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.

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.

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.

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.  

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

The Valuation Bible – Part 2: Applying the Rules to Tesla and Creating an Adjusted Valuation Method for Startups

This post is part 2 of our valuation discussion (see this post for part 1).  As I write this post Tesla’s market cap is about $56 billion. I thought it would be interesting to show how the rules discussed in the first post apply to Tesla, and then to take it a step further for startups.

Revenue and Revenue Growth

Revenue for Tesla in 2017 was $11.8 billion, about 68% higher than 2016, and it is likely to grow faster this year given the over $20 billion in pre-orders (and growing) for the model 3 coupled with continued strong demand for the model S and model X. Since it is unclear when the new sports car or truck will ship, I assume no revenue in those categories. As long as Tesla can increase production at the pace they expect, I estimate 2018 revenue will be up 80% – 120% over 2017, with Q4 year over year growth at or above 120%.

If I’m correct on Tesla revenue growth, its 2018 revenue will exceed $20 billion. So, Rule Number 1 from the prior post indicates that Tesla’s high growth rates should merit a higher “theoretical PE” than the S&P (by at least 4X if one believes that growth will continue at elevated rates).

Calculating TPE

Tesla gross margins have varied a bit while ramping production for each new model, but in the 16 quarters from Q1, 2014 to Q4, 2017 gross margin averaged 23% and was above 25%, 6 of the 16 quarters. Given that Tesla is still a relatively young company it appears likely margins will increase with scale, leading me to believe that long term gross margins are very likely to be above 25%. While it will dip during the early production ramp of the model 3, 25% seems like the lowest percent to use for long term modeling and I expect it to rise to between 27% and 30% with higher production volumes and newer factory technology.

Tesla recognizes substantial cost based on stock-based compensation (which partly occurs due to the steep rise in the stock). Most professional investors ignore artificial expenses like stock-based compensation, as I will for modeling purposes, and refer to the actual cost as net SG&A and net R&D. Given that Tesla does not pay commissions and has increased its sales footprint substantially in advance of the roll-out of the model 3, I believe Net SG&A and Net R&D will each increase at a much slower pace than revenue. If they each rise 20% by Q4 of this year and revenue is at or exceeds $20 billion, this would put their total at below 20% of revenue by Q4. Since they should decline further as a percent of revenue as the company matures, I am assuming 27% gross margin and 18% operating cost as the base case for long term operating profit. While this gross margin level is well above traditional auto manufacturers, it seems in line as Tesla does not have independent dealerships (who buy vehicles at a discount) and does not discount its cars at the end of each model year.

Estimated TPE

Table 1 provides the above as the base case for long term operating profit. To provide perspective on the Tesla opportunity, Table 1 also shows a low-end case (25% GM and 20% operating cost) and a high-end profit case (30% GM and 16% operating cost).  Recall, theoretic earnings are derived from applying the mature operating profit level to trailing and to forward revenue. For calculating theoretic earnings, I will ignore interest payments and net tax loss carry forwards as they appear to be a wash over the next 5 years. Finally, to derive the Theoretic Net Earnings Percent a potential mature tax rate needs to be applied. I am using 20% for each model case which gives little credit for tax optimization techniques that could be deployed. That would make theoretic earnings for 2017 and 2018 $0.85 billion and $1.51 billion, respectively and leads to:

  • 2017 TPE=$ 56.1 billion/$0.85 = 66.0
  • 2018 TPE= $ 56.1 billion/1.51 = 37.1

The S&P trailing P/E is 25.5 and forward P/E is about 19X. Based on our analysis of the correlation between growth and P/E provided in the prior post, Tesla should be trading at a minimum of 4X the trailing S&P ratio (or 102 TP/E) and at least 3.5X S&P forward P/E (or 66.5 TP/E). To me that shows that the current valuation of Tesla does not appear out of market.  If the market stays at current P/E levels and Tesla reaches $21B in revenue in 2018 this indicates that there is strong upside for the stock.

Table 1: Tesla TPE 2017 & 2018

The question is whether Tesla can continue to grow revenue at high rates for several years. Currently Tesla has about 2.4% share of the luxury car market giving it ample room to grow that share. At the same time, it is entering the much larger medium-priced market with the launch of the Model 3 and expects to produce vehicles in other categories over the next few years. Worldwide sales of new cars for the auto market is about 90 million in 2017 and growing about 5% a year. Tesla is the leader in several forward trends: electric vehicles, automated vehicles and technology within a car. Plus, it has a superior business model as well. If it reaches $21 billion in revenue in 2018, its share of the worldwide market would be about 0.3%. It appears poised to continue to gain share over the next 3-5 years, especially as it fills out its line of product.  Given that it has achieved a 2.4% share of the market it currently plays in, one could speculate that it could get to a similar share in other categories. Even achieving a 1% share of the worldwide market in 5 years would mean about 40% compound growth between 2018 and 2022 and imply a 75X-90X TP/E at the end of this year.

The Bear Case

I would be remiss if I omitted the risks that those negative on the stock point out. Tesla is a very controversial stock for a variety of reasons:

  1. Gross Margin has been volatile as it adds new production facilities so ‘Bears’ argue that even my 25% low case is optimistic, especially as tax rebate subsidies go away
  2. It has consistently lost money so some say it will never reach the mature case I have outlined
  3. As others produce better electric cars Tesla’s market share of electric vehicles will decline so high revenue growth is not sustainable
  4. Companies like Google have better automated technology that they will license to other manufacturers leading to a leap frog of Tesla

As they say, “beauty is in the eyes of the beholder” and I believe my base case is realistic…but not without risk. In response to the bear case that Tesla revenue growth can’t continue, it is important to recognize that Tesla already has the backlog and order momentum to drive very high growth for the next two years. Past that, growing market share over the 4 subsequent years to 1% (a fraction of their current share of the luxury market) would generate compound annual growth of 40% for that 4-year period. In my opinion, the biggest risk is Tesla’s own execution in ramping production. Bears will also argue that Tesla will never reach the operating margins of my base case for a variety of reasons. This is the weakness of the TPE approach: it depends on assumptions that have yet to be proven. I’m comfortable when my assumptions depend on momentum that is already there, gross margin proof points and likelihood that scale will drive operating margin improvements without any radical change to the business model.

Applying the rules to Startups

As a VC I am often in the position of helping advise companies regarding valuation. This occurs when they are negotiating a round of financing or in an M&A situation.  Because the companies are even earlier than Tesla, theoretic earnings are a bit more difficult to establish. Some investors ignore the growth rates of companies and look for comps in the same business. The problem with the comparable approach is that by selecting companies in the same business, the comps are often very slow growth companies that do not merit a high multiple. For example, comparing Tesla to GM or Ford to me seems a bit ludicrous when Tesla’s revenue grew 68% last year and is expected to grow even faster this year while Ford and GM are growing their revenue at rates below 5%. It would be similar if investors compared Apple (in the early days of the iPhone) to Nokia, a company it was obsoleting.

Investors look for proxies to use that best correlate to what future earnings will be and often settle on a multiple of revenue. As Table 2 shows, there is a correlation between valuation as a multiple of revenue and revenue growth regardless of what industry the companies are in. This correlation is closer than one would find by comparing high growth companies to their older industry peers.

Table 2: Multiple of Revenue and Revenue Growth

However, using revenue as the proxy for future earnings suffers from a wide variety of issues. Some companies have 90% or greater gross margins like our portfolio company Education.com, while others have very low gross margins of 10% – 20%, like Spotify. It is very likely that the former will generate much higher earnings as a percent of revenue than the latter. In fact, Education.com is already cash flow positive at a relatively modest revenue level (in the low double-digit millions) while Spotify continues to lose a considerable amount of money at billions of dollars in revenue. Notice, this method also implies that Tesla should be valued about 60% higher than its current market price.

This leads me to believe a better proxy for earnings is gross margin as it is more closely correlated with earnings levels. It also removes the issue of how revenue is recognized and is much easier to analyze than TPE. For example, Uber recognizing gross revenue or net revenue has no impact on gross margin dollars but would radically change its price to revenue. Table 3 uses the same companies as Table 2 but shows their multiple of gross margin dollars relative to revenue growth. Looking at the two graphs, one can see how much more closely this correlates to the valuation of public companies. The correlation coefficient improves from 0.36 for the revenue multiple to 0.62 for the gross margin multiple.

Table 3: Multiple of Gross Margin vs. Revenue Growth

So, when evaluating a round of financing for a pre-profit company the gross margin multiple as it relates to growth should be considered. For example, while there are many other factors to consider, the formula implies that a 40% revenue growth company should have a valuation of about 14X trailing gross margin dollars.  Typically, I would expect that an earlier stage company’s mature gross margin percent would likely increase. But they also should receive some discount from this analysis as its risk profile is higher than the public companies shown here.

Notice that the price to sales graph indicates Tesla should be selling at 60% more than its multiple of 5X revenue. On the other hand, our low-end case for Tesla Gross Margin, 25%, puts Tesla at 20X Gross Margin dollars, just slightly undervalued based on where the least square line in Table 3 indicates it should be valued.

The Valuation Bible

Facebook valuation image

After many years of successfully picking public and private companies to invest in, I thought I’d share some of the core fundamentals I use to think about how a company should be valued. Let me start by saying numerous companies defy the logic that I will lay out in this post, often for good reasons, sometimes for poor ones. However, eventually most companies will likely approach this method, so it should at least be used as a sanity check against valuations.

When a company is young, it may not have any earnings at all, or it may be at an earnings level (relative to revenue) that is expected to rise. In this post, I’ll start by considering more mature companies that are approaching their long-term model for earnings to establish a framework, before addressing how this framework applies to less mature companies. The post will be followed by another one where I apply the rules to Tesla and discuss how it carries over into private companies.

Growth and Earnings are the Starting Points for Valuing Mature Companies

When a company is public, the most frequently cited metric for valuation is its price to earnings ratio (PE). This may be done based on either a trailing 12 months or a forward 12 months. In classic finance theory a company should be valued based on the present value of future cash flows. What this leads to is our first rule:

Rule 1: Higher Growth Rates should result in a higher PE ratio.

When I was on Wall Street, I studied hundreds of growth companies (this analysis does not apply to cyclical companies) over the prior 10-year period and found that there was a very strong correlation between a given year’s revenue growth rate and the next year’s revenue growth rate. While the growth rate usually declined year over year if it was over 10%, on average this decline was less than 20% of the prior year’s growth rate. What this means is that if we took a group of companies with a revenue growth rate of 40% this year, the average organic growth for the group would likely be about 33%-38% the next year. Of course, things like recessions, major new product releases, tax changes, and more could impact this, but over a lengthy period of time this tended to be a good sanity test. As of January 2, 2018, the average S&P company had a PE ratio of 25 on trailing earnings and was growing revenue at 5% per year. Rule 1 implies that companies growing faster should have higher PEs and those growing slower, lower PEs than the average.

Graph 1: Growth Rates vs. Price Earnings Ratios

graph

The graph shows the correlation between growth and PE based on the valuations of 21 public companies. Based on Rule 1, those above the line may be relatively under-priced and those below relatively over-priced. I say ‘may be’ as there are many other factors to consider, and the above is only one of several ways to value companies. Notice that most of the theoretically over-priced companies with growth rates of under 5% are traditional companies that have long histories of success and pay a dividend. What may be the case is that it takes several years for the market to adjust to their changed circumstances or they may be valued based on the return from the dividend. For example, is Coca Cola trading on: past glory, its 3.5% dividend, or is there something about current earnings that is deceptive (revenue growth has been a problem for several years as people switch from soda to healthier drinks)? I am not up to speed enough to know the answer. Those above the line may be buys despite appearing to be highly valued by other measures.

Relatively early in my career (in 1993-1995) I applied this theory to make one of my best calls on Wall Street: “Buy Dell sell Kellogg”. At the time Dell was growing revenue over 50% per year and Kellogg was struggling to grow it over 4% annually (its compounded growth from 1992 to 1995, this was partly based on price increases). Yet Dell’s PE was about half that of Kellogg and well below the S&P average. So, the call, while radical at the time, was an obvious consequence of Rule 1. Fortunately for me, Dell’s stock appreciated over 65X from January 1993 to January 2000 (and well over 100X while I had it as a top pick) while Kellogg, despite large appreciation in the overall stock market, saw its stock decline slightly over the same 7-year period (but holders did receive annual dividends).

Rule 2: Predictability of Revenue and Earnings Growth should drive a higher trailing PE

Investors place a great deal of value on predictability of growth and earnings, which is why companies with subscription/SaaS models tend to get higher multiples than those with regular sales models. It is also why companies with large sales backlogs usually get additional value. In both cases, investors can more readily value the companies on forward earnings since they are more predictable.

Rule 3: Market Opportunity should impact the Valuation of Emerging Leaders

When one considers why high growth rates might persist, the size of the market opportunity should be viewed as a major factor. The trick here is to make sure the market being considered is really the appropriate one for that company. In the early 1990s, Dell had a relatively small share of a rapidly growing PC market. Given its competitive advantages, I expected Dell to gain share in this mushrooming market. At the same time, Kellogg had a stable share of a relatively flat cereal market, hardly a formula for growth. In recent times, I have consistently recommended Facebook in this blog for the very same reasons I had recommended Dell: in 2013, Facebook had a modest share of the online advertising, a market expected to grow rapidly. Given the advantages Facebook had (and they were apparent as I saw every Azure ecommerce portfolio company moving a large portion of marketing spend to Facebook), it was relatively easy for me to realize that Facebook would rapidly gain share. During the time I’ve owned it and recommended it, this has worked out well as the share price is up over 8X.

How the rules can be applied to companies that are pre-profit

As a VC, it is important to evaluate what companies should be valued at well before they are profitable. While this is nearly impossible to do when we first invest (and won’t be covered in this post), it is feasible to get a realistic range when an offer comes in to acquire a portfolio company that has started to mature. Since they are not profitable, how can I apply a PE ratio?

What needs to be done is to try to forecast eventual profitability when the company matures. A first step is to see where current gross margins are and to understand whether they can realistically increase. The word realistic is the key one here. For example, if a young ecommerce company currently has one distribution center on the west coast, like our portfolio company Le Tote, the impact on shipping costs of adding a second eastern distribution center can be modeled based on current customer locations and known shipping rates from each distribution center. Such modeling, in the case of Le Tote, shows that gross margins will increase 5%-7% once the second distribution center is fully functional. On the other hand, a company that builds revenue city by city, like food service providers, may have little opportunity to save on shipping.

  • Calculating variable Profit Margin

Once the forecast range for “mature” gross margin is estimated, the next step is to identify other costs that will increase in some proportion to revenue. For example, if a company is an ecommerce company that acquires most of its new customers through Facebook, Google and other advertising and has high churn, the spend on customer acquisition may continue to increase in direct proportion to revenue. Similarly, if customer service needs to be labor intensive, this can also be a variable cost. So, the next step in the process is to access where one expects the “variable profit margin” to wind up. While I don’t know the company well, this appears to be a significant issue for Blue Apron: marketing and cost of goods add up to about 90% of revenue. I suspect that customer support probably eats up (no pun intended) 5-10% of what is left, putting variable margins very close to zero. If I assume that the company can eventually generate 10% variable profit margin (which is giving it credit for strong execution), it would need to reach about $4 billion in annual revenue to reach break-even if other costs (product, technology and G&A) do not increase. That means increasing revenue nearly 5-fold. At their current YTD growth rate this would take 9 years and explains why the stock has a low valuation.

  • Estimating Long Term Net Margin

Once the variable profit margin is determined, the next step would be to estimate what the long-term ratio of all other operating cost might be as a percent of revenue. Using this estimate I can determine a Theoretic Net Earnings Percent. Applying this percent to current (or next years) revenue yields a Theoretic Earnings and a Theoretic PE (TPE):

TPE= Market Cap/Theoretic Earnings     

To give you a sense of how I successfully use this, review my recap of the Top Ten Predictions from 2017 where I correctly predicted that Spotify would not go public last year despite strong top line growth as it was hard to see how its business model could support more than 2% or so positive operating margin, and that required renegotiating royalty deals with record labels.  Now that Spotify has successfully negotiated a 3% lower royalty rate from several of the labels, it appears that the 16% gross margins in 2016 could rise to 19% or more by the end of 2018. This means that variable margins (after marketing cost) might be 6%. This would narrow its losses, but still means it might be several years before the company achieves the 2% operating margins discussed in that post. As a result, Spotify appears headed for a non-traditional IPO, clearly fearing that portfolio managers would not be likely to value it at its private valuation price since that would lead to a TPE of over 200. Since Spotify is loved by many consumers, individuals might be willing to overpay relative to my valuation analysis.

Our next post will pick up this theme by walking through why this leads me to believe Tesla continues to have upside, and then discussing how entrepreneurs should view exit opportunities.

 

SoundBytes

I’ve often written about effective shooting percentage relative to Stephen Curry, and once again he leads the league among players who average 15 points or more per game. What also accounts for the Warriors success is the effective shooting of Klay Thompson, who is 3rd in the league, and Kevin Durant who is 6th. Not surprisingly, Lebron is also in the top 10 (4th). The table below shows the top ten among players averaging 15 points or more per game.  Of the top ten scorers in the league, 6 are among the top 10 effective shooters with James Harden only slightly behind at 54.8%. The remaining 3 are Cousins (53.0%), Lillard (52.2%), and Westbrook, the only one below the league average of 52.1% at 47.4%.

Table: Top Ten Effective Shooters in the League

table

*Note: Bolded players denote those in the top 10 in Points per Game

Will Grocery Shopping Ever be the Same?

Will grocery shopping ever be the same?

Dining and shopping today is very different than in days gone by – the Amazon acquisition of Whole Foods is a result

“I used to drink it,” said Andy Warhol once of Campbell’s soup. “I used to have the same lunch every day, for 20 years, I guess, the same thing over and over again.” In Warhol’s signature medium, silkscreen, the artist reproduced his daily Campbell’s soup can over and over again, changing only the label graphic on each one.

When I was growing up I didn’t have exactly the same thing over and over like Andy Warhol, but virtually every dinner was at home, at our kitchen table (we had no dining room in the 4-room apartment). Eating out was a rare treat and my father would have been abhorred if my mom brought in prepared food. My mom, like most women of that era, didn’t officially work, but did do the bookkeeping for my dad’s plumbing business. She would shop for food almost every day at a local grocery and wheel it home in her shopping cart.

When my wife and I were raising our kids, the kitchen remained the most important room in the house. While we tended to eat out many weekend nights, our Sunday through Thursday dinners were consumed at home, but were sprinkled with occasional meals brought in from the outside like pizza, fried chicken, ribs, and Chinese food. Now, given a high proportion of households where both parents work, eating out, fast foods and prepared foods have become a large proportion of how Americans consume dinner. This trend has reached the point where some say having a traditional kitchen may disappear as people may cease cooking at all.

In this post, I discuss the evolution of our eating habits, and how they will continue to change. Clearly, the changes that have already occurred in shopping for food and eating habits were motivations for Amazon’s acquisition of Whole Foods.

The Range of How We Dine

Dining can be broken into multiple categories and families usually participate in all of them. First, almost 60% of dinners eaten at home are still prepared there. While the percentage has diminished, it is still the largest of the 4 categories for dinners. Second, many meals are now purchased from a third party but still consumed at home. Given the rise of delivery services and greater availability of pre-cooked meals at groceries, the category spans virtually every type of food. Thirdly, many meals are purchased from a fast food chain (about 25% of Americans eat some type of fast food every day1) and about 20% of meals2 are eaten in a car. Finally, a smaller percentage of meals are consumed at a restaurant. (Sources: 1Schlosser, Eric. “Americans Are Obsessed with Fast Food: The Dark Side of the All-American Meal.” CBSNews. Accessed April 14, 2014 / 2Stanford University. “What’s for Dinner?” Multidisciplinary Teaching and Research at Stanford. Accessed April 14, 2014).

The shift to consuming food away from home has been a trend for the last 50 years as families began going from one worker to both spouses working. The proportion of spending on food consumed away from home has consistently increased from 1965-2014 – from 30% to 50%.

Source: Calculated by the Economic Research Service, USDA, from various data sets from the U.S. Census Bureau and the Bureau of Labor Statistics.

With both spouses working, the time available to prepare food was dramatically reduced. Yet, shopping in a supermarket remained largely the same except for more availability of prepared meals. Now, changes that have already begun could make eating dinner at home more convenient than eating out with a cost comparable to a fast food chain.

Why Shopping for Food Will Change Dramatically over the Next 30 Years

Eating at home can be divided between:

  1. Cooking from scratch using ingredients from general shopping
  2. Buying prepared foods from a grocery
  3. Cooking from scratch from recipes supplied with the associated ingredients (meal kits)
  4. Ordering meals that have previously been prepared and only need to be heated up
  5. Ordering meals from a restaurant that are picked up or delivered to your home
  6. Ordering “fast food” type meals like pizza, ribs, chicken, etc. for pickup or delivery.

I am starting with the assumption that many people will still want to cook some proportion of their dinners (I may be romanticizing given how I grew up and how my wife and I raised our family). But, as cooking for yourself becomes an even smaller percentage of dinners, shopping for food in the traditional way will prove inefficient. Why buy a package of saffron or thyme or a bag of onions, only to see very little of it consumed before it is no longer usable? And why start cooking a meal, after shopping at a grocery, only to find you are missing an ingredient of the recipe? Instead, why not shop by the meal instead of shopping for many items that may or may not end up being used.

Shopping by the meal is the essential value proposition offered by Blue Apron, Plated, Hello Fresh, Chef’d and others. Each sends you recipes and all the ingredients to prepare a meal. There is little food waste involved (although packaging is another story). If the meal preparation requires one onion, that is what is included, if it requires a pinch of saffron, then only a pinch is sent. When preparing one of these meals you never find yourself missing an ingredient. It takes a lot of the stress and the food waste out of the meal preparation process. But most such plans, in trying to keep the cost per meal to under $10, have very limited choices each week (all in a similar lower cost price range) and require committing to multiple meals per week. Chef’d, one of the exceptions to this, allows the user to choose individual meals or to purchase a weekly subscription. They also offer over 600 options to choose from while a service like Blue Apron asks the subscriber to select 3 out of 6 choices each week.

Blue Apron meals portioned perfectly for the amount required for the recipes

My second assumption is that the number of meals that are created from scratch in an average household will diminish each year (as it already has for the past 50 years). However, many people will want to have access to “preferred high quality” meals that can be warmed up and eaten, especially in two-worker households. This will be easier and faster (but perhaps less gratifying) than preparing a recipe provided by a food supplier (along with all the ingredients). I am talking about going beyond the pre-cooked items in your average grocery. There are currently sources of such meals arising as delivery services partner with restaurants to provide meals delivered to your doorstep. But this type of service tends to be relatively expensive on a per meal basis.

I expect new services to arise (we’ve already seen a few) that offer meals that are less expensive prepared by “home chefs” or caterers and ordered through a marketplace (this is category 4 in my list). The marketplace will recruit the chefs, supply them with packaging, take orders, deliver to the end customers, and collect the money. Since the food won’t be from a restaurant, with all the associated overhead, prices can be lower. Providing such a service will be a source of income for people who prefer to work at home. Like drivers for Uber and Lyft, there should be a large pool of available suppliers who want to work in this manner. It will be very important for the marketplaces offering such service to curate to ensure that the quality and food safety standards of the product are guaranteed. The availability of good quality, moderately priced prepared meals of one’s choice delivered to the home may begin shifting more consumption back to the home, or at a minimum, slow the shift towards eating dinners away from home.

Where will Amazon be in the Equation?

In the past, I predicted that Amazon would create physical stores, but their recent acquisition of Whole Foods goes far beyond anything I forecast by providing them with an immediate, vast network of physical grocery stores. It does make a lot of sense, as I expect omnichannel marketing to be the future of retail.  My reasoning is simple: on the one hand, online commerce will always be some minority of retail (it currently is hovering around 10% of total retail sales); on the other hand, physical retail will continue to lose share of the total market to online for years to come, and we’ll see little difference between e-commerce and physical commerce players.  To be competitive, major players will have to be both, and deliver a seamless experience to the consumer.

Acquiring Whole Foods can make Amazon the runaway leader in categories 1 and 2, buying ingredients and/or prepared foods to be delivered to your home.  Amazon Fresh already supplies many people with products that are sourced from grocery stores, whether they be general food ingredients or traditional prepared foods supplied by a grocery. They also have numerous meal kits that they offer, and we expect (and are already seeing indications) that Amazon will follow the Whole Foods acquisition by increasing its focus on “meal kits” as it attempts to dominate this rising category (3 in our table).

One could argue that Whole Foods is already a significant player in category 4 (ordering meals that are prepared, and only need to be heated up), believing that category 4 is the same as category 2 (buying prepared meals from a grocery). But it is not. What we envision in the future is the ability to have individuals (who will all be referred to as “Home Chefs” or something like that) create brands and cook foods of every genre, price, etc. Customers will be able to order a set of meals completely to their taste from a local home chef. The logical combatants to control this market will be players like Uber and Lyft, guys like Amazon and Google, existing recipe sites like Blue Apron…and new startups we’ve never heard of.

Trump’s Carrier deal a positive step for workers

It saves at least 800 jobs at a 14x return to government

Let me start this post by saying I did not vote for Donald Trump and consider myself an independent. But, as my readers know, I can’t help analyzing everything including company business models (both public and private), basketball performance, football, and of course, economics. I have, to date, resisted opining on the election, as it appears to be a polarizing event and therefore a no-win for those who comment. However, I care deeply about the future of our country and the welfare of workers of all levels. Being in Venture Capital allows me to believe (perhaps naively) that I contribute to adding jobs to our country. All this brings me to the recent agreement reached between Trump and Carrier, as it may mark a shift in economic policy.

A key assumption in interpreting the value of the deal is how many jobs were already slated by Carrier to leave the country and which of these were saved. President-Elect Trump has claimed he saved 1,150 jobs. Trump’s opponents say 350 were never slated to leave the country. I’m not going to try to figure out which camp is right. My analysis will only assume 800 manufacturing jobs that were slated to leave the country now will remain in Indiana. This does not seem to be disputed by anyone and was confirmed by a Carrier spokesperson. My observations for this analysis are:

  1. Had those jobs left, 800 fewer people would be employed (which might be different ones than these but less jobs mean less employment).
  2. The average worker at these jobs would make $20 an hour plus overtime (some reports have put this as high as $30 per hour fully loaded cost to Carrier). The average worker at these jobs would make about $45,000 annually, assuming modest overtime.
  3. On average, assuming working spouses in many cases, family income would be an average of $65,000.

Given what we know, here’s why I think Trump’s Carrier deal is a good one for the U.S., and actually results in revenue to the government that far exceeds the tax credits:

Social security taxes are currently 6.2% of each worker’s wages. The employer matches that, resulting in about $5,600 in FICA tax income to the government per worker from social security. Medicare is 1.45% and is also matched, resulting in about $1,300 in Medicare taxes paid to the government.

The federal income tax increment between a $20,000 family income (for spouse) and $65,000 family income is about $4,000 (but depends on a number of factors). Indiana state taxes of 3.3% on adjusted gross income comes out to nearly $1,400.

To make the total relatively conservative, I’ve omitted county taxes, payroll taxes and other payments that various other governmental entities might receive. This should mean the total financial income to various governmental entities from these jobs remaining probably exceeds those calculated in Table 1 below even if some of my rough assumptions are not exact.

Table 1. Governmental Income per Worker

Table

So, the economic question of whether the subsidy Trump agreed to was worth it partly depends on how much additional income was derived by the government versus the tax credits of $700,000 per year granted to Carrier in exchange for keeping the jobs here.

Of course, there is also a multiplier effect of families having higher income available for spending. And if 800 additional people are unemployed, there are numerous costs paid by the government. We’ll leave these out of the analysis, but they are all real benefits to our society of more people being employed. It is important to realize how expensive it is for the government to subsidize unemployed workers as opposed to realizing multiple sources of tax revenues when these workers have good jobs.

If we take the total from Table 1, which we believe underestimates the income to governmental entities, and multiply it by the 800 workers, the annual benefit adds up to about $9.8 million. Since Carrier is getting a $700,000 annual subsidy, the governmental revenue derived is over 14 times the cost. And that is without including a number of other benefits, some of which we mentioned above. As an investor, I’d take a 14 times return every day of the year. Wouldn’t you? Shouldn’t the government?

This is not a sweetheart deal for Carrier

I won’t go into all the math, but it indicates that Carrier will spend tens of millions of dollars more by keeping workers in the U.S. rather than moving them to Mexico. Comments that the $700,000 yearly benefit they have been given is a sweetheart deal does not appear to be the case.

Why the Democrats lost the election

Trump campaigned on the promise that he would create policies and heavily negotiate to increase employment in America. While this is a small victory in the scheme of things and certainly falls short of retaining all the jobs Carrier wanted to move, the analysis demonstrates that spending some money in tax breaks to increase employment has a large payback to government. It also means a lot to 800 people who greatly prefer being paid for working rather than receiving unemployment benefits.

Is this approach scalable?

The other question is whether this is scalable as a way of keeping jobs in America. Clearly Trump would not be able to negotiate individually with every company planning on moving jobs out of the U.S. Some infrastructure would need to be created – the question would be at what cost? If this became policy, would it encourage more companies to consider moving jobs as a way of attracting tax benefits? Any approach would need to prevent that. My guess is that getting a few companies known to be moving jobs to reconsider is only an interim step. If Trump is to fulfill his promise, an ongoing solution will be needed. But it is important to properly evaluate any steps from an impartial financial viewpoint as the United States needs to increase employment.

Employment is the right way of measuring the economy’s health

My post of March 2015 discussed the health of the economy and pointed out that looking at the Unemployment Rate as the key indicator was deceptive as much of the improvement was from people dropping out of the workforce. Instead, I advocated using the “Employment Rate” (the percent of the eligible population employed) as a better indicator. I noted that in 2007, pre-downturn, 63.0% of the population had a job. By 2010 this had declined to 58.5%, a 450 basis point drop due to the recession. Four years later the “Recovery” drove that number up to 59.0% which meant only 1/9 of the drop in those working returned to the workforce. Since then the workforce has recovered further but still stands at 325 basis points below the pre-recession level. That is why the rust belt switched from voting Democrat to President-Elect Trump.

The real culprit is loss of better quality job opportunities

In an article in the New York Times on December 7, “stagnant wages” since 1980 were blamed for lack of income growth experienced by the lower half on the economic scale. I believe that the real culprit is loss of better quality job opportunities. Since 1980 production and non-supervisory hourly wages have increased 214% but at the same time manufacturing workers as a percent of the workforce has shrunk from 18.9% to 8.1% and there has been no recovery of these jobs subsequent to the 2007-2010 recession. Many of these displaced workers have been forced to take lower paying jobs in the leisure, health care or other sectors, part-time jobs or dropped out of the workforce entirely (triggering substantial government spending to help them). This loss of available work in manufacturing is staggering and presents a challenge to our society. It also is the button Donald Trump pushed to get elected. I am hoping he can change the trend but it is a difficult task for anyone, Republican or Democrat.

A condensed version of of this post is featured on Fortune.com 

How Healthy Is Our Economy?

In this era of globalization of the work force, the United States has become a country with a split personality. On the one hand, we continue to lead the world in innovation driven by a strong college and graduate education system (15 of the 20 top rated universities in the world are in the U.S., according to the Times Higher Education World rankings), a large population of risk-taking entrepreneurs, an influx of hard working, talented immigrants and the strength of the Venture Capital industry. This innovation is responsible for creating many jobs, as can be seen at the likes of Google, Apple, Tesla, Amazon, Facebook, LinkedIn, Twitter, Uber and many more rising stars.

On the other hand, we have failed as a country to remain competitive across the workforce. As a result, despite the many jobs created by innovators, the workforce as a portion of the population is contracting and currently is barely above recession level lows. Although this month’s jobs report suggests the employment picture is improving, it’s a mistake to think the falling unemployment rate from the January 2010 recession high of 10.6% to a recent level of 5.8% in February 2015 is proof the economy is healthy once more[1] . While the 2007 pre-downturn level was a much lower 4.3%, the degree of failure to recover is considerably bleaker than the current 5.8% level versus the pre-recession 4.3% difference would indicate.

Employment Rather than Unemployment is a Better Measure of Economic Health

The employment rate (the percentage of the population that has a job) is a far better indicator of the health of the economy than the unemployment rate (the % of those seeking jobs that don’t have one). People with jobs are what supports the economy and the mere fact that someone removes themselves from the workforce does not make the economy healthier. In fact, the percentage of the population that is not in the labor force is at its highest level in 36 years. In both January and February 2015, the seasonally unadjusted labor force participation rate was 62.5%. That means that 37.5% were not participating in the labor force[2] . The last time the labor force participation rate sunk to these levels was in 1978, when it was 62.8%. At that time, interest rates were soaring and the prime rate peaked at 11.75% later that year.

In 2007, 66.0% of the population was in the workforce (that is, sought a job) and 95.4% of those had a job, meaning 63.0% of the population were employed. In 2010, 64.7% of the population was still in the work force and 90.4% of those had a job, meaning that 58.5% of Americans were still employed during the lowest period in the downturn. How much of the 4.5 percentage points (or 450 basis points) loss of employment has been recovered? In 2014, only 62.9% of the population was in the workforce. So, despite the shrinkage in the unemployment rate (which was mostly due to fewer people seeking jobs), we now have 59.0% of the population working, a 50 basis point improvement from the low point of the recession. But there was a 450 basis point shrinkage in employment during the recession, so a 50 basis point improvement hardly qualifies as a true recovery!

Labor force & employment

The Law of Unintended Consequences Often Plagues the Best of Intentions

Our federal and state governments frequently pass laws that are intended to help workers. But often the cost to employers of fulfilling these new obligations has unintended consequences as added expense drives reaction. Examples:

1. Increase minimum wage: reaction by many employers is to replace domestic workers with ones in other countries and/or to increase the use of automation, reducing the work force. Although there are conflicting data on the impact of a minimum wage increase on unemployment, a 2013 study by the AAF found that a $1 increase in the minimum wage was associated with a 1.5% increase in the unemployment rate and a 0.18% decrease in the net job growth rate.

2. Taxing companies repatriating cash from abroad at high rates: Reaction by many corporations is to decide not to repatriate the cash and, instead, to re-invest it by expanding operations in other countries instead of in the United States, causing a loss of potential jobs here.

3. Cities controlling the number of taxis allowed (through requirement to purchase a medallion): Leading to the success of Uber as unavailability of sufficient numbers of cabs during high requirement periods causes a massive conversion to Uber and a loss of income for taxi drivers.

Why is the economy failing to recover to prior levels? My belief is that the combination of the Affordable Care Act (a $2,000 cost per employee), increasing minimum wages and strong competition from abroad have all contributed to the problem. Furthermore, they have not only held back employment increases but also pushed the part-time portion of the workforce to about 19% (it was 13.5% in the late 1960s and between 17% and 18% in the early 2000s).

Part-time

Finally, while our college and graduate education is outstanding, the U.S. K-12 education ranks quite low amongst nations:
1. 36th in mathematics for 15 year olds[3]
2. 24th in reading for 15 year olds[3]
3. 28th in science for 15 years olds[3]
4. 14th in cognitive skills and educational attainment[4]
5. 11th in fourth-grade mathematics and 9th in eighth-grade mathematics[5]
6. 7th in fourth-grade science and 10th in eighth-grade science[5]

Much of our priority as a country tends to emphasize short-term gratification over long-term issues like investing in primary education. If we make workers more expensive than in other parts of the developed world through requirements of expensive benefits, high minimum wages, heavy taxation, etc., then we need to make sure they are more skilled through better education and training. One of the policies that helped offset this in the past is prioritizing ease of immigration for those at the high end of the spectrum who could help create jobs.

If we fail to change our approach going forward, I continued to be concerned for America’s long-term future.

[1] Unemployment Rate (Not Seasonally Adjusted), United States Department of Labor, Bureau of Labor Statistics, http://data.bls.gov/timeseries/LNU04000000
[2] http://www.bls.gov/news.release/pdf/empsit.pdf
[3] Organization for Economic Cooperation and Development (OECD), Program for International Student Assessment (PISA). 65 educational systems ranked.
[4] Pearson Global Index of Cognitive Skills and Educational Attainment compares the performance of 39 countries and one region (Hong Kong) on two categories of education: Cognitive Skills and Educational Attainment. The Index provides a snapshot of the relative performance of countries based on their education outputs.
[5] International Study Center at Boston College. Fourth graders in 57 countries or education systems took the math and science tests, while 56 countries or education systems administered the tests to eighth graders.

Soundbytes:

– It will be interesting to see what the impact of the largest salary-cap jump in league history will be on the 2016-17 season. For example, LeBron James could take his salary from about $22 million next season to around $30 million if he signs for the maximum salary in 2016. This could have significant implications for many free agents and there might be those who accept only one-year contracts so they can retest the market in 2016, when there is more money available.