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.

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.