How to Improve Contribution Margin

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

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

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

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

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

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

1. Increase Follow-On sales from existing customers 

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

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

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

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

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

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

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

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

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

3. Increase Gross Margin through price Increases

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

 

4. Improving GM by reducing COGs

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

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

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

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

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

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

6. Decrease Marketing Spend as a % of Revenue.

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

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

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

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

 

SoundBytes

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

Why Contribution Margin is a Strong Predictor of Success for Companies

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

Contribution Margin = Variable Profits – Sales and Marketing Cost

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

The Drivers of Contribution Margin (CM)

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

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

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

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

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

Free Traffic and Contribution Margin

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

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

Spending to Drive Higher Growth Can Mean Lower Contribution Margin

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

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

Table 1: The Relationship Between Contribution Margin & Growth

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

Subscription Models Create More Consistency but are not a Panacea

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

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

Investing in Companies with High Contribution Margin

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

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

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

Table 2: Public Company Contribution Margin Analysis

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

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

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

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

 

SoundBytes

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

Company Valuations Implied by my Valuations Bible: Are Snap, Netflix, Square and Twitter Grossly Overvalued?

Applying the Gross Margin Multiple Method to Public Company Valuation

In my last two posts I’ve laid out a method to value companies not yet at their mature business models. The method provides a way to value unprofitable growth companies and those that are profitable but not yet at what could be their mature business model. This often occurs when a company is heavily investing in growth at the expense of near-term profits. In the last post, I showed how I would estimate what I believed the long-term model would be for Tesla, calling the result “Potential Earnings” or “PE”. Since this method requires multiple assumptions, some of which might not find agreement among investors, I provided a second, simplified method that only involved gross margin and revenue growth.

The first step was taking about 20 public companies and calculating how they were valued as a multiple of gross margin (GM) dollars. The second step was to determine a “least square line” and formula based on revenue growth and the gross margin multiple for these companies. The coefficient of 0.62 shows that there is a good correlation between Gross Margin and Revenue Growth, and one significantly better than the one between Revenue Growth and a company’s Revenue Multiple (that had a coefficient of 0.36 which is considered very modest).

Where’s the Beef?

The least square formula derived in my post for relating revenue growth to an implied multiple of Gross Margin dollars is:

GM Multiple = (24.773 x Revenue growth percent) + 4.1083

Implied Company Market Value = GM Multiple x GM Dollars

Now comes the controversial part. I am going to apply this formula to 10 companies using their data (with small adjustments) and compare the Implied Market Value (Implied MKT Cap) to their existing market Cap as of several days ago. I’ll than calculate the Implied Over (under) Valuation based on the comparison. If the two values are within 20% I view it as normal statistical variation.

Table 1: Valuation Analysis of 10 Tech Companies

  • * Includes net cash included in expected market cap
  • ** Uses adjusted GM%
  • *** Uses 1/31/18 year end
  • **** Growth rate used in the model is q4 2017 vs q4 2016.  See text

This method suggests that 5 companies are over-valued by 100% or more and a fifth, Workday, by 25%. Since Workday is close to a normal variation, I won’t discuss it further. I have added net cash for Facebook, Snap, Workday and Twitter to the implied market cap as it was material in each case but did not do so for the six others as the impact was not as material.

I decided to include the four companies I recommended, in this year’s top ten list, Amazon, Facebook, Tesla and Stitchfix, in the analysis. To my relief, they all show as under-valued with Stitchfix, (the only one below the Jan 2 price) having an implied valuation more than 100% above where it currently trades. The other three are up year to date, and while trading below what is suggested by this method, are within a normal range. For additional discussion of these four see our 2018 top Ten List.

 

Digging into the “Overvalued” Five

Why is there such a large discrepancy between actual market cap and that implied by this method for 5 companies? There are three possibilities:

  1. The method is inaccurate
  2. The method is a valid screen but I’m missing some adjustment for these companies
  3. The companies are over-valued and at some point, will adjust, making them risky investments

While the method is a good screen on valuation, it can be off for any given company for three reasons:  the revenue growth rate I’m using will radically change; a particular company has an ability to dramatically increase gross margins, and/or a particular company can generate much higher profit margins than their gross margin suggests. Each of these may be reflected in the company’s actual valuation but isn’t captured by this method.

To help understand what might make the stock attractive to an advocate, I’ll go into a lot of detail in analyzing Snap. Since similar arguments apply to the other 4, I’ll go into less detail for each but still point out what is implicit in their valuations.

Snap

Snap’s gross margin (GM) is well below its peers and hurts its potential profitability and implied valuation. Last year, GM was about 15%, excluding depreciation and amortization, but it was much higher in the seasonally strong Q4. It’s most direct competitor, Facebook, has a gross margin of 87%.  The difference is that Facebook monetizes its users at a much higher level and has invested billions of dollars and executed quite well in creating its own low-cost infrastructure, while Snap has outsourced its backend to cloud providers Google and Amazon. Snap has recently signed 5-year contracts with each of them to extend the relationships. Committing to lengthy contracts will likely lower the cost of goods sold.  Additionally, increasing revenue per user should also improve GM.  But, continuing to outsource puts a cap on how high margins can reach. Using our model, Snap would need 79% gross margin to justify its current valuation. If I assume that scale and the longer-term contracts will enable Snap to double its gross margins to 30%, the model still shows it as being over-valued by 128% (as opposed to the 276% shown in our table). The other reason bulls on Snap may justify its high valuation is that they expect it to continue to grow revenue at 100% or more in 2018 and beyond. What is built into most forecasts is an assumed decline in revenue growth rates over time… as that is what typically occurs. The model shows that growing revenue 100% a year for two more years without burning cash would leave it only 32% over-valued in 2 years. But as a company scales, keeping revenue growth at that high a level is a daunting task. In fact, Snap already saw revenue growth decline to 75% in Q4 of 2017.

Twitter

Twitter is not profitable.  Revenue declined in 2017 after growing a modest 15% in 2016, and yet it trades at a valuation that implies that it is a growth company of about 50%. While it has achieved such levels in the past, it may be difficult to even get back to 15% growth in the future given increased competition for advertising.

Netflix

I recommended Netflix in January 2015 as one of my stock picks for the year, and it proved a strong recommendation as the stock went up about 140% that year. However, between January 2015 and January 2018, the stock was up over 550% while trailing revenue only increased 112%.  I continue to like the fundamentals of Netflix, but my GM model indicates that the stock may have gotten ahead of itself by a fair amount, and it is unlikely to dramatically increase revenue growth rates from last year’s 32%.

Square

Square has followed what I believe to be the average pattern of revenue growth rate decline as it went from 49% growth in 2015, down to 35% growth in 2016, to under 30% growth in 2017. There is no reason to think this will radically change, but the stock is trading as if its revenue is expected to grow at a nearly 90% rate. On the GM side, Square has been improving GM each year and advocates will point out that it could go higher than the 38% it was in 2017. But, even if I use 45% for GM, assuming it can reach that, the model still implies it is 90% over-valued.

Blue Apron

I don’t want to beat up on a struggling Blue Apron and thought it might have reached its nadir, but the model still implies it is considerably over-valued. One problem that the company is facing is that investors are negative when a company has slow growth and keeps losing money. Such companies find it difficult to raise additional capital. So, before running out of cash, Blue Apron began cutting expenses to try to reach profitability. Unfortunately, given their customer churn, cutting marketing spend resulted in shrinking revenue in each sequential quarter of 2017. In Q4 the burn was down to $30 million but the company was now at a 13% decline in revenue versus Q4 of 2016 (which is what we used in our model). I assume the solution probably needs to be a sale of the company. There could be buyers who would like to acquire the customer base, supplier relationships and Blue Apron’s understanding of process. But given that it has very thin technology, considerable churn and strong competition, I’m not sure if a buyer would be willing to pay a substantial premium to its market cap.

 

An Alternative Theory on the Over Valued Five

I have to emphasize that I am no longer a Wall Street analyst and don’t have detailed knowledge of the companies discussed in this post, so I easily could be missing some important factors that drive their valuation.  However, if the GM multiple model is an accurate way of determining valuation, then why are they trading at such lofty premiums to implied value? One very noticeable common characteristic of all 5 companies in question is that they are well known brands used by millions (or even tens of millions) of people. Years ago, one of the most successful fund managers ever wrote a book where he told readers to rely on their judgement of what products they thought were great in deciding what stocks to own. I believe there is some large subset of personal and professional investors who do exactly that. So, the stories go:

  • “The younger generation is using Snap instead of Facebook and my son or daughter loves it”
  • “I use Twitter every day and really depend on it”
  • “Netflix is my go-to provider for video content and I’m even thinking of getting rid of my cable subscription”

Once investors substitute such inclinations for hard analysis, valuations can vary widely from those suggested by analytics. I’m not saying that such thoughts can’t prove correct, but I believe that investors need to be very wary of relying on such intuition in the face of evidence that contradicts it.

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

Ten Predictions for 2018

In my recap of 2017 predictions I pointed out how boring my stock predictions have been with Tesla and Facebook on my list every year since 2013 and Amazon on for two of the past three years. But what I learned on Wall Street is that sticking with companies that have strong competitive advantages in a potentially mega-sized market can create great performance over time (assuming one is correct)! So here we go again, because as stated in my January 5 post, I am again including Tesla, Facebook and Amazon in my Top ten list for 2018. I believe they each continue to offer strong upside, as explained below. I’m also adding a younger company, with a modest market cap, thus more potential upside coupled with more risk. The company is Stitch Fix, an early leader in providing women with the ability to shop for fashion-forward clothes at home. My belief in the four companies is backed up by my having an equity position in each of them.

I’m expecting the four stocks to outperform the market. So, in a steeply declining market, out-performance might occur with the stock itself being down (but less than the market). Having mentioned the possibility of a down market, I’m predicting the market will rise this year. This is a bit scary for me, as predicting the market as a whole is not my specialty.

We’ll start with the stock picks (with January 2 opening prices of stocks shown in parenthesis) and then move on to the remainder of my 10 predictions.

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

The good news and bad news on Tesla is the delays in production of the Model 3. The good part is that we can still look forward to massive increases in the number of cars the company sells once Tesla gets production ramping (I estimate the Model 3 backlog is well in excess of 500,000 units going into 2018 and demand appears to be growing). In 2017, Tesla shipped between 80,000 and 100,000 vehicles with revenue up 30% in Q3 without help from the model 3. If the company is successful at ramping capacity (and acquiring needed parts), it expects to reach a production rate of 5,000 cars per week by the end of Q1 and 10,000 by the end of the year. That could mean that the number of units produced in Q4 2018 will be more than four times that sold in Q4 2017 (with revenue about 2.0-2.5x due to the Model 3 being a lower priced car). Additionally, while it is modest compared to revenue from selling autos, the company appears to be the leader in battery production. It recently announced the largest battery deal ever, a $50 million contract (now completed on time) to supply what is essentially a massive backup battery complex for energy to Southern Australia. While this type of project is unlikely to be a major portion of revenue in the near term, it can add to Tesla’s growth rate and profitability.

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

The core Facebook user base growth has slowed considerably but Facebook has a product portfolio that includes Instagram, WhatsApp and Oculus. This gives Facebook multiple opportunities for revenue growth: Improve the revenue per DAU (daily active user) on Facebook itself; increase efforts to monetize Instagram and WhatsApp in more meaningful ways; and build the install base of Oculus. Facebook advertising rates have been increasing steadily as more mainstream companies shift budget from traditional advertising to Facebook, especially in view of declining TV viewership coupled with increased use of DVRs (allowing viewers to skip ads). Higher advertising rates, combined with modest growth in DAUs, should lead to continued strong revenue growth. And while the Oculus product did not get out of the gate as fast as expected, it began picking up steam in Q3 2017 after Facebook reduced prices. At 210,000 units for the quarter it may have contributed up to 5% of Q3 revenue. The wild card here is if a “killer app” (a software application that becomes a must have) launches that is only available on the Oculus, sales of Oculus could jump substantially in a short time.

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

Amazon, remarkably, increased its revenue growth rate in 2017 as compared to 2016. This is unusual for companies of this size. In 2018, we expect online to continue to pick up share in retail and Amazon to gain more share of online. The acquisition of Whole Foods will add approximately $4B per quarter in revenue, boosting year/year revenue growth of Amazon an additional 9%-11% per quarter, if Whole Foods revenue remains flattish. If Amazon achieves organic growth of 25% (in Q3 it was 29% so that would be a drop) in 2018, this would put the 3 quarters starting in Q4 2017 at about 35% growth. While we do expect Amazon to boost Whole Foods revenue, that is not required to reach those levels. In Q4 2018, reported revenue will return to organic growth levels. The Amazon story also features two other important growth drivers. First, I expect the Echo to have another substantial growth year and continue to emerge as a new platform in the home. Additionally, Amazon appears poised to benefit from continued business migration to the cloud coupled with increased market share and higher average revenue per cloud customer. This will be driven by modest price increases and introduction of more services as part of its cloud offering. The success of the Amazon Echo with industry leading voice technology should continue to provide another boost to Amazon’s revenue. Additionally, having a large footprint of physical stores will allow Amazon to increase distribution of many products.

4. Stitch Fix stock appreciation will outpace the market (it opened the year at $25/share and is at the same level as I write this post).

Stitch Fix is my riskiest stock forecast. As a new public company, it has yet to establish a track record of performance that one can depend upon. On the other hand, it’s the early leader in a massive market that will increasingly move online, at-home shopping for fashion forward clothes. The number of people who prefer shopping at home to going to a physical store is on the increase. The type of goods they wish to buy expands every year. Now, clothing is becoming a new category on the rapid rise (it grew from 11% of overall clothing retail sales in 2011 to 19% in 2016). It is important for women buying this way to feel that the provider understands what they want and facilitates making it easy to obtain clothes they prefer. Stitch Fix uses substantial data analysis to personalize each box it sends a customer. The woman can try them on, keep (and pay for) those they like, and return the rest very easily.

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

While I have been accurate on recommending individual stocks over a long period, I rarely believe that I understand what will happen to the overall market. Two prior exceptions were after 9/11 and after the 2008 mortgage crisis generated meltdown. I was correct both times but those seemed like easy calls. So, it is with great trepidation that I’m including this prediction as it is based on logic and I know the market does not always follow logic! To put it simply, the new tax bill is quite favorable to corporations and therefore should boost after-tax earnings. What larger corporations pay is often a blend of taxes on U.S. earnings and those on earnings in various countries outside the U.S. There can be numerous other factors as well. Companies like Microsoft have lower blended tax rates because much of R&D and corporate overhead is in the United States and several of its key products are sold out of a subsidiary in a low tax location, thereby lowering the portion of pre-tax earnings here. This and other factors (like tax benefits in fiscal 2017 from previous phone business losses) led to blended tax rates in fiscal 2015, 2016 and 2017 of 34%, 15% and 8%, respectively. Walmart, on the other hand, generated over 75% of its pre-tax earnings in the United States over the past three fiscal years, so their blended rate was over 30% in each of those years

Table 1: Walmart Blended Tax Rates 2015-2017

The degree to which any specific company’s pre-tax earnings mix changes between the United States and other countries is unpredictable to me, so I’m providing a table showing the impact on after-tax earnings growth for theoretical companies instead. Table 2 shows the impact of lowering the U.S. corporate from 35% to 21% on four example companies. To provide context, I show two companies growing pre-tax earnings by 10% and two companies by 30%. If blended tax rates didn’t change, EPS would grow by the same amount as pre-tax earnings. For Companies 1 and 3, Table 2 shows what the increase in earnings would be if their blended 2017 tax rate was 35% and 2018 shifts to 21%. For companies 2 and 4, Table 2 shows what the increase in earnings would be if the 2017 rate was 30% (Walmart’s blended rate the past three years) and the 2018 blended rate is 20%.

Table 2: Impact on After-Tax Earnings Growth

As you can see, companies that have the majority of 2018 pre-tax earnings subject to the full U.S. tax rate could experience EPS growth 15%-30% above their pre-tax earnings growth. On the other hand, if a company has a minimal amount of earnings in the U.S. (like the 5% of earnings Microsoft had in fiscal 2017), the benefit will be minimal. Whatever benefits do accrue will also boost cash, leading to potential investments that could help future earnings.  If companies that have maximum benefits from this have no decline in their P/E ratio, this would mean a substantial increase in their share price, thus the forecast of an up market. But as I learned on Wall Street, it’s important to sight risk. The biggest risks to this forecast are the expected rise in interest rates this year (which usually is negative for the market) and the fact that the market is already at all-time highs.

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

The battle over legalization of Marijuana reached a turning point in 2017 as polls showed that over 60% of Americans now favor full legalization (as compared to 12% in 1969). Prior to 2000, only three states (California, Oregon and Maine) had made medical cannabis legal. Now 29 states have made it legal for medical use and six have legalized sale for recreational use. Given the swing in voter sentiment (and a need for additional sources of tax revenue), more states are moving towards legalization for recreational and medical purposes. This has put the “legal” marijuana industry on a torrid growth curve. In Colorado, one of the first states to broadly legalize use, revenue is over $1 billion per year and overall 2017 industry revenue is estimated at nearly $8 billion, up 20% year/year. Given expected legalization by more states and the ability to market product openly once it is legal, New Frontier Data predicts that industry revenue will more than triple by 2025. The industry is making a strong case that medical use has compelling results for a wide variety of illnesses and high margin, medical use is forecast to generate over 50% of the 2025 revenue. Given this backdrop, public cannabis companies have had very strong performance. Despite this, in 2016, VCs only invested about $49 million in the sector. We expect that number to escalate dramatically in 2017 through 2019. While public cannabis stocks are trading at nosebleed valuations, they could have continued strong performance as market share consolidates and more states (and Canada) head towards legalization. One caveat to this is that Federal law still makes marijuana use illegal and the Trump administration is adopting a more aggressive policy towards pursuing producers, even in states that have made use legal. The states that have legalized marijuana use are gearing up to battle the federal government.

7. At least one city will announce a new approach to Urban transport

Traffic congestion in cities continues to worsen. Our post on December 14, 2017 discussed a new approach to urban transportation, utilizing small footprint automated cars (one to two passengers, no trunk, no driver) in a dedicated corridor. This appears much more cost effective than a Rapid Bus Transit solution and far more affordable than new subway lines. As discussed in that post, Uber and other ride services increase traffic and don’t appear to be a solution. The thought that automating these vehicles will relieve pressure is overly optimistic. I expect at least one city to commit to testing the method discussed in the December post before the end of this year – it is unlikely to be a U.S. city. The approach outlined in that post is one of several that is likely to be tried over the coming years as new thinking is clearly needed to prevent the traffic congestion that makes cities less livable.

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

Retailers will adopt more of a multi-pronged approach to increasing their participation in e-commerce. I expect this to include:

  • An increased pace of acquisition of e-commerce companies, technologies and brands with Walmart leading the way. Walmart and others need to participate more heavily in online as their core offline business continues to lose share to online. In 2017, Walmart made several large acquisitions and has emerged as the leader among large retailers in moving online. This, in turn, has helped its stock performance. After a stellar 12 months in which the stock was up over 40%, it finally exceeded its January 2015 high of $89 per share (it reached $101/share as we are finalizing the post). I expect Walmart and others in physical retail to make acquisitions that are meaningful in 2018 so as to speed up the transformation of their businesses to an omnichannel approach.
  • Collaborating to introduce more online/technology into their physical stores (which Amazon is likely to do in Whole Foods stores). This can take the form of screens in the stores to order online (a la William Sonoma), having online purchases shipped to your local store (already done by Nordstrom) and adding substantial ability to use technology to create personalized items right at the store, which would subsequently be produced and shipped by a partner.

9. Social commerce will begin to emerge as a new category.

Many e-commerce sites have added elements of social, and many social sites have begun trying to sell various products. But few of these have a fully integrated social approach to e-commerce. The elements of a social approach to e-commerce include:

  • A feed-based user experience
  • Friends’ actions impact your feed
  • Following trend setters to see what they are buying, wearing, and favoring
  • Notifications based on your likes and tastes
  • One click to buy
  • Following particular stores and/or friends

I expect to see existing e-commerce players adding more elements of social, existing social players improving their approach to commerce and a rising trend of emerging companies focused on fully integrated social commerce.

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

It is almost shameful that automobile manufacturers, other than Tesla, have lost substantial usage of their onboard GPS systems as many people use their cell phones or a small device to run Google, Waze (owned by Google) or Garmin instead of the larger screen in their car. In the hundreds of times I’ve taken an Uber or Lyft, I’ve never seen the driver use their car’s system. To modernize their existing systems, manufacturers may need to license software from a third party. Several companies are offering next generation products that claim to replicate the optimization offered by Waze but also add new features that go beyond it like offering to order coffee and other items to enable the driver to stop at a nearby location and have the product prepaid and waiting for them. In addition to adding value to the user, this also leads to a lead-gen revenue opportunity. In 2018, I expect one or more auto manufacturers to commit to including a third-party product in one or more of their models.

Soundbytes

Tesla model 3 sample car generates huge buzz at Stanford Mall in Menlo Park California. This past weekend my wife and I experienced something we had not seen before – a substantial line of people waiting to check out a car, one of the first Model 3 cars seen live. We were walking through the Stanford Mall where Tesla has a “Guide Store” and came upon a line of about 60 people willing to wait a few hours to get to check out one of the two Model 3’s available for perusal in California (the other was in L.A.). An hour later we came back, and the line had grown to 80 people. To be clear, the car was not available for a test drive, only for seeing it, sitting in it, finding out more info, etc. Given the buzz involved, it seems to me that as other locations are given Model 3 cars to look at, the number of people ordering a Model 3 each week might increase faster than Tesla’s capacity to fulfill.

Re-cap of 2017 Top Ten Predictions

I started 2017 by saying:

When I was on Wall Street I became very boring by having the same three strong buy recommendations for many years…  until I downgraded Compaq in 1998 (it was about 30X the original price at that point). The other two, Microsoft and Dell, remained strong recommendations until I left Wall Street in 2000. At the time, they were each well over 100X the price of my original recommendation. I mention this because my favorite stocks for this blog include Facebook and Tesla for the 4th year in a row. They are both over 5X what I paid for them in 2013 ($23 and $45, respectively) and I continue to own both. Will they get to 100X or more? This is not likely, as companies like them have had much higher valuations when going public compared with Microsoft or Dell, but I believe they continue to offer strong upside, as explained below.

Be advised that my top ten for 2018 will continue to include all three picks from 2017. I’m quite pleased that I continue to be fortunate, as the three were up an average of 53% in 2017. Furthermore, each of my top ten forecasts proved pretty accurate, as well!

I’ve listed in bold the 2017 stock picks and trend forecasts below, and give a personal evaluation of how I fared on each. For context, the S&P was up 19% and the Nasdaq 28% in 2017.

  1. Tesla stock appreciation will continue to outpace the market. Tesla, once again, posted very strong performance.  While the Model 3 experienced considerable delays, backorders for it continued to climb as ratings were very strong. As of mid-August, Tesla was adding a net of 1,800 orders per day and I believe it probably closed the year at over a 500,000-unit backlog. So, while the stock tailed off a bit from its high ($385 in September), it was up 45% from January 3, 2017 to January 2, 2018 and ended the year at 7 times the original price I paid in 2013 when I started recommending it. Its competitors are working hard to catch up, but they are still trailing by quite a bit.
  2. Facebook stock appreciation will continue to outpace the market. Facebook stock appreciated 57% year/year and opened on January 2, 2018 at $182 (nearly 8 times my original price paid in 2013 when I started recommending it). This was on the heels of 47% revenue growth (through 3 quarters) and even higher earnings growth.
  3. Amazon stock appreciation will outpace the market. Amazon stock appreciated 57% in 2017 and opened on January 2, 2018 at $1,188 per share. It had been on my recommended list in 2015 when it appreciated 137%. Taking it off in 2016 was based on Amazon’s stock price getting a bit ahead of itself (and revenue did catch up that year growing 25% while the stock was only up about 12%). In 2017, the company increased its growth rate (even before the acquisition of Whole Foods) and appeared to consolidate its ability to dominate online retail.
  4. Both online and offline retailers will increasingly use an omnichannel approach. Traditional retailers started accelerating the pace at which they attempted to blend online and offline in 2017. Walmart led, finally realizing it had to step up its game to compete with Amazon. While its biggest acquisition was Jet.com for over $3 billion, it also acquired Bonobos, Modcloth.com, Moosejaw, Shoebuy.com and Hayneedle.com, creating a portfolio of online brands that could also be sold offline. Target focused on becoming a leader in one-day delivery by acquiring Shipt and Grand Junction, two leaders in home delivery. While I had not predicted anything as large as a Whole Foods acquisition for Amazon, I did forecast that they would increase their footprint of physical locations (see October 2016 Soundbytes). The strategy for online brands to open “Guide” brick and mortar stores ( e.g. Tesla, Warby Parker, Everlane, etc.) continued at a rapid pace.
  5. A giant piloted robot will be demo’d as the next form of entertainment. As expected, Azure portfolio company, Megabots, delivered on this forecast by staging an international fight with a giant robot from Japan. The fight was not live as the robots are still “temperamental” (meaning they occasionally stop working during combat). However, interest in this new form of entertainment was incredible as the video of the fight garnered over 5 million views (which is in the range of an average prime-time TV show). There is still a large amount of work to be done to convert this to an ongoing form of entertainment, but all the ingredients are there.
  6. Virtual and Augmented reality products will escalate. Sales of VR/AR headsets appear to have well exceeded 10 million units for the year with some market gain for higher-end products. The types of applications have expanded from gaming to room design (and viewing), travel, inventory management, education, healthcare, entertainment and more. While the actual growth in unit sales fell short of what many expected, it still was substantial. With Apple’s acquisition of Vrvana (augmented reality headset maker) it seems clear that Apple plans to launch multiple products in the category over the next 2-3 years, and with Facebook’s launch of ArKIT, it’s social AR development platform, there is clearly a lot of focus and growth ahead.
  7. Magic Leap will disappoint in 2017. Magic Leap, after 5 years of development and $1.5 billion of investment, did not launch a product in 2017. But, in late December they announced that their first product will launch in 2018. Once again, the company has made strong claims for what its product will do, and some have said early adopters (at a very hefty price likely to be in the $1,500 range) are said to be like those who bought the first iPod. So, while it disappointed in 2017, it is difficult to tell whether or not this will eventually be a winning company as it’s hard to separate hype from reality.
  8. Cable companies will see a slide in adoption. According to eMarketer, “cord cutting”, i.e. getting rid of cable, reached record proportions in 2017, well exceeding their prior forecast. Just as worrisome to providers, the average time watching TV dropped as well, implying decreased dependence on traditional consumption. Given the increase now evident in cord cutting, UBS (as I did a year ago) is now forecasting substantial acceleration of the decline in subscribers. While the number of subscribers bounced around a bit between 2011 and 2015, when all was said and done, the aggregate drop in that four-year period was less than 0.02%. UBS now forecasts that between the end of 2016 and the end of 2018 the drop will be 7.3%. The more the industry tries to offset the drop by price increases, the more they will accelerate the pace of cord cutting.
  9. Spotify will either postpone its IPO or have a disappointing one. When we made this forecast, Spotify was expected to go public in Q2 2017. Spotify postponed its IPO into 2018 while working on new contracts with the major music labels to try to improve its business model. It was successful in these negotiations in that the labels all agreed to new terms. Since the terms were not announced, we’ll need to see financials for Q1 2018 to better understand the magnitude of improvement. In the first half of the year, Spotify reported that gross margins improved from 16% to 22%, but this merely cut its loss level rather than move the company to profitability. It has stated that it expects to do a non-traditional IPO (a direct listing without using an investment bank) in the first half of 2018. If the valuation approaches its last private round, I would caution investors to stay away, as that valuation, coupled with 22% gross margins (and over 12% of revenue in sales and marketing cost to acquire customers), implies net margin in the mid-single digits at best (assuming they can reduce R&D and G&A as a percent of revenue). This becomes much more challenging in the face of a $1.6 billion lawsuit filed against it for illegally offering songs without compensating the music publisher. Even if they managed to successfully fight the lawsuit and improve margin, Spotify would be valued at close to 100 times “potential earnings” and these earnings may not even materialize.
  10. Amazon’s Echo will gain considerable traction in 2017. Sales of the Echo exploded in 2017 with Amazon announcing that it “sold 10s of millions of Alexa-enabled devices” exceeding our aggressive forecast of 2-3x the 4.4 million units sold in 2016. The Alexa app was also the top app for both Android and iOS phones. It clearly has carved out a niche as a new major platform.

Stay tuned for my top 10 predictions of 2018!

 

SoundBytes

  • In our December 20, 2017 post, I discussed just how much Steph Curry improves teammate performance and how effective a shooter he is. I also mentioned that Russell Westbrook leading the league in scoring in the prior season might have been detrimental to his team as his shooting percentage falls well below the league average. Now, in his first game returning to the lineup, Curry had an effective shooting percentage that exceeded 100% while scoring 38 points (this means scoring more than 2 points for every shot taken). It would be interesting to know if Curry is the first player ever to score over 35 points with an effective shooting percentage above 100%! Also, as of now, the Warriors are scoring over 15 points more per game this season with Curry in the lineup than they did for the 11 games he was out (which directly ties to the 7.4% improvement in field goal percentage that his teammates achieve when playing with Curry as discussed in the post).