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.

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 2018 Top Ten Predictions

Have the bears finally won back control?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Interesting KPIs (Key Performance Indicators) for a Subscription Company

what-are-key-performance-indicators-kpis

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

Areas KPIs Should Cover

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

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

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

P&L Trends: Less is More

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

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

Table1: P&L by Quarter

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

Table 2: P&L Actual / Budget Comparison

Tracking MRR and LTR

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

Table 3: MRR and Retention

Calculating Life Time Revenue through Cohort Analysis

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

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

Table 4: Customer Lifetime Revenue

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

Table 5: Average Revenue per Cohort

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

Customer Acquisition Cost (CAC)

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

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

Table 6: Customer Acquisition Costs

table 6.1

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

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

CAC when a Sales Force is Involved

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

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

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

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

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

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

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

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

Calculating LTV (Lifetime Value)

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

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

Variable Profit = Revenue – Variable Cost

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

LTV = LTR x VP%

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

Marketing Efficiency

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

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

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

Contribution Margin = Variable Profits – Sales and Marketing Cost

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

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

Soundbytes

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

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).