire, I will either own the same shares, or double the number of shares or I will have had my shares “called” at $85/share.

The possibilities are: 

  • If the stock is $85 or more at the call date, the stock would be called, and my profit would be roughly 140% of the net $35 invested
  • If the stock is between $70 and $85, I would net $42 from the options expiring worthless plus or minus the change in value from my purchase price of $76.92. The gain would exceed 100%
  • If the stock is below $70, I’ll own 2x shares at an average price of $52.50/share – which should be a reasonably good price to be at 20 months out.
  •  Of course, the options can be repurchased, and new options sold during the time period resulting in different outcomes.

Break-Even Point for the Transaction Is a 32% Decline in Zoom Video Stock Price

Portfolio Managers that are “Value Oriented” will undoubtedly have a problem with this, but I view this transaction as the equivalent of a value stock purchase (of a high flyer) since the break-even of $52/share should be a great buy in January 2021. Part of my reasoning is the downside protection offered: where my being forced to honor the put option would mean that in January 2021, I would own twice the number of shares at an average price of $52.50/share. If I’m right about the likelihood of 150% revenue growth during the period, it would mean price/revenue had declined about 73% or more. Is there some flaw in my logic or are the premiums on the options so high that the risk reward appears to favor this transaction?

I started writing this before Zoom reported their April quarter earnings, which again showed over 100% revenue growth year/year. As a result, the stock jumped and was about $100/share. I decided to do a similar transaction where my upside is 130% of net dollars invested…but that’s a story for another day.

Estimating the “Probabilistic” Return Using My Performance Estimates

Because I was uncomfortable with the valuation, I created the transaction described above. I believe going almost 2 years out provides protection against volatility and lowers risk. This can apply to other companies that are expected to grow at a high rate. As to my guess at probabilities:

  1. 75% that revenue run rate is 2.5x January 2019 (base) quarter in the quarter ending in January 2021. A 60% compound annual growth (CAG) for 2 years puts the revenue higher (they grew over 100% in the January 2019 quarter to revenue of $105.8M)
  2. 95% that revenue run rate is over 2.0X the base 2 years later (options expire in January of that year). This requires revenue CAG of 42%. Given that the existing customer revenue retention rate averaged 140% last year, this appears highly likely.
  3. 99% that revenue is over 1.5X the base in the January 2021 quarter (requires slightly over 22% CAG)
  4. 1% that revenue is less than 1.5X

Assuming the above is true, I believe that when I did the initial transaction the probabilities for the stock were (they are better today due to a strong April quarter):

  1. 50% that the stock trades over 1.5X today by January 2021 (it is almost there today, but could hit a speed bump)
  2. 80% that the stock is over $85/share (up 10% from when I did the trade) in January 2021
  3. 10% that the stock is between $70 and $85/share in January 2021
  4. 5% that the stock is between $52 and $70 in January 2021
  5. 5% that the stock is below $52

Obviously, probabilities are guesses since they heavily depend on market sentiment, whereas my revenue estimates are more solid as they are based upon analysis, I’m more comfortable with. Putting the guesses on probability together this meant:

  1. 80% probability of 140% profit = 2.4X
  2. 10% probability of 100% profit = 2.0X
  3. 5% probability of 50% profit (this assumes the stock is in the middle at $61/share) = 1.5X
  4. 5% probability of a loss assuming I don’t roll the options and don’t buy them back early. At $35/share, loss would be 100% = (1.0X)

If I’m right on these estimates, then the weighted probability is 120% profit. I’ve been doing something similar with Amazon for almost 2 years and have had great results to date. I also did part of my DocuSign buy this way in early January. Since then, the stock is up 27% and my trade is ahead over 50%. Clearly if DocuSign (or Amazon or Zoom) stock runs I won’t make the same money as a straight stock purchase would yield given that I’m capped out on those DocuSign shares at slightly under 100% profit, but the trade also provides substantial downside protection.

Conclusion: Investing in Newly Minted IPOs of High Growth Companies with Solid Contribution Margins Can be Done in a “Value Oriented” Way  

When deciding whether to invest in a company that IPOs, first consider the business model:

  • Are they growing at a high rate of at least 30%?
  • Experiencing increasing contribution margins already at 20% or more?
  • Is there visibility to profitability without a landscape change?

Next, try to get the stock on the IPO if possible. If you can’t, is there a way of pseudo buying it at a lower price? The transaction I constructed may be to complex for you to try and carries the additional risk that you might wind up owning twice the number of shares. If you decide to do it make sure you are comfortable with the potential future cash outlay.

R&D: Amazon’s Dirty Little Secret Weapon

 

Why doesn’t Amazon produce more earnings given its dominance?

Amazon just reported earnings and, as was the case in 2017 and 2016, emphasized that 2019 will be an investment year, so the strong operating margin expansion of 2018 would be capped in 2019. This, of course, is great fodder for bears on the stock as Amazon gave sceptics renewed opportunity to point out that it is a company that has a flawed business model and would find it difficult to ever earn a reasonable return on revenue.

In contrast, I believe that Amazon continues to transform itself into a potential strong profit performer. For example, taking the longer perspective, Amazon’s gross margins are now over 40% up from 27.2% five years ago (2013). So why doesn’t Amazon deliver higher operating margin than the slightly over 6% it reported in 2018? Amazon’s dirty little secret is that it continues to invest heavily in creating future dominance through R&D. Had it spent a similar amount in R&D to its long time competitor, Walmart, EBITDA would have nearly tripled… to over 17% of revenue! I must confess that in the past I haven’t paid enough attention to how much Amazon spends on R&D. As a result, I was surprised that Apple and Microsoft trailed it in voice recognition technology and that Amazon could lead IBM and Microsoft in cloud technology. The reason this occurred is not a surprising one: Amazon outspends Apple, Microsoft and IBM in R&D.

In fact, Amazon now outspends every company in the world (see Table 1) and have been dedicating a larger portion of available dollars to R&D (as measured by the % of gross margin dollars spent on R&D) than any other large technology company, except Qualcomm, for more than 10 years. Even though Amazon had less than 50% of Apple’s revenue and less than 1/3 of its gross margin dollars 5 years ago (2013) Amazon spent nearly 50% more than Apple on R&D that year… by 2018 the gap had increased to close to 100% more.

Table 1: Top 10 (and a few more) U.S. R&D Spenders in 2018 ($Bn)

Sources: market watch, analyst reports, annual filings

Note 1: Ford and GM may be in the top 10 but so far have not reported R&D in 2018. If they report it at year end the table could change. Walmart does not report R&D and their spend is generally unavailable, but I found a reference that said they expected to spend $1.1M in 2017.

Note 2: A 2018 global list would include auto makers VW and Toyota (with R&D of $15.8B and about 10.0B), drug company Roche (&10.8B) and tech company Samsung at $15.3B in place of the lowest 4 in Table 1.

The Innovators Financial Dilemma: Increasing Future Prospects can lower Current Earnings

When I was on Wall Street covering Microsoft (and others) Bill Gates would often point out that the company was going to make large investments the following year so they could stay ahead of competition. He said he was less concerned with what that meant for earnings. That investment helped drive Microsoft to dominance by the late 1990s. Companies are often confronted with the dilemma of whether to increase spending to drive future growth or to maximize current earnings. I believe that investment in R&D, when effective, is correlated to future success.

It is interesting to see how leaders in R&D spending have transitioned over the past 10 years. In 2008 the global leaders in R&D spending included 5 pharma companies, 3 auto makers and only 2 tech companies (Nokia and Microsoft which subsequently merged). In 2018, 6 of the top 7 spenders (Samsung plus the 5 shown in Table 1) were technology companies.

Table 2 – 2008 global R&D leaders ($Bn)

Note: *Facebook data from 2009, first available financials from S-1 filing

It’s hard to change without tanking one’s stock

When a company has a business model that allocates 1% of gross margin dollars to R&D, it is not easy to turn on the dime. If Walmart had decided to invest half as much as Amazon in R&D in 2018, its earnings would have decreased by 80% – 90% and its stock would have depreciated substantially. So, instead it began a buying binge several years ago to try to close the technology gap through acquisitions (which has a much smaller impact on operating margins). It remains to be seen if this strategy will succeed going forward but in the past 5 years Walmart revenue (including acquisitions) increased only 5% while Amazon’s was up 130% in the same period (also including acquisitions).

Whatever Happened to IBM?

When I was growing up, I thought of IBM as the king of tech. In the early 1990s it still seemed to rule the roost. The biggest fear for Microsoft was that IBM could overwhelm it, yet now it appears to be an also ran in technology. From 2014 to 2018, a heyday era for tech companies, its revenue shrank from $93 billion in 2014 to $80 billion in 2018. I can’t tell how much of the problem stems from under investing in R&D versus poor execution, but for the past 5 years it has spent an average of about 13% of GM on R&D, while the 6 tech companies in Table 1 have averaged about 24% of GM dollars with Apple the only one under 20%.

 

Soundbytes

Soundbyte I: Tesla

  • I recently had a long dialogue with a very smart fund manager and was struck by what I believe to be misinformation he had read regarding Tesla. There were 3 major points that he had heard:
    • The quality of Tesla cars was shoddy
    • Tesla could not maintain reasonable margins as it began producing lower priced Model 3s
    • The upcoming influx of electric cars from companies like Porsche, Jaguar and Audi would take substantial market share away from Tesla

I decided to do a bit of research to determine how valid each of these issues might be.

  • Tesla Quality: I found it hard to believe that the majority of Tesla owners thought the car was of poor quality since every one of the 15 or so people I knew who had bought one had already bought another or were planning to for their next car. So, I found a report on customer satisfaction from Consumer Reports, and I was not surprised to find that Tesla was the number 1 ranked car by customer satisfaction.
  • Tesla margins: this is much harder to predict. Since Tesla is relatively young as a manufacturer it has had numerous issues with production. Yet it is probably ahead of many others when it comes to automating its facilities. This tends to cause gross margins to be lower while volume ramps and higher subsequently. The combination of that, plus moving up the learning curve, should mean that Tesla lowers the cost of producing its products. However, Tesla charges more for cars with higher capacity for distance, but as I understand it uses software to limit battery capacity for lower priced cars. This would mean that a portion of the difference between a lower priced Model 3 and a higher priced one (the battery capacity) would be minimal change in cost, putting pressure on margins. The question becomes whether Tesla’s improving cost efficiencies offset the average price decline of a Model 3 as Tesla begins fulfilling demand for lower priced versions.
  • March 1 Update: After this post was complete (Thursday February 28) the company announced it was closing many showrooms to reduce costs. Then late today (Friday) announced that the $35,000 version of the model 3 is now available. So, we shall soon see the impact. I believe that if Tesla has increased capacity there will be very strong sales. It also likely will experience lower gross margin percentages as it climbs the learning curve and ramps production.
  • Will the influx of electric cars from others impact Tesla market share?

 

  1. Porsche is an electric sports car starting at $90K – at that price point it is competitive with model S not model 3. In competing with the S it comes down to whether one prefers a sports car to a sedan. I have owned a Porsche in the past and would only consider it if I wanted a sports car with limited seating capacity (but very cool). I loved my Porsche but decided to switch to sedans going forward. Since then I’ve owned only sedans for the past 10+ years. It also appears that early production is almost a year away, so it is unlikely to be competitive for 2019.
  2. Audi is at price points that do compete with the Model 3 and expects to start delivering cars in March. However, I think that is mainly in Europe where Tesla is an emerging brand so it might not impact them at all. When I look at the Audi models I don’t think they will appeal to Tesla buyers as they are very old-line designs (I would call them ugly). The range of the cars on a charge is not yet official but seems likely to be much lower than Tesla which has a big lead in battery technology.
  3. The Jaguar competes with the Tesla Model X but while cheaper, appears a weak competitor.

 

I don’t want to dismiss the fact that traditional players will be introducing a large number of electronic vehicles. The question really is whether the market size for electric cars is a fixed portion of all cars or whether it will become a much larger part of the entire market over time. I would compare this to fears that analysts had when Lotus and Wordperfect created Windows versions. They felt that Microsoft would lose share of windows spreadsheets and word processors. I agreed but pointed out that Windows was 10% of the entire market for spreadsheets, so having a 90% share gave Microsoft 9% of the overall spreadsheet market. I also predicted Microsoft would have over a 45% share when Windows was 100% of the market. So, while this would decrease Microsoft’s share of Windows spreadsheets, it would grow its total share of the market by 5X Of course we all were proven wrong as Microsoft eventually reached over 90% of the entire market.

For Tesla, the question becomes whether these rivals are helping accelerate the share electric cars will have of the overall market, rather than eroding Tesla volumes. I’m thinking that it’s the former, and that Tesla will have a great volume year in 2019 and that its biggest competitive issue will be whether the Model 3 is so strong that it will get people to buy it over the Model S. Of course, I could be wrong, but believe the odds favor Tesla in 2019, especially the first half of the year where the competitors are not that strong.

Soundbyte II: The NYC / Amazon Deal Collapses

I never cease to be amazed at how little regard some Politicians have for facts. I should likely not have been surprised by the furor created over Amazon locating a major facility in New York City. I thought the $44 billion or more in benefits to the City and State and massive job creation were such a win that no one would contest it. Instead, the dialog centered around the $ 3 billion in tax benefits to Amazon. All but 1/6 of the benefits (which was cash from the state) were based on existing laws and amounted to a reduction of future taxes rather than upfront cash. What a loss for the City.

2019 Top Ten Predictions

Opportunity Knocks!

The 2018 December selloff provides buying opportunity

One person’s loss is another’s gain. The market contraction in the last quarter of the year means that most stocks are at much lower prices than they were in Q3 of 2018. The 5 stocks that I’m recommending (and already own) were down considerably from their Q3 2018 highs. While this may be wishful thinking, returning to those highs by the end of 2019 would provide an average gain of 78%. Each of the 5 had revenue growth of 25% or more last year (and 3 were over 35%) and each is poised for another strong year in 2019.

For the 4 continued recommendations (all of which I mentioned I would recommend again in my last post), I’ll compare closing price on December 31, 2019 to the close on December 31, 2018 for calculating performance. For the new add to my list, I’ll use the stock price as I write this post. I won’t attempt to predict the overall market again (I’m just not that good at it) but feel that the 14% drop in Q4 means there is a better chance that it won’t take a nosedive. However, since stock picks are always relative to the market, success is based on whether my picks, on average, outperform the market.

I’ll start the post with stock picks and then follow with the remaining 5 predictions.

 2019 Stocks  

Tesla stock will outpace the market (it closed last year at $333/share and is essentially the same as I write this)

In Q3, 2018 the Tesla model 3 was the bestselling car in the U.S. in terms of revenue and 5th highest by volume. This drove a 129% revenue increase versus a year earlier and $1.75 in earnings per share versus a loss of $4.22 in the prior quarter. I expect Q4 revenue to increase sequentially and growth year/year to exceed 100%. In Q3, Tesla reported that nearly half of vehicles traded in for the Model 3 were originally priced below $35,000. As Tesla begins offering sub-$40,000 versions of it, demand should include many buyers from this high-volume price range. Since the backlog for the Model 3 is about 300,000 units I expect 2019 sales to remain supply constrained if Tesla can offer lower price points (it already has announced a $2,000 price reduction). The important caveat to demand is that tax credits will be cut in H1 2019, from $7500 to $3750 and then cut again to $1875 in the second half of the year. Part of Tesla’s rationale for a $2000 price drop is to substantially offset the initial reduction of these tax credits.

Tesla began taking orders for its Q1 launch in Europe where demand over time could replicate that in the U.S. The average price of a Model 3 will initially be about $10,000 higher than in the U.S. Tesla is also building a major manufacturing facility in China (where Model 3 prices are currently over $20,000 higher than the U.S.). This Giga-Factory is expected to begin production in the latter half of 2019. While moving production to China for vehicles sold there should eliminate trade war issues, Tesla still expects to begin delivering Model 3s to Chinese customers in March.

The combination of a large backlog, reducing prices within the U.S. and launches in Europe and China should generate strong growth in 2019. Some investors fear price reductions might lead to lower gross margins. When I followed PC stocks on Wall Street, this was a constant question. My answer is the same as what proved true there: strong opportunity for continuous cost reduction should enable gross margins to remain in the 20-25% range in any location that is at volume production. So, perhaps the Chinese Giga-Factory and a future European factory will start at lower margins while volume ramps but expect margins in the U.S. (the bulk of revenue in 2019) to remain in the targeted range. Higher prices in Europe and China due to massive initial demand allows premium pricing which may keep margins close to 20%+ in each.

Facebook stock will outpace the market (it closed last year at $131/share).

Facebook underperformed in 2018, closing the year down 28% despite revenue growth that should be 35% to 40% and EPS tracking to about 36% growth (despite a massive increase in SG&A to spur future results).  The stock reacted to the plethora of criticism regarding privacy of user information coupled with the continuing charges of Russian use of Facebook to impact the election. Before the wave of negative publicity, Facebook reached a high of $218/share in July. Facebook is likely to continue to increase its spending to address privacy issues and to burnish its image. However, scaling revenue could mean it keeps operating margins at a comparable level to 2018 rather than increasing them. Rumors of Facebook’s demise seem highly exaggerated!  According to a December 2018 JP Morgan survey of U.S. Internet users, the three most used social media products were Facebook (88% of participants), Facebook Messenger (61%) and Instagram (47%). Also, 82% of those surveyed picked a Facebook-owned platform as being the most important to them. Finally, the average Facebook user reported checking Facebook roughly 5 times per day with 56% of users spending 15 minutes to an hour or more on the platform on an average day. While Facebook has experienced a minor decrease in overall usage, Instagram usage has increased dramatically. Facebook, Instagram, and WhatsApp together give the company a growing and dominant position.

At the beginning of 2018 Facebook stock was trading at 34 times trailing EPS. By the end of the year the multiple of trailing EPS was below 18. If I assume EPS can grow 20%+ in 2019 (which is below my expectation but higher than the consensus forecast) than a multiple of 20 would put the stock at about $180/share by December 31. If it grew EPS, more in line with revenue and/or returned to a multiple closer to 34 it could reach well over 200.

Two key factors:

  1. A 20% increase in revenue (I expect the increase to be about 30%) adds over $11 billion in revenue. A comparable 20% increase in SG&A would provide over $4 billion in additional money to spend, affording the company ample dollars to devote to incremental marketing without impacting operating margins.
  2. Given the “low” stock price, Facebook increased its buyback program by $9 billion to $15 billion. Since it generates $6B – $7B in cash per quarter from operations (before capex) and has roughly $40 billion in cash and equivalents it could easily increase this further if the stock remains weak. The $15 billion could reduce the share count by as much as 3% in turn increasing EPS by a similar amount.

Amazon stock will outpace the market (it closed last year at $1502/share).

While its stock dropped from its September high of $2050, Amazon remained one of the best market performers in 2018 closing the year at $1502/share. At its 2018 high of $2050, It may have gotten ahead of itself, but at year end it was up less than 2018 revenue growth. Leveraging increased scale meant net income grew faster than revenue and is likely to triple from 2017. Growth will be lower in Q4 then Q3 as Q4 2017 was the first quarter that included all revenue from Whole Foods. Still, I would not be surprised if Amazon beat expectations in Q4 since this is already factored into analyst forecasts. Amazon trades on revenue coupled with the prospect of increasingly mining the revenue into higher profits. But the company will always prioritize making long term investments over maximizing near term earnings. Growth in the core ecommerce business is likely to gradually slow, but Amazon has created numerous revenue streams like its cloud and echo/Alexa businesses that I expect to result in maintaining revenue growth in the 20% plus range in 2019. The prospect of competing with an efficient new brick and mortar offering (see prediction 6 in this post) could drive new excitement around the stock.

Profitability in 2019 could be reduced by: announced salary increases to low end workers; increasing the number of physical store locations; and greater marketing incentives for customers. Offsets to this include higher growth in stronger margin businesses like AWS and subscription services. The stock may gyrate a bit, but I expect it to continue to outperform.

Stitch Fix stock will outpace the market (it closed last year at $17/share).

In my 2018 forecast I called this my riskiest pick and it was the most volatile which is saying a lot given the turbulence experience by Facebook, Tesla, and Amazon. I was feeling pretty smug when the stock reached a high of $52/share in September! I’m not sure how much of the subsequent drop was due to VCs and other early investors reducing their positions but this can have an impact on newly minted public companies. Whatever the case, the stock dropped from September’s high to a low point of $17.09 by year’s end. The drop was despite the company doing a good job balancing growth and profitability with October quarter revenue up 24% and earnings at $10.7 million up from $1.3 million in the prior year. Both beat analyst expectations. The stock was impacted because the number of users grew 22% (1-2% less than expected) despite revenue exceeding expectations at 24% growth. I’m not sure why this was an issue.

Stitch Fix continues to add higher-end brands and to increase its reach into men, plus sizes and kids. Its algorithms to personalize each box of clothes it ships keeps improving. Therefore, the company can spend less on acquiring new customers as it has increased its ability to get existing customers to spend more and come back more often. I believe the company can grow by roughly 20% or more in 2019. If it does and achieves anything close to the revenue multiple that it started with in 2018 (before the multiple doubled in mid-year), there would be a sizeable stock gain this year. But it is a thinly traded stock and likely to be quite volatile.

Docusign Stock will outpace the market in 2019 (it is currently at $43/share).

Docusign is a new recommendation. Like Stitch Fix, it is a recent IPO and could be volatile. Docusign is the runaway leader in e-signatures, facilitating multiple parties signing documents in a secure, reliable way on board resolutions, mortgages, investment documents, etc. Strong positives include:

  • A high value for a reasonable price – I am increasingly annoyed when I need to deal with manual signatures for documents.
  • As of October 31, 2018, Docusign had over 450,000 customers up from 350,000 customers one year earlier. Of which 50,000 are Enterprise/Commercial accounts;
  • There are hundreds of millions of users whose e-signatures are stored by the company making the network effect quite large;
  • Roughly 95% of revenue is from its SaaS product which has 80% gross margin with the rest from services where margins have improved and are now positive;
  • As a SaaS company with a stable revenue base growth is more predictable. The company exceeded revenue guidance each quarter with the October 31, 2018 quarter revenue up 37%;
  • Most customers pay annually in advance. This means cash flow from operations is positive despite the company recording an operating loss;
  • Customers expand their use resulting in retained customers growing revenue faster than decreases from churned customers making net revenue retention over 100%;
  • International expansion remains a large opportunity as international is only 18% of revenue.

Picks 6 – 10: Major Trends that will surface in 2019

I developed my primary method of stock picking at my first Wall Street firm, Stanford Bernstein. The head of research there, Chuck Cahn, emphasized that you could get small wins by correctly determining that a stock would trade up on certain news like a new product, a big customer win, and beating consensus forecasts. But larger and more predictable wins of 5X or more were possible if one identified a long-term winner riding a major trend and stuck with it for multiple years. All 5 of my stock picks fall into the latter category. I’ve been recommending Facebook, Tesla, and Amazon for 4 years or more. All 3 are now over 5X from when I first targeted them as I bought Tesla at $46 and Facebook at $24 in 2013 (before this blog) and they have been in my top 10 since. Amazon was first included in 2015 when it was at $288/share. Stitch Fix and DocuSign are riskier but if successful have substantial upside since both are early in their run of leveraging their key trends.

The next 4 picks are in early stages of trends that could lead to current and next generation companies experiencing benefits for many years. The first two go hand in hand as each describes transformation of physical retail/restaurants, namely, replacing staff with technology in a way that improves the customer experience. This is possible because we are getting closer to the tipping point where the front-end investment in technology can have a solid ROI from subsequent cost savings.

Replacing Cashiers with technology will be proven out in 2019

In October 2015 I predicted that Amazon (and others like Warby Parker) would move into physical retail between then and 2020. This has occurred with Amazon first opening bookstores and then buying Whole Foods, and Warby Parker expanding its number of physical locations to about 100 by the end of 2018. My reasoning then was simple: over 92% of purchases in the U.S. were made offline. Since Amazon had substantial share of e-commerce it would begin to have its growth limited if it didn’t create an off-line presence.

Now, for Amazon to maintain a 20% or greater revenue growth rate it’s even more important for it to increase its attack on offline commerce (now about 90% of U.S. retail) I’m not saying it won’t continue to try to increase its 50% share of online but at its current size offline offers a greater opportunity for growth.

A key to Amazon’s success has been its ability to attack new markets in ways that give it a competitive advantage. Examples of this are numerous but three of the most striking are Amazon Cloud Services (where it is the industry leader), the Kindle (allowing it to own 70% share of eBook sales) and Prime (converting millions of customers to a subscription which in turn incentivized buying more from Amazon due to free shipping).

Now the company is testing an effort to transform brick and mortar retail by replacing staff with technology and in doing so improving the buying experience. The format is called Go stores and there are currently 5 test locations. Downloading the Amazon Go App enables the user to use it to open the automated doors. The store is stocked (I think by actual people) with many of the same categories of products as a 7-Eleven, in a more modern way. Food items include La Boulangerie pastries, sushi, salads, an assortment of sandwiches and even meal kits. Like a 7-Eleven, it also has convenience items like cold medicine, aspirins, etc. The store uses cameras and sensors to track your movements, items you remove from the shelves and even whether you put an item back. When you leave, the app provides you with a digital receipt. Not only does the removal of cashiers save Amazon money but the system improves customer service by eliminating any need to wait in line. I expect Amazon to open thousands of these stores over the next 3-5 years as it perfects the concept. In the future I believe it will have locations that offer different types of inventory. While Amazon may be an early experimenter here, there is opportunity for others to offer similar locations relying on third party technology.

Replacing Cooks, Baristas and Waitstaff with robots will begin to be proven in 2019

The second step in reducing physical location staff will accelerate in 2019. There are already:

  1. Robotic coffee bars:  CafeX opened in San Francisco last year, and in them one orders drip coffee, cappuccino, latte, or hot chocolate using an app on your phone or an iPad available at a kiosk. The coffee is made and served by a robot “barista” with the charge automatically put on your credit card. Ordering, billing, and preparation are automatic, but there is still one staff member in the shop to make sure things go smoothly.
  2. The first robotic burger restaurant: Creator opened in San Francisco last June. It was in beta mode through September before opening to the general public. While a “robot” makes the burgers, Creator is not as automated as CafeX as humans prepare the sauces and prep the items that go into the machine. Creator also hasn’t automated ordering/payment. Startup Momentum Machines expects to open a robotic burger restaurant and has gotten substantial backing from well-known VCs.
  3. Robots replacing waitstaff: For example, at Robo Sushi in Toronto, a “Butlertron” escorts you to your table, you order via an iPad and a second robot delivers your meal. Unlike the robots in the coffee bar and burger restaurant these are made into cute characters rather than a machine. Several Japanese companies are investing in robotic machines that make several of the items offered at a sushi restaurant.
  4. Robotic Pizza restaurants: The furthest along in automation is the Pizza industry. Zume Pizza, a startup that uses robots to make pizzas, has recently received a $375 million investment from Softbank. Zume currently uses a mix of humans and robots to create and deliver their pizzas and is operational in the Bay Area. Pizza Hut and Dominos are working on drones and/or self-driving vehicles to deliver pizzas. And Little Caesars was just issued a patent for a robotic arm and other automated mechanisms used to create a pizza.

At CES, a robot that makes breads was announced. What all these have in common is replacing low end high turnover employees with technology for repetitive tasks. The cost of labor continues to rise while the cost of technology shrinks a la Moore’s Law. It is just a matter of time before these early experiments turn into a flood of change. I expect many of these experiments will turn into “proof points” in 2019. Successful experiments will generate substantial adoption in subsequent years. Opportunities exist to invest in both suppliers and users of many robotic technologies.

“Influencers” will be increasingly utilized to directly drive Commerce

Companies have long employed Influencers as spokespersons for products and in some cases even as brands (a la Michael Jordon and Stephan Curry basketball shoes or George Forman Grills). They appear on TV ads for products and sometimes used their social reach to tout them. Blogger, a prior Azure investment, understood how to use popular bloggers in advertising campaigns. But Blogger ads, like most TV ads did not directly offer the products to potential customers. Now we are on the verge of two major changes: tech players creating structured ways to enable fans of major influencers (with millions of followers) to use one-click to directly buy products; and technology companies that can economically harness the cumulative power of hundreds of micro-influencers (tens of thousands of fans) to replicate the reach of a major influencer. I expect to see strong growth in this method of Social Commerce this year.

The Cannabis Sector should show substantial gains in 2019

In my last post I said about the Cannabis Sector: “The industry remains at a very early stage, but numerous companies are now public, and the recent market correction has the shares of most of these at more reasonable levels. While I urge great care in stock selection, it appears that the industry has emerged as one to consider investing in.” Earlier in this post, I mentioned that riding a multi-year wave with a winning company in that segment is a way to have strong returns. I’m not knowledgeable enough regarding public Cannabis companies, so I haven’t included any among my stock recommendations. However, I expect industry wide revenue to grow exponentially. The 12 largest public Cannabis companies by descending market cap are: Canopy Growth Corp (the largest at over $11B), Tilray, Aurora Cannabis, GW Pharmaceuticals, Curealeaf Holdings, Aphria, Green Thumb Industries, Cronos Group, Medmen Enterprises, Acreage Holdings, Charlotte’s Web Holdings and Trulieve Cannabis.

I believe one or more of these will deliver major returns over the next 5 years. Last year I felt we would see good fundamentals from the industry but that stocks were inflated. Given that the North American Cannabis Index opened this year at 208 well down from its 2018 high of 386 investing now seems timely. I’ll use this index as the measure of performance of this pick.

2019 will be the Year of the Unicorn IPO

Many Unicorns went public in 2018, but this year is poised to be considerably larger and could drive the largest IPO market fund raising in at least 5 years.  Disbelievers will say: “the market is way down so companies should wait longer.” The reality is the Nasdaq is off from its all-time high in August by about 15% but is higher than its highest level at any time before 2018. Investment funds are looking for new high growth companies to invest in. It appears very likely that as many as 5 mega-players will go public this year if the market doesn’t trade off from here. Each of them is a huge brand that should have very strong individual support. Institutional investors may not be as optimistic if they are priced too high due to the prices private investors have previously paid. They are: Uber, Lyft, Airbnb, Pinterest, and Slack. Each is one of the dominant participants in a major wave, foreshadowing substantial future revenue growth. Because information has been relatively private, I have less knowledge of their business models so can’t comment on whether I would be a buyer. Assuming several of these have successful IPOs many of the other 300 or so Unicorns may rush to follow.

It will be an interesting year!

Recap of 2018 Top Ten Predictions

Have the bears finally won back control?

Oh, what a difference a month or 3 makes! If only 2018 had ended earlier…

I’m sure I’m not the only one who would have liked 2018 results to have been as of November 30th (or even better, October 1st). My stock forecasts were looking a lot better on those dates (and if I were smarter, perhaps I would have taken some of the gains at that point). My average gain was over 34% on October 1st (versus the S&P being up 8.5%) and was still holding at +10% as of November 30th with the S&P ahead 2.4%. Unfortunately, the year includes a disastrous December and my 4 stock picks ended the year at a 6.6% average loss. Since stock picks are always relative to the market, I take some solace in minutely beating the performance of the S&P which was down 7.0% for the year, especially since I favor very high beta stocks.

Before reviewing each of my picks from last year, I would like to provide a longer term view of my performance as it has now been 5 years that I’ve published my blog’s stock picks. Even with a down year in 2018 my compound gain is 310% versus an S&P gain of 38% over the same period. This translates to an average annual gain of 25% per year which coincidently is the target I set in my book (published years ago and now out of print).

Table 1: Mike’s Annual Blog Stock Pick Performance (5 Years)

Unlike last year, I certainly cannot take a victory lap for my 10 forecasts as I missed on 3 of the 10 and barely beat the S&P for my average among my 4 stock picks (all of which will be included again in my 2019 top ten). I’ve listed in bold each of my 2018 stock picks and trend forecasts below and give a personal, and only modestly biased, evaluation of how I fared on each.

  1. Tesla stock appreciation will continue to outpace the market (it opened the year at $312/share)

Tesla had an extraordinary Q3, 2018 as the model 3 launch showed how potent a player the company is becoming. In the quarter the Model 3 was the best selling car in the U.S. in terms of revenue and 5th highest by volume. This drove a greater than 100% revenue increase versus a year earlier and $1.75 in earnings per share versus a loss of $4.22 in the prior quarter. Given that the starting price for a model 3 was at $49,000, it is rather amazing that it could generate that volume of sales. Since the backlog for the Model 3 appears to remain at well over 300,000 cars and Tesla is closing in on a launch in Europe, Tesla seems assured of continued strong revenue through 2019 and likely beyond. However, much of the backlog is awaiting the lower priced (sub $40,000) version of the car which I believe will be available in Q2, 2019. As I had predicted, the Model 3 ramp up in production volume led to improved gross margins which exceeded 20% in the quarter. Despite the down market, Tesla stock was up about 7% in 2018. While we will continue recommending the stock, the phaseout of tax credits for buying an electric car has already begun. In its Q3 update Tesla stated that “better than expected Model 3 cost reductions is allowing us to bring more affordable options to the market sooner.” Yet, despite this forecast, the recently announced price decreases drove the stock down.

  1. Facebook stock appreciation will continue to outpace the market (it opened the year at $182/share).

Facebook stock did not perform well in 2018, closing the year down 28%, making this pick a losing proposition last year. This comes despite revenue growth that should be between 35% and 40%, and net income that is tracking towards about 35% growth (despite a massive increase in SG&A to spur future results).  What impacted the stock heavily was the plethora of criticism regarding privacy of user information coupled with the continuing charges of Russian usage to impact the election. Before the wave after wave of negative publicity the stock had reached a new high of $218/share in July. Because of the need to improve its reputation, Facebook is likely to continue to increase its spending to address privacy issues and to burnish its image. In summary, the fundamentals of the company remained quite sound in 2018 but the barrage of issues torpedoed the stock.

  1. Amazon stock appreciation will outpace the market (it opened the year at $1188/share).

While its stock dropped considerably from its September high of $2050, Amazon remained one of the best market performers in 2018 closing the year at over $1500/share. The company continued to execute well, growing every part of its business. It also began to leverage its scale as net income grew considerably faster than revenue and is likely to be well over triple that of 2017. Growth should be lower in Q4 2018 than earlier in the year as Q4 2017 was the first quarter that included all revenue from the acquisition of Whole Foods. Since the analyst consensus forecast already reflects Whole Foods revenue being in Q4 last year, as well as concerns over Amazon maintaining strong performance in Q4, I would not be surprised if Amazon was able to beat expectations in Q4.

  1. Stitch Fix stock appreciation will outpace the market (it opened the year at $25/share).

In my forecast I stated that this was my riskiest pick and it certainly proved the most volatile (which is saying a lot given the turbulence experience by Facebook, Tesla, and Amazon). I was feeling pretty smug when the stock reached a high of $52/share in September with a little over 3 months left in the year! Obviously, I was less sanguine as it dropped precipitously from September’s high to a low point of $17.09 by year’s end. I’m hoping that those of you who followed my advice trimmed back when the stock soared (I confess that I didn’t). The company continued to balance growth and profitability throughout the calendar year with October quarter revenue (up 24%) and earnings ($10.7 million up from $1.3 million in the prior year) both beating analyst expectations. Yet, concerns over user growth severely impacted the stock. I’m somewhat surprised by this as the users grew 22% and revenue 24% – since revenue beat expectations this means that analysts did not forecast an increase in average revenue per user. But the bottom line is, despite solid fundamentals the stock did not perform well.

  1. The stock market will rise in 2018 (the S&P opened the year at 2,696 on January 2).

When I made this forecast, I pointed out that I’m not particularly good at forecasting the overall market. My belief was based on the fact that the tax cut for corporations would mean a rise in earnings that exceeded the norm. I felt stronger earnings growth would be enough to offset the risk of the longest bull market in history turning negative. I sited the likelihood of higher interest rates being an additional risk. The market almost made it through the year as it was still up heading into December, but the combination of 4 interest rate hikes in the year coupled with considerable criticism of President Trumps behavior was just too much for the market by December. I view this as a partial victory as I had all the fundamentals right and came within less than a month of being right for the year when many felt the bears would gain control in early 2018.

  1. Battles between the federal government and states will continue over marijuana use but the cannabis industry will emerge as one to invest in.

During the year the legalization of marijuana for recreational use continued to increase on a state by state basis with the number increasing from 6 at the start of the year to 10 by years end. Use of medical marijuana is now legal in 33 states. Several other states, while not formally legalizing it have lowered restrictions on individual use. The industry remains at a very early stage, but numerous companies are now public, and the recent market correction has the shares of most of these at more reasonable levels. While I would urge great care in stock selection, it appears that the industry has emerged as one to consider investing in.

  1. At least one city will announce a new approach to urban transport.

In this prediction I cited the likelihood that at least one city would commit to testing a system of small footprint automated cars on a dedicated route (as discussed in our post on December 14, 2017) as this appears to be a more cost effective solution than rail, bus, Uber, etc. Kyoto has now announced that it signed an agreement to test the system offered by Wayfarer and the company is now out of stealth mode. Wayfarer expects to provide substantial capacity at a fraction of the cost of other alternatives: both in the initial cost of the infrastructure/equipment and the annual cost of running the system. Of course, once there is a live installation in Kyoto or one of their other prospective customers, the validity of this system will be authenticated (or not).

  1. Offline retailers will increase the velocity of moving towards omnichannel.

This forecast discussed both acquisitions of e-commerce companies by offline retailers (with Walmart leading the way) and introducing more online technology in physical stores. Walmart did continue its online buying spree in 2018 with major acquisitions of Art.com, Bare Necessities, Eloquii, Cornershop and Flipkart (the largest at $16 billion). In the case of the acquisitions that are online brands, Walmart intends to introduce these into their physical stores and continue to sell them online. Nordstrom has also moved further to integrate its online and offline business by taking valuable floor space in stores and repurposing it for online buyers to pick up and try on clothes they have purchased online. By placing the location in a very prominent spot, I’m sure Nordstrom is thinking it will help spur more customers to buy online. By having in store locations for picking up and trying on, Nordstrom should reduce returns, lower the cost of shipping, and bring additional customers into their stores (who otherwise might not visit them).

  1. Social Commerce will begin to emerge as a new category

Recall that social commerce involves the integration of social media with commerce through tactics like:

  1. A feed-based user experience
  2. Having friends’ actions impact one’s feed
  3. Following trend setters to see what they are buying, wearing, and/or favoring
  4. One click to buy

Now, about 25% – 30% of shoppers say that social platforms like Pinterest, Instagram, Facebook and Snapchat have influence over their purchases. On June 28, 2018 Snapchat began a program for its influencers to use Social Commerce through a tool that allows users to view a video from the influencer and then to swipe up on a product shown in the video to buy it. In September, The Verge reported that Instagram is developing a new app for social commerce. Pinterest and Facebook have been in the social commerce fray longer and have increasing success. It appears that 2018 was the year the social commerce wars accelerated.

  1. “The Empire Strikes Back”: automobile manufacturers will begin to take steps to reclaim use of its GPS.

Carmakers face a serious problem regarding their built-in navigation systems. Consumers are forced to pay hundreds of dollars for them and then use free apps on their phones like Waze or Google maps instead. This does not endear them to consumers. The problem is that carmakers are not great at software design but have been reluctant to use third party providers for their GPS and entertainment. Now, the Renault-Nissan-Mitsubishi Alliance has agreed to design Google’s Android OS, including Google navigation, into their next generation cars expected starting in 2021. This is a win for users as that will provide a competent GPS that utilizes the existing screen in cars as opposed to having to rely on your phone app for navigation.

In another win for consumers, Amazon and Telenav (a connected car and location based services provider) announced a significant partnership today, January 7, 2019. As part of it, Amazon’s voice assistant will now be part of Telenavs in-car navigation systems. With this included, Telenav’s next generation system will enable its customers, like General Motors, to provide a “smart assistant” thereby making the system included with cars the one to use rather than one’s phone apps.

Stay tuned for my top ten predictions for 2019…but remember that I have already said the 4 stocks recommended for 2018 will remain on the list.

Amazon HQ Award: Huge Positive for New York City and State

My December 2016 post analyzed the Trump deal to retain Carrier workers in the United States and concluded it was positive for the country and for the state of Indiana. It saved 800 jobs and had a payback to the government of more than 14X their investment. I was clear in the post that I hadn’t voted for Trump and consider myself an independent. While I remain an independent, the opportunity to analyze the recently announced deal to get Amazon to commit 25,000 – 40,000 jobs for New York City is irresistible to me as my conclusions will be in support of politicians on the opposite side of the spectrum from Trump: New York Mayor Bill de Blasio and Governor Andrew Cuomo. I believe that:

Analysis of benefits and drawbacks of any major negotiation should be politically independent.

Unfortunately, this has become less and less the case given the divisive politics that we have in our country. What was shocking to me in this case was that some members of their own party (Democrats), heavily criticized de Blasio and Cuomo.

Major Assumption: Jobs are good for a City/State if the cost to government is reasonable

One of the major responsibilities of a political leader is improving the economy in their State/City. The crux of the discussion is really the question: ‘what is a reasonable cost’ for doing so? On one hand, it can be measured in pure cash flow of moneys paid to Amazon (or any other entity a government wants to attract) versus the cash the government will receive from additional tax dollars. On the other hand, there are other factors that benefit or degrade life in the community. Since the former is more measurable, I’ll start with that.

What are the Actual Out-of-Pocket dollars New York City (NYC) and New York State (NYS) will give to Amazon?

I can’t tell if its rhetoric or a lack of clear communication, but many detractors, like state Senator Michael Gianaris, are saying “We’ve got $3 billion dollars to spend, how would you spend it? Amazon would be very low on the list of where that money would go.” To be blunt, this is a ridiculous comment. NYC is spending zero dollars in cash and while the state is providing $505 million of actual cash as a capital grant, far more money will flow back to it. The Capital grant is based on $2.5 billion that Amazon has promised to invest in New York City (to build their HQ, a 600-seat public school, affordable space for manufacturers and to develop a 3.5-acre waterfront esplanade and park).

The rest of the $3 billion falls into 3 incentive programs that have existed for many years to help woo companies to NYS. They are:

  1. The Excelsior Jobs Program was created in 2010 to replace the expiring Empire Zone Program. Like the prior program, it’s objectives are to provide job creation incentives to firms in targeted industries, like high-tech, for relocating in NYS. The credits are based on the wages added and several other factors. This program, which is available to all companies in the targeted sectors, will generate $1.2 billion in state business income tax credits for Amazon if it meets its commitments.
  2. The Relocation and Employment Assistance Program (REAP), first established in 2003, targets creating jobs in parts of the city more in need of them, rather than adding to the heavy cluster in downtown and midtown Manhattan, namely the outer boroughs or north of 96th street in Manhattan. The tax credits generated from this program total $897 million and can be used towards reducing Amazon’s New York City corporate taxes over 12 years. This credit is based on the rules of the existing law.
  3. The Industrial and Commercial Abatement Program (ICAP), which replaced a prior program, created in 2008, provides tax incentives for commercial and industrial buildings that are built, modernized, or expanded. The credits are based on the taxable value created if the city believes it is beneficial based on its location and other factors. This program is generally available and the $386 million in credits are directly tied to the rules of the law.

Table 1: Benefits to Amazon from NYS and NYC

It is important to note most of the benefits to Amazon are “as of right”, so any company can get them. Since these programs scale based on the number of employees or the amount of capital investment, the sheer size of the Amazon commitment creates a “sticker shock” given the associated benefits. The 3 programs were not created for Amazon but have been in existence for years to encourage job creation and industrial development in targeted areas. The credits under REAP and ICAP appear to be as mandated by those programs and not discretionary. It’s harder for me to tie the state tax abatement amount granted under the Excelsior program (by the state) to the law, but the calculation appears to follow it with some judgement in the cap of what is awarded. The capital grant seems to be the only discretionary part of the package and is the only portion that involves out of pocket dollars from the state (the city will not provide any cash incentives).

Could New York Have won the HQ with lesser incentives?

Given the large return on investment to NYC and NYS, the only question in my mind is whether they could have succeeded with even less incentives and generated an even greater return! A whitepaper by Reis, an analytic company for real estate evaluation, judged New York City as a top candidate without considering incentives offered to Amazon. It’s difficult to judge whether New York City would have been chosen with reduced incentives. On the one hand it has the best public transportation, strong cultural advantages, and several great Universities (as a source of employees), especially the new Cornell-Technion campus located directly next to Amazon’s HQ2 location. On the other hand, it is a very expensive place to do business which is why these incentive programs were created to begin with. As a basis of comparison, consider the bundle of incentives Wisconsin offered to get the Taiwanese technology company Foxconn to build a U.S. plant there. For the 13,000 jobs (at an average annual wage of $53,000) that Foxconn has committed to, Wisconsin plus the County and local village have provided about $3.8 billion in tax credits and breaks. The taxable wages in NY will be 6-9 times as much and the incentives are lower. Therefore, I suspect other locations offered Amazon incentives at the same or a greater level as those from New York.

How Does Revenue to the City and State Compare to the out of pocket cost?

I’m going to make the following assumptions:

  1. New York State Corporate Tax is 6.5% and NYC is 8.85% but I’m assuming the business tax incentives from Excelsior and REAP will be sufficient to preclude Amazon paying any incremental taxes to NYC or NYS (above what they currently pay) for the 12 years they apply. Subsequently, there should be substantial incremental taxes for the additional 8 years of the time horizon I’m using. Since I’m not including this income flow to the city and state, there is considerable upside to my calculations.
  2. The PILOT program payments, estimated by Deputy Mayor Alicia Glen, at $600 to $650 million are the only real estate taxes Amazon will pay. I’m not sure what it would have been without the ICAP credit but the range for the PILOT program amount appears to be known.
  3. NYS and/or NYC will benefit from income, sales and property taxes on employees hired by Amazon and taxes on any additional jobs that get created because of Amazon. I’ll assume taxes are on full wages but that employees have no other income (like interest, capital gains, etc.) and all individuals are single. This puts my model for some who are married without a working spouse at higher taxes then they will pay, but my estimates will be too low for those with a working spouse or any with other sources of income. For this purpose, I’ll use the initial 25,000 jobs plus half of the additional 15,000 (32,500) as the average number over a 20 year period. Since the incremental employment should average longer, that seemed a conservative average to use. I’ll also use an average starting salary of $150,000 for the future Amazon employees as that has been in the announcement. As another assumption, to keep my calculations below what should occur, I haven’t assumed any increases in salary. Even a 4% increase per year would cause salaries to more than double by the end of the 20 years (and NYS and NYC income taxes grow by even more). Since those involved in the project would likely have wage increases over time their income and other taxes would be considerably higher than those based on my assumptions. This coupled with the fact that the negotiators for NYC and NYS used 25 years as the horizon, means their tax calculations will be considerably higher (and more accurate) than mine for the direct employees.

I used the website Smart Asset calculator to generate estimates of NYS and NYC Income tax, sales tax, and property tax per year for each income level. As stated before, the actual numbers will be higher because many of these individuals will have other sources of income, a working spouse and will have salaries escalating over time. Table 2 shows the totals for these estimated taxes to be nearly $15B.

Table 2: NYS & NYC Tax Impact from Amazon HQ

 

  1. Scholars have found strong evidence of the presence of a local multiplier effect. These come from the direct employees hired, indirect jobs created from suppliers and partners and induced jobs that are a result of the spending of the direct and indirect jobs as well as each layer of induced jobs. For example, a noted scholar on the subject, Enrico Moretti, determined that when Apple Computer was employing 12,000 workers locally, an additional 60,000 jobs were created. These included 36,000 unskilled positions like restaurant or retail workers, and 24,000 skilled jobs like lawyers or doctors. If I assume this 5 to 1 ratio would hold for the highly paid Amazon workers, then 32,500 technology jobs would generate 162,500 more jobs in NYC! Based on the Apple example, 60% of these would be unskilled and 40% highly skilled. Assuming an average salary of $35,000 for the unskilled, an average of $100,00 for half of the skilled and $150,000 for the other half, taxes generated from the multiplier effect over the 20 years would be over $28 billion.

Table 3: NYS & NYC Tax Impact from Amazon HQ Multiplier Effect

  1. The $2.5 billion Amazon has committed to spend on capital projects would in turn generate further jobs in construction and an associated multiplier impact, but since this is a temporary benefit over 2-5 years, I have omitted it from the analysis.
  2. The $43 billion estimated total of these income streams to the city and state assume the tax abatements cause no incremental corporate taxes from Amazon. While Amazon will be paying rent on the land leased from the city, I also left out this benefit as I couldn’t estimate the amount. While I believe the actual benefit could be higher, consider that even if I’m off by 75% on the multiplier effect, the total would still be over $22 billion and the payback about 44X the $505 million cash outlay!

Other Benefits and Negatives of Attracting Amazon

There are a variety of more difficult factors to analyze than the straight forward financial windfall the city and state will get from this agreement. Living in the San Francisco Bay Area has taught me that what I may view as obvious might not be so to others. Becoming the Florence of the Tech World has meant that the Bay Area is incredibly wealthy, in turn generating a huge tax base for government to use to fund helping the homeless, stem research and many other perceived public good initiatives. Attracting 25,000 – 40,000 technology jobs will vault New York City into a clear contender for tech community leadership. It will lead to others following and to the creation of more startups, one or two who could become the next Amazon, Apple, Google, Facebook, or Microsoft (generating more jobs and more tax income to NYC and NYS). This is not universally celebrated in the Bay Area as it also has led to traffic congestion, higher housing prices, and increased cost of entertainment. But It has meant increased employment opportunities across the full spectrum of jobs. However, an average worker, while making more than elsewhere, can find it a difficult place to afford. In New York City these issues are partly offset for those renting apartments due to rent control and rent stabilization as over 50% of all rental units are under some form of regulation.

New York City is large enough to be able to absorb 25,000 to 40,000 workers relatively easily, but it could add to the problems for the already strained subway system. I believe it’s no accident that Amazon chose a location near the water so that its employees could take advantage of the new, highly praised, NYC Ferry system. While many of the workers may choose to live near the Amazon facilities, some may decide to buy houses in locations that require utilizing mass transit. If I were to guess, I would say a portion of the increased cash flow, to the city will be used to improve the subway system, Long Island Railroad and to add more Ferries each of which will benefit all New Yorkers.

Conclusion: The Amazon Agreement for HQ2 to be in NYC is a Huge Positive for NYC and NYS

While detractors may nitpick at the deal, it has a great ROI for the City and State, will increase employment, provide revenue to improve mass transit and follows incentives mandated by existing laws. Clearly a coup for Mayor de Blasio and Governor Cuomo.

Soundbytes

  • The SF Chronicle published an article on November 28, 2018 touting Stephan Curry’s strong credentials as a possible MVP this year. In it they used several of the statistics we discussed a year ago. Namely, how much better his teammates shoot when they play with Curry and his amazing plus/minus.
  • Sticking with sports, I can’t help ruminating on how the NFL keeps shooting itself in the foot. I won’t comment on the latest unsavory incidents among players towards women or the Kaepernick fiasco. Instead, I keep thinking about what to call the team about to leave Oakland:
    • Oakland Raiders, their current name
    • Oakland Traders, given their propensity to exchange top players for draft choices
    • Oakland Traitors, trading away their best current players, which has insured a terrible season – thus completing the betrayal of the City of Oakland and the most loyal and colorful fan base in the league

How to Improve Contribution Margin

This post is the third in my series on Key Performance Indicators (KPIs), with a heavy emphasis on contribution margin (CM). Previously, I analyzed why CM is such a strong predictor of success. Given that, companies should consistently look at ways of improving it while still maintaining sufficient growth in their business.

In Azure’s recent full day marketing seminar for our consumer (B2C) focused companies, my session highlighted 6 methods of improving CM:

  1. Increase follow-on sales from existing customers
  2. Raise the average invoice value of the initial and subsequent sales to a customer
  3. Increase GM (Gross Margin) through price increases
  4. Increase GM by reducing cost of goods sold (COGs)
  5. Reduce Blended CAC (cost of customer acquisition) by increasing free or very low cost traffic
  6. Decrease marketing spend as a % of revenue

Before drilling down on each of these I want to define several key terms that will be used throughout the discussion:

  • Contribution Margin = GM – Marketing/Sales Costs – other cost that vary with sales
  • Paid CAC = Market Spend/New Customers acquired through this spend
  • Blended CAC = Market Spend/All new customers
  • CAC Recovery Time (CAC RT) = the number of months until variable profit on a customer equals CAC
  • LTV/CAC = Life Time Value (LTV) of a customer/CAC

I will now review each of these strategies and provide some thoughts on how to activate these in consumer-facing businesses:

1. Increase Follow-On sales from existing customers 

Since existing customers have little or no cost associated with getting them to buy, this will decrease blended CAC, increasing CM.

  • Increasing customer retention through improvements in customer care, more interesting and more targeted emails to a customer, or launching a subscription of one kind or another can all help.

On the first point here is an email I received shortly after subscribing to Harry’s, that I thought did an excellent job at engaging me with their customer support, increasing my likelihood to keep my subscription active:

Hi there,
My name is Katie, and I’m a member of the Harry’s team. I wanted to reach out and say thanks for supporting Harry’s.
You are important to us, and I am here to personally help you however I can to make your Harry’s experience as smooth as possible – both literally and figuratively. Please don’t hesitate to reach out with any thoughts or questions about your Harry’s products or Shave Plan, or just life in general. (And just a reminder that your next box is scheduled to ship on October 27th.) Thanks again for your support, and I hope to speak soon!
All the best,
Katie

On the subscription concept, think about Amazon Prime. How many of you buy more frequently from Amazon because of being a prime member?

  • Add to product portfolio. By giving your customers more options of what to buy (all within the concept of your brand) customers are given the opportunity to spend more often.
  • Make sure your emails are interesting. This will increase the open rate and drive more follow on sales. If all your emails are about discounting your product, then customers will have less interest in opening them and your brand will be devalued. I’ve received emails from numerous sites that say an X% discount is available until a certain date, and then when that date passes, I receive a new offer that is the same or sometimes better.  The most frequently opened emails have headers and content that creates interest beyond whatever products you sell. A/B test different headers and different content. It doesn’t matter how small or large you are or how many emails you send, it always pays to try different variations to increase open rates and conversion. Experiment with different messaging to different customer segments like those who purchased recently, those who “liked” an item, those that have never purchased, etc.
  • Build a Community of your customers. The more you can get customers engaged with you and with each other, the more committed to you they become and the longer they are retained. Think through how you can build an active community among your users through shared photos, videos, chatting, podcasts or events. Most of this should not involve trying to push new purchases but engaging your community to interact with you and each other.

2. Raise the average invoice value of the initial and subsequent sales to a customer

Since shipping costs will not increase proportionately, this will raise GM dollars and therefore CM.

  • Increase pricing. Most startups underprice their product thinking that will increase market adoption. Even some of the largest companies in the world have found there was ample room to increase prices. Thinking differently, Apple upped prices to over $1,000 for an iPhone. And then increased it again to $1,349 for the top of the line product. Five years ago, how many of you thought people would pay over $1,000 for a cell phone? This shows that unless you A/B test different price points you have no idea whether a price increase is the right strategy.
  • Upsell logical add-on products. While trying to get a customer to add to their shopping cart may seem obvious, many companies do not do this on a consistent basis. Some examples of ones that have: a flower company added vases to the offer, a mattress company added pillows and sheets; a subscription razor company added shaving gel; a cell phone company added a case. All of these led to reasonable attach rates of the add-on product and higher average invoice value. Testing what you could add to generate upsell should be a constant process.
  • “Selling” value added services is another form of upsell. This could include things like concierge customer service, service contacts, premier membership with benefits like: invites to special events, early access to new products, reduced shipping cost, preferred discounts on products, etc. If you get your customers to engage in one or more services, you will significantly increase their connection to your product and likely increase retention.

3. Increase Gross Margin through price Increases

Surprisingly, sometimes higher prices position a product as premium (having more value) and generate increased unit sales. Often higher prices generate more revenue even when fewer unit sales result. What may be counter intuitive is that GM$ can increase even if revenue declines. For example, suppose a company has COGs of $50 for a product and is currently pricing it at $100. If a price increase of 20% causes 20% lower unit sales, revenue would decline by 4% while GM$ would increase 12%. Higher gross margin dollars provide more ability to spend on marketing.

 

4. Improving GM by reducing COGs

  • Better Pricing: When your volume increases, ask for better pricing from suppliers. Just as its important to price test regularly, its also important to talk to multiple potential suppliers of your parts/product. An existing supplier may not be eager to voluntarily offer a price discount that goes with increased volume but is more likely to do so if it knows you are checking with others.
  • Changing Packaging: Packaging should be re-examined regularly as improvements may help customer retention. But it also may be possible to lower the cost of the packaging or to change it in a way that lowers shipping costs since that may be based on the size of the box rather than weight.
  • Shipping Costs: Lower shipping cost per $ of revenue (increasing GM and CM) by generating larger orders. In addition to upsell, this can be done by offering better discounts if the order size is larger. One site I have purchased from offers 10% discount if your net spend (after discount) is over $100, 15% if over $150 and 20% if over $200. Getting to the highest discount lowers the price of the product by enough to motivate buyers (including me) to try to buy over $200 in merchandise. The extra revenue creates incremental product margin dollars and decreases shipping cost as a percentage of revenue. This in turn increases GM$.

For a subscription company this can be done by scheduling less frequent (larger) deliveries. The shipping cost of the larger order will be a much smaller percent of revenue, raising GM.

  • Opening a Second distribution center to reduce shipping cost. Orders shipped from a west coast distribution center to an east coast customer will have 5 zone pricing. By having a second distribution center in a place like Columbus, Ohio (a frequently used location) those same orders will usually be 1 zone, sometimes 2 zone pricing, resulting in substantial savings per order. The caveat here is that a company needs enough volume for the total savings on orders to exceed the fixed cost of a second distribution center.

5. Improving CM by driving “free” or “nearly free” traffic

The higher the proportion of free or inexpensive traffic to total traffic, the lower the blended CAC.

  • Improving SEO (search engine optimization). I’ve learned from SEO experts that optimizing SEO is not free, but rather very low cost compared to paid traffic. Our previous post walks through some of the science involved in making improvements. I would suggest using an SEO consultant as it is likely to lead to far better results.
  • Convert a visitor not ready to buy to an email recipient. If you do that than you will have subsequent opportunities to market to her or him. A slightly costlier version of this is to use remarketing to woo visitors who came to your site but didn’t buy. While using remarketing (advertising) has a cost, it is usually much lower CAC than other methods.
  • Produce emails that get forwarded and go viral. Such emails need to motivate recipients to forward them due to being very funny, of human interest, etc. While there is typically a product offering embedded in them, the header emphasizes the reason to read it. One Azure portfolio company, Shinesty, recently had an email that was opened by about 7X the number of people it was initially sent to.  That generated a lot of potential customers without spending extra marketing dollars. Engaging emails has enabled Shinesty to maintain high CM and high growth.
  • Use social networking to generate incremental customers. Having the right posts on a social network like Instagram can lead to new potential customers finding out about you and lead to additional sales.
  • Optimize Customer Retention. Or as my good friend Chris Bruzzo (CMO of EA) spoke about at the Azure Marketing conference: “Love the ones you’re with.” Existing customers are usually the largest source of “free” buyers in a period. The longer you retain a customer, the more repeat buyers you have, increasing contribution margin. So, it’s imperative to take great care of your existing customers.
  • Drive PR. Like SEO, there is some cost involved in this but if you are judicious in any agency spend and thoughtful in creating news worthy press releases this can be a great source of traffic at a modest cost. However, I recommend you try to understand what you are getting from PR because I have seen situations where the spend did not produce meaningful results.

6. Decrease Marketing Spend as a % of Revenue.

The CAC Recovery Time plays a major role in how to manage your market spend to balance growth and burn. For example, if CAC Recovery Time is one month, spending more will not drive up burn appreciably. If it takes more than a year to recover your CAC, moderating market spend is critical to achieving a reasonable CM. If you recoup CAC faster, you can invest more quickly in the next round of customers. In the consumer space, I won’t invest in a company that has a long (a year or more) CAC Recovery Time as customers are likely to churn in an average of 2-3 years, making it difficult to achieve a reasonable business model. For B2B company’s customer longevity tends to be much longer, and the LTV/CAC can be 5X or more even if CAC Recovery Time is a year.

When a company decreases its market spend as a % of revenue it may experience lower growth but better CM. However, many companies have waste in their marketing spend so it’s important to measure the efficacy of each area of spend separately and to eliminate programs with a low return. This will allow you to reduce the spend with minimal impact on growth rates. There is a balance needed to try to optimize the relationship between CM and revenue growth as higher burn requires raising money more frequently and can put your company at risk. On the other hand, a company generating $1M in revenue needs to be growing at 100% or more to warrant most VCs to consider investing. Since CM should improve with scale, spending more on marketing may be a viable strategy for early stage companies. Once a company reaches $10M in revenue, annual growth of 50% will get it to $76M in revenue in 5 years so such a company should consider better CM rather than driving much higher growth rates and continuing to burn excessive cash.

In summary, Contribution Margin is the lifeblood of a company. If it is weak, the company is likely to fail over time. If it is strong and revenue growth is high, success seems likely. Improving CM is an ongoing process. I realize many of you probably feel much of what I’ve said is obvious, but my question is:“How many of these suggestions are you already doing on a regular basis?”

While you may be using several of the suggestions in this post, I encourage you to try more and to also double down where you can on the ones you already are trying. The results will make your company more valuable!

 

SoundBytes

  • I just want to remind readers that my collaborator on my blog posts, Andrea Drager, doesn’t typically take a bow for her significant contributions. Also, in this post, Chris Bruzzo added several improvements that have been incorporated. So many thanks to Andrea and Chris.
  • Can’t help but comment on the start to the NBA season. Not surprisingly, the Warriors are off to a great start with Curry and Durant leading the way. Greene and Thompson now have moved close to their usual contribution so I’m hopeful that the team can keep up its current pace.
  • What surprised me early on was the lack of recognition that both Toronto and San Antonio would be greatly improved. Remember, while San Antonio lost Kawhi, he only played a few games last year so with the addition of DeRozan should improve and once again reach the playoffs. For Toronto the change to Kawhi is a marked improvement placing them very competitive with the Celtics for eastern leadership.
  • I also feel it necessary to comment on the “Las Vegas” Raiders. I call them that already as they have shown zero regard for Oakland fans. While commentators have criticized their trading of all-star level players for draft choices, this is precisely on-strategy. When they get to Vegas they want a brand-new set of rising stars that the new fan base can identify with (using the numerous first round draft choices they traded for), and they don’t mind having the worst record in the league while still in Oakland. I believe Oakland fans should stop attending games as a response. I also think the NFL continues to shoot itself in the foot, allowing one of the most loyal and visible fan bases in the league to once again be abandoned

Why Contribution Margin is a Strong Predictor of Success for Companies

In the last post I concluded with a brief discussion of Contribution Margin as a key KPI. Recall:

Contribution Margin = Variable Profits – Sales and Marketing Cost

The higher the contribution margin, the more dollars available towards covering G&A. Once contribution margin exceeds G&A, a company reaches operating profits. For simplicity in this post, I’ll use gross margin (GM) as the definition of variable profits even though there may be other costs that vary directly with revenue.

The Drivers of Contribution Margin (CM)

There is an absolute correlation between GM percent and CM. Very high gross margin companies will, in general, get to strong contribution margins and low gross margin companies will struggle to get there. But the sales and marketing needed to drive growth is just as important. There are several underlying factors in how much needs to be spent on sales and marketing to drive growth:

  1. The profits on a new customer relative to the cost of acquiring her (or him). That is, the CAC (customer acquisition cost) for customers derived from paid advertising compared to the profits on those customers’ first purchase
  2. The portion of new traffic that is “free” from SEO (search engine optimization), PR, existing customers recommending your products, etc.
  3. The portion of revenue that comes from repeat customers

The Relationship Between CAC and First Purchase Profits Has a Dramatic Impact on CM

Suppose Company A spends $60 to acquire a customer and has GM of $90 on the initial purchase by that customer. The contribution margin will already be positive $30 without accounting for customers that are organic or those that are repeat customers; in other words, this tends to be extremely positive! Of course, the startups I see in eCommerce are rarely in this situation but those that are can get to profitability fairly quickly if this relationship holds as they scale.

It would be more typical for companies to find that the initial purchase GM only covers a portion of CAC but that subsequent purchases lead to a positive relationship between the LTV (life time value) of the customer and CAC. If I assume the spend to acquire a customer is $60 and the GM is $30 then the CM on the first purchase would be negative (-$30), and it would take a second purchase with the same GM dollars to cover that initial cost. Most startups require several purchases before recovering CAC which in turn means requiring investment dollars to cover the outlay.

Free Traffic and Contribution Margin

If a company can generate a high proportion of free/organic traffic, there is a benefit to contribution margin. CAC is defined as the marketing spend divided by the number of new customers derived from this spend. Blended CAC is defined as the marketing spend divided by all customers who purchased in the period. The more organically generated and return customers, the lower the “blended CAC”. Using the above example, suppose 50% of the new customers for Company A come from organic (free) traffic. Then the “blended CAC“ would be 50% of the paid CAC. In the above example that would be $30 instead of $60 and if the GM was only $30 the initial purchase would cover blended CAC.

Of course, in addition to obtaining customers for free from organic traffic, companies, as they build their customer base, have an increasing opportunity to obtain free traffic by getting existing customers to buy again. So, a company should never forget that maintaining a persistent relationship with customers leads to improved Contribution Margin.

Spending to Drive Higher Growth Can Mean Lower Contribution Margin

Unless the GM on the first purchase a new customer makes exceeds their CAC, there is an inverse relationship between expanding growth and achieving high contribution margin. Think of it this way: suppose that going into a month the likely organic traffic and repeat buyers are somewhat set. Boosting that month’s growth means increasing the number of new paid customers, which in turn makes paid customers a higher proportion of blended CAC and therefore increases CAC. For an example consider the following assumptions for Company B:

  • The GM is $60 on an average order of $100
  • Paid CAC is $150
  • The company will have 1,000 new customers through organic means and 2,000 repeat buyers or $300,000 in revenue with 60% GM ($180,000) from these customers before spending on paid customers
  • G&A besides marketing for the month will be $150,000
  • Last year Company B had $400,000 in revenue in the same month
  • The company is considering the ramifications of targeting 25%, 50% or 100% year-over-year growth

Table 1: The Relationship Between Contribution Margin & Growth

Since the paid CAC is $150 while Gross Margin is only $60 per new customer, each acquired customer generates negative $90 in contribution margin in the period. As can be seen in Table 1, the company would shrink 25% if there is no acquisition spend but would have $180,000 in contribution margin and positive operating profit. On the other end of the spectrum, driving 100% growth requires spending $750,000 to acquire 5,000 new customers and results in a negative $270,000 in contribution margin and an Operating Loss of $420,000 in the period. Of course, if new customers are expected to make multiple future purchases than the number of repeat customers would rise in future periods.

Subscription Models Create More Consistency but are not a Panacea

When a company’s customers are monthly subscribers, each month starts with the prior month’s base less churn. To put it another way, if churn from the prior month is modest (for example 5%) then that month already has 95% of the prior months revenue from repeat customers. Additionally, if the company increases the average invoice value from these customers, it might even have a starting point where return customers account for as much revenue as the prior month. For B-to-B companies, high revenue retention is the norm, where an average customer will pay them for 10 years or more.

Consumer ecommerce subscriptions typically have much more substantial churn, with an average life of two years being closer to the norm. Additionally, the highest level of churn (which can be as much as 30% or more) occurs in the second month, and the next highest, the third month before tapering off. What this means is that companies trying to drive high sequential growth will have a higher % churn rate than those that target more modest growth. Part of a company’s acquisition spend is needed just to stay even. For example, if we assume all new customers come from paid acquisition, the CAC is $200, and that 15% of 10,000 customers churn then the first $300,000 in marketing spend would just serve to replace the churned customers and additional spend would be needed to drive sequential growth.

Investing in Companies with High Contribution Margin

As a VC, I tend to appreciate strong business models and like to invest after some baseline proof points are in place.  In my last post I outlined a number of metrics that were important ways to track a company’s health with the ratio of LTV (life time value) to CAC being one of the most important. When a company has a high contribution margin they have the time to build that ratio by adding more products or establishing subscriptions without burning through a lot of capital. Further, companies that have a high LTV/CAC ratio should have a high contribution margin as they mature since this usually means customers buy many times – leading to an expansion in repeat business as part of each month’s total revenue.

This thought process also applies to public companies. One of the most extreme is Facebook, which I’ve owned and recommended for five years. Even after the recent pullback its stock price is about 7x what it was five years ago (or has appreciated at a compound rate of nearly 50% per year since I’ve been recommending it). Not a surprise as Facebook’s contribution margin runs over 70% and revenue was up year/year 42% in Q2. These are extraordinary numbers for a company its size.

To give the reader some idea of how this method can be used as one screen for public companies, Table 2 shows gross margin, contribution margin, revenue growth and this year’s stock market performance for seven public companies.

Table 2: Public Company Contribution Margin Analysis

Two of the seven companies shown stand out as having both high Contribution Margin and strong revenue growth: Etsy and Stitch Fix. Each had year/year revenue growth of around 30% in Q2 coupled with 44% and 29% contribution margins, respectively. This likely has been a factor in Stitch Fix stock appreciating 53% and Etsy 135% since the beginning of the year.

Three of the seven have weak models and are struggling to balance revenue growth and contribution margin: Blue Apron, Overstock, and Groupon. Both Blue Apron and Groupon have been attempting to reduce their losses by dropping their marketing spend. While this increased their CM by 10% and 20% respectively, it also meant that they both have negative growth while still losing money. The losses for Blue Apron were over 16% of revenue. This coupled with shrinking revenue feels like a lethal combination. Blue Apron stock is only down a marginal amount year-to-date but is 59% lower than one year ago. Groupon, because of much higher gross margins than Blue Apron (52% vs 35%), still seems to have a chance to turn things around, but does have a lot of work to do. Overstock went in the other direction, increasing marketing spend to drive modest revenue growth of 12%. But this led to a negative CM and substantially increased losses. That strategy did not seem to benefit shareholders as the stock has declined 53% since the beginning of the year.

eBay is a healthy company from a contribution margin point of view but has sub 10% revenue growth. I can’t tell if increasing their market spend by a substantial amount (at the cost of lower CM) would be a better balance for them.

For me, Spotify is the one anomaly in the table as its stock has appreciated 46% since the IPO despite weak contribution margins which was one reason for my negative view expressed in a prior post. I think that is driven by three reasons: its product is an iconic brand; there is not a lot of float in the stock creating some scarcity; and contribution margin has been improving giving bulls on the stock a belief that it can get to profitability eventually. I say it is an anomaly, as comparing it to Facebook, it is hard to justify the relative valuations. Facebook grew 42% in Q2, Spotify 26%; Facebook is trading at a P/E of 24 whereas even if we assume Spotify can eventually get to generating 6% net profit (it currently is at a 7% loss before finance charges and 31% loss after finance charges, so this feels optimistic) Spotify would be trading at 112 times this theoretic future earnings.

 

SoundBytes

I found the recent controversy over Elon Musk’s sharing his thoughts on taking Tesla private interesting. On the one hand, people want transparency from companies and Elon certainly provides that! On the other hand, it clearly impacted the stock price for a few days and the SEC abhors anything that can be construed as stock manipulation. Of course, Elon may not have been as careful as he should have been when he sent out his tweet regarding whether financing was lined up…but like most entrepreneurs he was optimistic.

Interesting KPIs (Key Performance Indicators) for a Subscription Company

what-are-key-performance-indicators-kpis

In working with early stage businesses, I often get the question as to what metrics should management and the board use to help understand a company’s progress. It is important for every company to establish a set of consistent KPIs that are used to objectively track progress. While these need to be a part of each board package, it is even more important for the executive team to utilize this for managing their company. While this post focuses on SaaS/Subscription companies, the majority of it applies to most other types of businesses.

Areas KPIs Should Cover

  1. P&L Trends
  2. MRR (Monthly Recurring Revenue) and LTR (Lifetime Revenue)
  3. CAC (Cost of Customer Acquisition)
    1. Marketing to create leads
    2. Customers acquired electronically
    3. Customers acquired using sales professionals
  4. Gross Margin and LTV (Life Time Value of a customer)
  5. Marketing Efficiency

Many companies will also need KPIs regarding inventory in addition to the ones above.

While there may be very complex analysis behind some of these numbers, it’s important to try to keep KPIs to 2-5 pages of a board package. Use of the right KPIs will give a solid, objective, consistent top-down view of the company’s progress. The P&L portion of the package is obviously critical, but I have a possibly unique view on how this should be included in the body of a board package.

P&L Trends: Less is More

One mistake many companies make is confusing detail with better analysis. I often see models that have 50-100 line items for expenses and show this by month for 3 or more years out… but show one or no years of history. What this does is waste a great deal of time on predicting things that are inconsequential and controllable (by month), while eliminating all perspective. Things like seasonality are lost if one is unable to view 3 years of revenue at a time without scrolling from page to page. Of course, for the current year’s budget it is appropriate for management to establish monthly expectations in detail, but for any long-term planning, success revolves around revenue, gross margins, marketing/sales spend and the number of employees. For some companies that are deep technology players there may be significant costs in R&D other than payroll, but this is the exception. By using a simple formula for G&A based on the number of employees, the board can apply a sanity check on whether cost estimates in the long-term model will be on target assuming revenue is on target. So why spend excessive time on nits? Aggregating cost frees up time for better understanding how and why revenue will ramp, the relationship between revenue types and gross margin, the cost of acquiring a customer, the lifetime value of a customer and the average spend per employee.

In a similar way, the board is well served by viewing a simple P&L by quarter for 2 prior years plus the current one (with a forecast of remaining quarters). The lines could be:

Table1: P&L by Quarter

A second version of the P&L should be produced for budget comparison purposes. It should have the same rows but have the columns be current period actual, current period budget, year to date (YTD) actual, year to date budget, current full year forecast, budget for the full year.

Table 2: P&L Actual / Budget Comparison

Tracking MRR and LTR

For any SaaS/Subscription company (I’ll simply refer to this as SaaS going forward) MRR growth is the lifeblood of the company with two caveats: excessive churn makes MRR less valuable and excessive cost in growing MRR also leads to deceptive prosperity. More about that further on. MRR should be viewed on a rolling basis. It can be done by quarter for the board but by month for the management team. Doing it by quarter for the board enables seeing a 3-year trend on one page and gives the board sufficient perspective for oversight. Management needs to track this monthly to better manage the business. A relatively simple set of KPIs for each of 12 quarterly periods would be:

Table 3: MRR and Retention

Calculating Life Time Revenue through Cohort Analysis

The detailed method of calculating LTR does not need to be shown in every board package but should be included at least once per year, but calculated monthly for management.

The LTR calculation uses a grid where the columns would be the various Quarterly cohorts, that is all customers that first purchased that quarter (management might also do this using monthly instead of quarterly). This analysis can be applied to non-SaaS companies as well as SaaS entities. The first row would be the number of customers in the cohort. The next row would be the first month’s revenue for the cohort, the next the second months revenue, and so on until reaching 36 months (or whatever number the board prefers for B2B…I prefer 60 months). The next row would be the total for the full period and the final row would be the average Lifetime Revenue, LTR, per member of the cohort.

Table 4: Customer Lifetime Revenue

A second table would replicate the grid but show average per member of the cohort for each month (row). That table allows comparisons of cohorts to see if the average revenue of a newer cohort is getting better or worse than older ones for month 2 or month 6 or month 36, etc.

Table 5: Average Revenue per Cohort

Cohorts that have a full 36 months of data need to be at least 36 months old. What this means is that more recent cohorts will not have a full set of information but still can be used to see what trends have occurred. For example, is the second months average revenue for a current cohort much less than it was for a cohort one year ago? While newer cohorts do not have full sets of monthly revenue data, they still are very relevant in calculating more recent LTR. This can be done by using average monthly declines in sequential months and applying them to cohorts with fewer months of data.

Customer Acquisition Cost (CAC)

Calculating CAC is done in a variety of ways and is quite different for customers acquired electronically versus those obtained by a sales force.  Many companies I’ve seen have a combination of the two.

Marketing used to generate leads should always be considered part of CAC. The marketing cost in a month first is divided by the number of leads to generate a cost/lead. The next step is to estimate the conversion rate of leads to customers. A simple table would be as follows:

Table 6: Customer Acquisition Costs

table 6.1

For an eCommerce company, the additional cost to convert might be one free month of product or a heavily subsidized price for the first month. If the customer is getting the item before becoming a regular paying customer than the CAC would be:

CAC = MCTC / the percent that converts from the promotional trial to a paying customer.

CAC when a Sales Force is Involved

For many eCommerce companies and B2B companies that sell electronically, marketing is the primary cost involved in acquiring a paying customer. For those utilizing a sales force, the marketing expense plus the sales expense must be accumulated to determine CAC.

Typically, what this means is steps 1 through 3 above would still be used to determine CPL, but step 1 above might include marketing personnel used to generate leads plus external marketing spend:

  1. CPL (cost per lead) as above
  2. Sales Cost = current month’s cost of the sales force including T&E
  3. New Customers in the month = NC
  4. Conversion Rate to Customer = NC/number of leads= Y%
  5. CAC = CPL/Y% + (Sales Cost)/NC

There are many nuances ignored in the simple method shown. For example, some leads may take many months to close. Some may go through a pilot before closing. Therefore, there are more sophisticated methods of calculating CAC but using this method would begin the process of understanding an important indicator of efficiency of customer acquisition.

Gross Margin (GM) is a Critical Part of the Equation

While revenue is obviously an important measure of success, not all revenue is the same. Revenue that generates 90% gross margin is a lot more valuable per dollar than revenue that generates 15% gross margin. When measuring a company’s potential for future success it’s important to understand what level of revenue is required to reach profitability. A first step is understanding how gross margin may evolve. When a business scales there are many opportunities to improve margins:

  • Larger volumes may lead to larger discounts from suppliers
  • Larger volumes for products that are software/content may lower the hosting cost as a percent of revenue
  • Shipping to a larger number of customers may allow opening additional distribution centers (DCs) to facilitate serving customers from a DC closer to their location lowering shipping cost
  • Larger volumes may mean improved efficiency in the warehouse. For example, it may make more automation cost effective

When forecasting gross margin, it is important to be cautious in predicting some of these savings. The board should question radical changes in GM in the forecast. Certain efficiencies should be seen in a quarterly trend, and a marked improvement from the trend needs to be justified. The more significant jump in GM from a second DC can be calculated by looking at the change in shipping rates for customers that will be serviced from the new DC vs what rates are for these customers from the existing one.

Calculating LTV (Lifetime Value)

Gross Margin, by itself may be off as a measure of variable profits of a customer. If payment is by credit card, then the credit card cost per customer is part of variable costs. Some companies do not include shipping charges as part of cost of goods, but they should always be part of variable cost. Customer service cost is typically another cost that rises in proportion to the number of customers. So:

Variable cost = Cost of Goods sold plus any cost that varies directly with sales

Variable Profit = Revenue – Variable Cost

Variable Profit% (VP%) = (Variable Profit)/Revenue

LTV = LTR x VP%

The calculation of VP% should be based on current numbers as they will apply going forward. Determining a company’s marketing efficiency requires comparing LTV to the cost of customer acquisition. As mentioned earlier in the post, if the CAC is too large a proportion of LTV, a company may be showing deceptive (profitless) growth. So, the next set of KPIs address marketing efficiency.

Marketing Efficiency

It does not make sense to invest in an inefficient company as they will burn through capital at a rapid rate and will find it difficult to become profitable. A key measure of efficiency is the relationship between LTV and CAC or LTV/CAC. Essentially this is how many dollars of variable profit the company will make for every dollar it spends on marketing and sales. A ratio of 5 or more usually means the company is efficient. The period used for calculating LTR will influence this number. Since churn tends to be much lower for B2B companies, 5 years is often used to calculate LTR and LTV. But, using 5 years means waiting longer to receive resulting profits and can obscure cash flow implications of slower recovery of CAC. So, a second metric important to understand burn is how long it takes to recover CAC:

CAC Recovery Time = number of months until variable profit equals the CAC

The longer the CAC recovery time, the more capital required to finance growth. Of course, existing customers are also contributing to the month’s revenue alongside new customers. So, another interesting KPI is contribution margin which measures the current state of balance between marketing/sales and Variable Profits:

Contribution Margin = Variable Profits – Sales and Marketing Cost

Early on this number will be negative as there aren’t enough older customers to cover the investment in new ones. But eventually the contribution margin in a month needs to turn positive. To reach profitability it needs to exceed all other costs of the business (G&A, R&D, etc.). By reducing a month’s marketing cost, a company can improve contribution margin that month at the expense of sequential growth… which is why this is a balancing act.

I realize this post is long but wanted to include a substantial portion of KPIs in one post. However, I’ll leave more detailed measurement of sales force productivity and deeper analysis of several of the KPIs discussed here for one or more future posts.

Soundbytes

I’ll begin by apologizing for a midyear brag, but I always tell others to enjoy success and therefore am about to do that myself. In my top ten predictions for 2018 I included a market prediction and 4 stock predictions. I was feeling pretty good that they were all working well when I started to create this post. However, the stock prices for high growth stocks can experience serious shifts in very short periods. Facebook and Tesla both had (what I consider) minor shortfalls against expectations in the 10 days since and have subsequently declined quite a bit in that period. But given the strength of my other two recommendations, Amazon and Stitchfix, the four still have an average gain of 15% as of July 27. Since I’ve only felt comfortable predicting the market when it was easy (after 9/11 and after the 2008 mortgage blowup), I was nervous about predicting the S&P would be up this year as it was a closer call and was somewhat controversial given the length of the bull market prior to this year. But it seemed obvious that the new tax law would be very positive for corporate earnings. So, I thought the S&P would be up despite the likelihood of rising interest rates. So far, it is ahead 4.4% year to date driven by stronger earnings. Since I always fear that my record of annual wins can’t continue I wanted to take a midyear victory lap just in case everything collapses in the second half of the year (which I don’t expect but always fear). So I continue to hold all 4 stocks and in fact bought a bit more Facebook today.