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Chipotle Mexican Grill (NYSE: CMG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Chipotle (pronounced “chi-POAT-lay”) shares for the portfolio in April 2012 at a price of US$265 and subsequently made five more purchases (in April 2015 at US$649; in November 2015 at US$605; in June 2016 at US$396; and twice in August 2017 at US$307 and US$311). I’ve not sold any of the shares I’ve bought. 

Four of the six purchases have worked out very well for my family’s portfolio, with Chipotle’s share price being around US$882 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Chipotle shares.

Company description

Chipotle’s business is simple. It runs fast-casual restaurants mainly in the US. Its namesake restaurants serve Mexican food – think burritos, burrito bowls (a burrito without the tortilla), tacos, and salads. A fast-casual restaurant is one with food quality that’s similar to full-service restaurants, but with the speed and convenience of fast food. 

At the end of 2019, Chipotle had 2,580 namesake restaurants in the US and 39 namesake restaurants in other countries. The company also operated three restaurants in the US that are not under the Chipotle brand. That’s it for Chipotle’s business… on the surface.

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Chipotle.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

In 2019, Chipotle raked in US$5.6 billion in revenue with its 2,622 restaurants. That sounds like Chipotle’s business is already massive. But it really isn’t. For perspective: 

• Number of Subway restaurants in the US in 2018, according to Satista: 24,798 
• Number of McDonald’s restaurants in the US currently: 14,428
• Total retail sales of restaurants and other eating places in the US in 2019 according to data from the St Louis Federal Reserve: US$670 billion

These numbers show that Chipotle still has plenty of runway to grow. 

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 March 2020, Chipotle held zero debt and US$881.3 million in cash and investments. This is a rock solid balance sheet.

For the sake of conservatism, I note that Chipotle also had US$2.9 billion in operating lease liabilities. Given the ongoing restrictions on human movement in the US because of the country’s battle against COVID-19, restaurants in general are operating in a really tough environment. The good thing for Chipotle is that 94% of its total operating lease liabilities of US$2.9 billion are long-term in nature, with payment typically due only from 31 March 2021 onwards.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Chipotle’s CEO is currently Brian Niccol, 46. Niccol joined Chipotle as CEO in March 2018 and was previously running the show at fast food chain Taco Bell. I appreciate Niccol’s relatively young age. The other important leaders in Chipotle, most of whom have relatively young ages (a good thing in my eyes), include:

In 2019, Niccol’s total compensation (excluding US$2.3 million of compensation for legal and tax fees that are related to his initial employment by Chipotle) was US$13.6 million. That’s a tidy sum of money. But of that, 62% came from stock awards and stock options. The stock awards are based on (1) the three-year growth in Chipotle’s comparable restaurant sales, which represents the year-on-year change in the revenue from Chipotle’s existing restaurants; and (2) the three-year average cash flow margin – cash flow as a percentage of revenue – for Chipotle’s restaurants. Meanwhile, the stock options vest over three years. These mean that the majority of Niccol’s compensation in 2019 depended on multi-year changes in Chipotle’s stock price and important financial metrics. I thus think that Niccol’s compensation structure is sensible and aligns his interests with mine as a shareholder of the company. 

I want to highlight too that the other leaders of Chipotle that I mentioned earlier have similar remuneration plans as Niccol. In 2019, they received 69% of each of their compensation for the year in the form of stock awards and stock options with the same characteristics as Niccol’s. 

On capability and innovation

There are a few key numbers that can tell us how well-run a restaurant company is: (1) Same store sales growth, and (2) average restaurant sales. The latter is self-explanatory but some of you may not be familiar with the former. Same store sales growth typically represents the change in period-over-period revenue for a company’s restaurants that are in operation for 12 months or more (it’s 13 months in the case of Chipotle). So what same store sales growth measures is essentially the growth in revenue for a restaurant company from its existing stores. The table below shows Chipotle’s same store sales growth and average restaurant sales from 2004 to 2019:

You can see that the company fared really well on both fronts until 2015, when there were some struggles for a few years before growth started resuming in 2017. When discussing Chipotle’s management, I want to break up the story into two portions. The first stretches from Chipotle’s founding to 2015, while the second is from 2015 to today.  

First portion of the story

Chipotle was founded by classically-trained chef Steve Ells in 1993. He served as the company’s CEO from its founding to early 2018. Ells created the company’s first restaurant with what I think is a pretty simple but radical idea. According to the first page of Chipotle’s IPO prospectus, Ells wanted to “demonstrate that food served fast didn’t have to be a “fast-food” experience.” The first page of the prospectus continued:

“We use high-quality raw ingredients, classic cooking methods and a distinctive interior design, and have friendly people to take care of each customer — features that are more frequently found in the world of fine dining.”

Ells never floundered on his initial vision for serving great food, not even when Chipotle was owned by – you’ll never guess it – McDonald’s. All told, Chipotle was under McDonald’s for eight years from 1998 to 2006. McDonald’s gave Chipotle the operational knowledge needed to scale from 13 restaurants to almost 500. But Ells frequently clashed with McDonald’s management over cultural differences. Here are two quotes from a brilliant Bloomberg profile of Chipotle’s entire history from 1993 to 2014 that describes the differences:

1. “What we found at the end of the day was that culturally we’re very different. There are two big things that we do differently. One is the way we approach food, and the other is the way we approach our people culture. It’s the combination of those things that I think make us successful.”

2. “Our food cost is what runs in a very upscale restaurant, which was really hard for McDonald’s. They’d say, “Gosh guys, why are you running 30 percent to 32 percent food costs? That’s ridiculous; that’s like a steakhouse.””  

Nonetheless, Chipotle became a fast-growing restaurant company under McDonald’s. Its success even spawned the “fast-casual” category of restaurants in the US. For a feel of what fast-casual means, the closest example I can think of in Singapore will be the Shake Shack burger restaurants here. The food is of much better quality than traditional fast food and the price point is a little higher, but the serving format is quick and casual.

After leaving McDonald’s umbrella via an IPO in January 2006, Chipotle continued to succeed for many years. As I mentioned earlier, Chipotle enjoyed strong growth in same store sales and average restaurant sales from 2004 to 2015. A beautiful example of Chipotle’s relative success over McDonald’s can be found in the Bloomberg profile. There’s a chart showing Chipotle’s much higher same-store sales growth from 2006 to the third-quarter of 2014:

To me, one of the key reasons behind Chipotle’s growth was its unique food culture. The company calls this “Food with Integrity.” Here’s how Chipotle described its food mantra in its IPO prospectus:

“Our focus has always been on using the kinds of higher-quality ingredients and cooking techniques used in high-end restaurants to make great food accessible at reasonable prices.

But our vision has evolved. While using a variety of fresh ingredients remains the foundation of our menu, we believe that “fresh is not enough, anymore.” Now we want to know where all of our ingredients come from, so that we can be sure they are as flavorful as possible while understanding the environmental and societal impact of our business. We call this idea “food with integrity,” and it guides how we run our business.”

This is how Chipotle discussed “Food with Integrity” in its annual report for 2015; the focus on serving tasty, fresh, sustainably-produced food still remained in 2015: 

“Serving high quality food while still charging reasonable prices is critical to our vision to change the way people think about and eat fast food. As part of our Food With Integrity philosophy, we believe that purchasing fresh ingredients is not enough, so we spend time on farms and in the field to understand where our food comes from and how it is raised. Because our menu is so focused, we can concentrate on the sources of each ingredient, and this has become a cornerstone of our continuous effort to improve our food.”

Another key contributor to Chipotle’s strong restaurant performance, in my opinion, is its Restaurateur program. The program, which started in 2005, is meant to improve employee-performance at each restaurant while providing excellent career prospects. Here’s a description of it from a 2014 Quartz article:

“During a busy lunch rush at a typical Chipotle restaurant, there are 20 steaks on the grill, and workers preparing massive batches of guacamole and seamlessly swapping out pans of ingredients. Compared to most fast-food chains, Chipotle favors human skill over rules, robots, and timers. Every employee can work in the kitchen and is expected to adjust the guacamole recipe if a crate of jalapeños is particularly hot.

So how did the Mexican-style food chain come to be like this while expanding massively since the 2000s?

In 2005, the US company underwent a transformation that would make its culture as distinct as its food. As more than 1,000 stores opened across the US, the company focused on creating a system where promoting managers from within would create a feedback loop of better, more motivated employees. That year, about 20% of the company’s managers had been promoted from within. Last year, nearly 86% of salaried managers and 96% of hourly managers were the result of internal promotions.

Fundamental to this transformation is something Chipotle calls the restaurateur program, which allows hourly crew members to become managers earning well over [US]$100,000 a year. Restaurateurs are chosen from the ranks of general managers for their skill at managing their restaurant and, especially, their staff. When selected, they get a one-time bonus and stock options. And after that they receive an extra [US]$10,000 each time they train a crew member to become a general manager.”

The Restaurateur program was the brainchild of Monty Moran. Moran joined Chipotle as COO (Chief Operating Officer) in March 2005 and became Co-CEO with Ells in January 2009. Moran stepped down from his position as Co-CEO in late 2016. 

Second portion of the story

2015 was a turning point for Chipotle. In the second half of the year, a food-safety crisis erupted. Around 500 people became ill from E.Coli, salmonella, and norovirus after eating at the company’s restaurants. This badly affected consumer confidence at Chipotle, which manifested in the sharp declines in the company’s same store sales growth and average restaurant sales in 2016. 

What were initially strengths – Chipotle’s food and people culture – ended up causing problems for the company. “Food with Integrity” meant that every restaurant used a lot of raw food ingredients and had to do a lot of food preparation within its own four walls; the company’s people culture involved measuring performance based on a restaurant’s throughput (or how fast it can take an order, make the order, and serve it). These two things combined meant that food safety could at times be compromised.

After the late-2015 food safety issue flared up, Ells and his team embarked on fixing the issues at the company. But they struggled, and 2016 became a painful year for Chipotle. Monty Moran left as Co-CEO in late December 2016; around a year later, Ells stepped down from his CEO position and assumed the role of executive chairman. Ells left Chipotle completely in March this year. Brian Niccol, who already had leadership experience at a fast food chain (Taco Bell), succeeded Ells as CEO in March 2018. 

When Niccol first came onboard, I remember being worried. I was concerned that he would dilute Chipotle’s food and people culture by introducing a more sterile way of doing business, such as the methods found in traditional fast food chains. But Niccol and his team have managed to retain what is special about Chipotle while improving the areas that needed fixing. 

In Chipotle’s latest annual report (for 2019), the company still placed an emphasis on “Food with Integrity”:

“Serving high quality food while still charging reasonable prices is critical to ensuring guests enjoy wholesome food at a great value. We respect our environment and insist on preparing, cooking, and serving nutritious food made from natural ingredients and animals that are raised or grown with care. We spend time on farms and in the field to understand where our food comes from and how it is raised. We concentrate on the sourcing of each ingredient, and this has become a cornerstone of our continuous effort to improve the food we serve. Our food is made from ingredients that everyone can both recognize and pronounce.

We’re all about simple, fresh food without the use of artificial colors or flavors typically found in fast food—just genuine real ingredients and their individual, delectable flavors.”    

The Restaurateur program still exists, but there is a more holistic framework at Chipotle for evaluating and improving employee performance compared to the past. 

Niccol and his team have also directed Chipotle to invest heavily in digital and other initiatives, such as: Digital/mobile ordering platforms; digital pick-up shelves; digital order pick-up drive-through lanes that are cutely named “Chipotlanes”; delivery and catering; and a rewards program. These investments have seen massive success. Here are some data points:

• In 2017 Chipotle started upgrading second-make lines in its restaurants to specifically handle digital and delivery orders, so as not to disrupt the company’s in-restaurant food preparation procedures; the company ended 2019 with nearly all restaurants having these upgraded second-make lines.
• 2019 also saw Chipotle complete the rollout of digital pick-up shelves across all its restaurants, and expand delivery capabilities to over 98% of its store base. 
• In 2018 digital and delivery sales grew by 43% and accounted for 10.9% of Chipotle’s overall revenue; in 2019, digital and delivery sales surged by 90% and accounted for 18.0% of total revenue; in the first quarter of 2020, digital and delivery sales were up 81% and were 26.3% of total revenue; digital and delivery sales were in the “high 60s” percentage range of total revenue for the month of April so far.
• Chipotle introduced a rewards program in March 2019 that kicked off with 3 million members. At end-2019, there were 8.5 million members; in the first quarter of 2020, the member count has jumped to 11.5 million.
• Chipotle enjoyed a strong uptick in same store sales growth and average restaurant sales in 2019; in the first two months of 2020, same store sales growth was a sensational 14.4%. 

The work isn’t done. Chipotle’s restaurant-level operating margin was 20.5% in 2019, up from 18.7% in 2018 but a far cry from the high-20s range the company was famous for prior to its late-2015 food safety issue. But in all, I give Niccol an A-plus for his time at Chipotle so far. He has only been at the company for a relatively short while, but the transformation has been impressive.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

I think it’s sensible to conclude that restaurant companies such as Chipotle enjoy recurring revenues simply due to the nature of their business: Customers keep coming back to buy food. 

5. A proven ability to grow

The table below shows Chipotle’s important financials from 2005 to 2019:

A few key points about Chipotle’s financials:

• Revenue compounded at an impressive rate of 21.8% from 2005 to 2015. Net profit stepped up at an even faster pace of 28.9% per year over the same period. Operating cash flow was consistently positively from 2005 to 2015 and compounded at a similarly strong annual rate of 24.3%. Free cash flow was positive in every year from 2006 to 2015, and became strong from 2008 onwards. 
• 2016 was a year where Chipotle reset its business after it suffered from food safety issues, as mentioned earlier. Some of the 2019 numbers for Chipotle are still lower than in 2015. But it’s worth noting that net profit, operating cash flow, and free cash flow compounded at 40.9%, 24.1%, and 24.2%, respectively, from 2017 to  2019. It’s also a positive, in my eyes, that Chipotle managed to produce solidly positive operating cash flow and free cash flow in 2016, at the height of its struggles with the food safety problems. 
• Chipotle’s balance sheet was rock-solid for the entire time period I’m looking at, with debt being zero all the way. This is made even more impressive when I consider the fact that the company had expanded its restaurant count significantly from 2005 to 2019 (see table below). I salute a restaurant company when it is able to grow without taking on any debt.
• Dilution has not happened at Chipotle, since its diluted shares outstanding has actually declined from 2006 to 2019. 

In the first quarter of 2020, Chipotle’s business encountered some speed bumps through no fault of its own. The US has been hit hard by the ongoing pandemic, COVID-19, with most states in the country currently in some form of lockdown. The lockdowns have understandably affected Chipotle’s business, but the company is handling the crisis well, even though there will be pain in the coming quarters. Here are some data I picked up from the company’s latest earnings update and earnings conference call (I had already discussed some of them earlier in this article):

• Revenue increased 7.8% year-on-year to US$1.4 billion in the first quarter of 2020.
• The balance sheet remains robust with zero debt and US$881.3 million in cash and investments as of 31 March 2020.
• Chipotle was still profitable in the first quarter of 2020, with profit of US$76.4 million, down 13.3% year-on-year.
• Operating cash flow for the first quarter of 2020 was unchanged from a year ago at US$182.1 million; free cash flow was down 12% to US$104.4 million.
• Same store sales in the first two months of 2020 were up 14.4%. In March, it was down by 16%, with the week ending March 29 being the worst with a decline of 35%. April’s same store sales for the most recent week was in the “negative high-teens range.”
• Digital and delivery sales were up 103% year-on-year in March to account for 37.6% of Chipotle’s total revenue; in April, digital and delivery sales were nearly 70% of total revenue. Digital sales have traditionally been stickier for Chipotle. 
• The company is continuing to reward its employees: (1) Employees who were willing and able to work between 16 March and 10 May were given a 10% increase in hourly rates; (2) a discretionary bonus of nearly US$7 million for the first quarter of 2020 was given to field leaders, general managers, apprentices, and eligible hourly employees; (3) US$2 million in assistance bonuses have been made available for general managers and their apprentices for their services in April; and (4) Emergency lead benefits were expanded to accommodate those directly affected by COVID-19.
• Chipotle is continuing to develop new restaurant units (although there are construction-related delays) and the availability of sites have increased as other businesses have pulled back spending.
• Chipotle’s rewards program has increased from 8.5 million members at end-2019 to 11.5 million in the first quarter of 2020; daily signups to the rewards program have also spiked by nearly four fold in the last month.
• In the first quarter of 2020, Chipotle opened 19 restaurants, of which 11 have a Chipotlane, the company’s digital-order pick-up drive-through lane. Even before COVID-19 struck, stores with Chipotlanes had opening sales that were 5% to 10% higher than those without Chipotlanes; now, the outperformance has reached over 30%. What’s more, stores with Chipotlanes have a digital mix of nearly 80%; the mix of “higher margin order-ahead and pick-up transactions has more than doubled” for Chipotlane restaurants compared to pre-COVID times. As a result of the continued strong performance at restaurants with a Chipotlane, and lesser competition for new sites, restaurants with a Chipotlane will comprise an even greater proportion of Chipotle’s future restaurant openings.
• Assuming a same store sales decline of 30% to 35%, Chipotle’s balance sheet can sustain the company for “well over a year.” It’s worth noting that Chipotle’s same store sales has increased to the negative high-teens range in April. The company still has room to make additional adjustments to reduce expenses if the recovery from COVID-19 takes longer than expected.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Chipotle excels in this criterion.

Firstly, the restaurant operator has done very well in producing free cash flow from its business for a long time. It even managed to produce a solid stream of free cash flow in 2016, when it was mired in its food safety crisis.

Secondly, there’s still tremendous room to grow for Chipotle. Yes, there’s plenty of short-term uncertainty now because of the COVID-19 pandemic. But when it clears, customers should still continue to flock to the company’s restaurants. Chipotle is nowhere near saturation point when it comes to its restaurant-count, and the US restaurant market is significantly larger than the company’s revenue. I want to repeat that digital sales have traditionally been sticky for Chipotle. So the current surge in digital sales for the company during this COVID-19 period could become a strong foundation for Chipotle’s future growth when the pandemic eventually clears.

Valuation

I like to keep things simple in the valuation process. In the case of Chipotle, I think the price-to-free cash flow (P/FCF) ratio is an appropriate measure for its value. The company operates restaurants, which is a cash-generative business, and it has been adept at producing free cash flow over time.

On a trailing basis, Chipotle has a trailing P/FCF ratio of around 67 at a share price of US$882. There’s no way to sugar-coat this, but Chipotle’s P/FCF ratio is high. The chart below shows Chipotle’s historical P/FCF ratio over the past 10 years:

We can see that Chipotle’s current P/FCF ratio is also high when compared to history. The next few quarters will be a massive test for the company. But Chipotle is well-positioned to survive the COVID-19 crisis as I discussed earlier. It is also putting in place the building blocks for future growth – such as well-designed drive-through lanes and digital/mobile ordering platforms – once the ongoing health crisis becomes a memory. So I’m still comfortable staying invested with Chipotle despite the seemingly high P/FCF ratio, which should become even higher over the next few quarters as the company’s free cash flow falls, temporarily. 

The risks involved

The biggest risk confronting Chipotle at the moment has to be the economic slowdown and restrictions on human movement in the US that have appeared because of COVID-19. But I also discussed earlier in this article how Chipotle is faring relatively well during the pandemic. Nonetheless, I’m still keeping an eye on things here. 

Another big risk affecting Chipotle is food safety. Chipotle was well on its way to recovering from its food safety issue that flared up in late 2015 before COVID-19 struck. The company has dramatically improved its food safety measures compared to in 2015, but I don’t think it’s possible to completely eliminate the chances of food safety problems appearing again in the future. If Chipotle is unfortunate to have to deal with another food safety problem during this ongoing COVID-19 pandemic, its reputation with consumers could be dealt a crippling blow.

The last big risk I’m watching are changes to Chipotle’s food and people culture. CEO Brian Niccol has done a great job in improving Chipotle’s business operations while retaining the things that make Chipotle special. But if Chipotle’s food and people culture were to change in the future, I will be watching the developments. I think that Chipotle’s food and people culture have been tremendous drivers of the company’s growth, so I want to keep track of changes in these areas.

My conclusion

Chipotle’s a fast-casual restaurant company with a unique people and food culture. From its founding in 1993 to 2015, it managed to grow tremendously under the watch of founder Steve Ells – and it grew without using debt, which is a mightily impressive feat. Food safety issues erupted in late 2015, which caused setbacks for Chipotle. But new CEO Brian Niccol came in and made significant positive changes at the company. Chipotle was well on its way to recovery when COVID-19 struck. Thankfully, the changes that Niccol has implemented, such as the digital investments, have served Chipotle well. The company looks well positioned to survive the current COVID-19 crisis, and changes to consumer behaviour in the current environment also appear to be building a solid foundation for Chipotle’s future growth when the crisis ends. 

There are risks to note of course. A prolonged recovery from COVID-19 could hurt Chipotle’s business near-permanently. The occurrence of another food safety issue during COVID-19 will also be disastrous for the company. But after weighing the pros and cons, I’m happy to continue owning Chipotle shares. 

And now it’s time for me to find some delivery or takeaway for great Mexican fare for lunch…

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

With a recession looming, it is no surprise that bank stocks in Singapore have been massively sold down. Besides the COVID-19 pandemic halting businesses around the globe, lower interest rates and the plunge in oil prices could also hurt banks.

Despite this, I think the three major banks in Singapore are more than able to weather the storm. Here’s why.

Well capitalised

First of all, DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corp (SGX: O39) and United Overseas Bank (SGX: U11) are each very well capitalised.

A good metric to gauge this is the Common Equity Tier-1 ratio (CET-1 ratio). This measures a bank’s Tier-1 capital – which consists of common equity, disclosed reserves, and non-redeemable preferred stock – against its risk-weighted assets (i.e. its loan book). The higher the CET-1 ratio, the better the financial position the bank is in. In Singapore, banks are required to maintain a CET-1 ratio of at least 6.5%.

As of 31 December 2019, DBS, OCBC, and UOB had CET-1 ratios of 14.1%, 14.9%, and 14.3% respectively. All three banks had CET-1 ratios that were more than double the regulatory requirement in Singapore.

This suggests that each bank has the financial strength to ride out the ongoing stresses in Singapore and the global economy. In a recent interview with Euromoney, DBS CEO Piyush Gupta “noted that years of Basel reforms have left banks with ‘enormous capital reserves’ and a clear protocol: to dip first into buffers, then counter-cyclical buffers and finally into capital reserves.”

Diversified loan book

The trio of banks also have well-diversified loan portfolios.

For instance, the chart below shows DBS’s gross loans and advances to customers based on MAS industry code.

From the chart, we can see that building and construction and housing loans make up the bulk of the loan book. While the 22% exposure to building and construction could be seen as risky, I think it is still manageable considering that the loan portfolio is well-spread across the other industries.

Similarly, UOB’s and OCBC’s largest exposure was to the building and construction sector at around 25% and 24% of their total loan portfolio respectively. Though there is an element of risk, the loan portfolios at the three banks are sufficiently diversified in my opinion.

Will Singapore banks cut their dividend?

I think the big question on investors’ minds is whether the trio of banks will cut their dividend. We’ve seen some banks around the globe slash their dividends amid the crisis to shore up their balance sheet. Regulatory bodies in some other countries have even stepped in to prevent some banks from paying a dividend in order to ensure that the banks have sufficient capital to ride out the current slump.

However, based on what DBS’s CEO said in the interview with Euromoney, it seems unlikely that DBS will cut its dividend in the coming quarters. The bank is sufficiently capitalised and can continue to pay its regular dividend without stretching its balance sheet. Gupta elaborated:

“If there is a multi-year problem… banks will likely get to the point where they can’t pay dividends. But promising now to not pay them is, to me, illogical.”

I think besides DBS, both UOB and OCBC also have sufficient capital to keep dishing out their dividends too. Both have high CET-1 ratios, as I mentioned earlier, and similar dividend payout ratios to DBS. 

Final thoughts

Banks in Singapore are going to be hit hard by COVID-19. There’s no sugarcoating that.

We have seen banks in the US increase their allowances for non-performing loans in the first quarter of 2020 and they expect to do so again in the coming quarters. If the US banks are anything to go by, we can expect a similar situation in Singapore, with bank earnings being slashed.

However, all three major local banks still have strong balance sheets and diversified loan portfolios. So, despite the near-term headwinds, I think that the three banks will ultimately be able to ride out the recession.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.

Veeva Systems (NYSE: VEEV) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Veeva shares for the portfolio in November 2017 at a price of US$61 and subsequently made three more purchases (in September 2018 at US$100, in November 2018 at US$98, and in June 2019 at US$165). I’ve not sold any of the shares I’ve bought. 

The purchases have mostly worked out well for my family’s portfolio, with Veeva’s share price being around US$181 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to invest in Veeva shares.

Company description

The process to develop medical devices and drugs is highly complex and time consuming for the life sciences industry, which includes pharmaceutical, biotechnology, and medical device companies. For instance, clinical studies for drug development can take anywhere from six months to several years. Proper documentation is also necessary all the way from drug development to commercialisation and there are easily hundreds if not thousands of documents involved. Veeva provides cloud-based software to help pharma, biotech, and medical device companies better handle all that complexity. 

Here’s a graphic from Veeva showing all the software products it has that support the commercial and research & development (R&D) activities of the life sciences industry:

There are a lot of software products that Veeva has, but the company groups them into three categories:

• Veeva Commercial Cloud: It supports a life sciences company’s sales & marketing activities. Some of the products within Veeva Commercial Cloud include a commercial data warehouse, customer relationship management (CRM) apps, data management apps, and key opinion leader data.
• Veeva Vault: It houses software that helps life sciences companies to manage content and data from R&D through to commercialisation.    
• Veeva Data Cloud: A new service introduced in March 2020 that is scheduled for launch in December 2020. Veeva Data Cloud is a patient and prescriber data service and will initially focus on patient and prescriber data solutions for the US specialty drugs distribution market. Veeva Data Cloud will be built on existing technology from Crossix, a privacy-safe patient data and analytics company that Veeva acquired in late 2019.

In FY2020 (fiscal year ended 31 January 2020), 49% of Veeva’s total revenue of US$1.1 billion came from Veeva Commercial Cloud while the remaining 51% came from Veeva Vault. The table below gives an overview of the geographical breakdown of Veeva’s revenue in FY2020:

At the end of FY2020, Veeva had 861 customers in total. These customers range from the largest pharma and biotech companies in the world (such as Bayer, Eli Lilly, Novartis, and more) to small players in the same space (such as Alkermes, Ironwood Pharmaceuticals, and more). 

In recent years, Veeva has started selling content and data management software services to companies outside of the life sciences industries. Veeva is targeting three regulated industries: Consumer goods, chemicals, and cosmetics. I don’t have data on the exact split for Veeva in terms of revenue from life sciences and outside life sciences. But the lion’s share of the company’s revenue is still derived from the life sciences industry. 

Investment thesis

I had previously laid out my six-criteria investment framework in The Good Investors. I will use the same framework to describe my investment thesis for Veeva.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

The total market opportunity for Veeva is currently over US$10 billion, which is around 10 times the company’s current revenue of US$1.1 billion in the last 12 months. The chart below shows the breakdown of Veeva’s market opportunity:

I also think it’s likely that Veeva’s market opportunity will grow over time. In Veeva’s September 2016 Investor Day presentation, management shared the charts below, which illustrate the company’s market opportunity back then. Management showed that Veeva’s market had expanded from US$5 billion in September 2015 to US$6 billion in September 2016 because of software innovation at the company. (More on Veeva’s innovation later!)

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 31 January 2020, Veeva held zero debt and US$1.1 billion in cash and short-term investments. That’s a rock solid balance sheet.

For the sake of conservatism, I also note that Veeva had US$54.8 million in lease liabilities. But that’s a tiny sum compared to the cash and short-term investments that the company had on hand.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Leading Veeva as CEO is Peter Gassner, 55. Gassner is a co-founder of the company, and has served as Veeva’s CEO since the company’s founding in 2007. From 1995 to 2003, he was Chief Architect and General Manager at PeopleSoft. And from 2003 to 2005, Gassner was Senior Vice President of Technology at salesforce.com, one of the pioneering software-as-a-service companies. In my view, the relatively young age of Gassner, his years of experience in leadership roles in other tech companies, and his long tenure with Veeva, are positives.

The other important leaders in Veeva, most of whom have multi-year tenures and relatively young ages (both are good things in my eyes), include: 

Veeva’s compensation structure for management makes me think that my interests as a shareholder of the company are well-aligned with management’s. Here are the key points:

• From Veeva’s IPO in October 2013 to FY2019, the company (1) was paying its key leaders cash compensation that were below market rates; (2) never offered any short-term cash-incentives to management; and (3) placed heavy emphasis on long-term stock awards, in the form of stock options and restricted stock units that vest over multiple years.
• In FY2019, all of the aforementioned leaders of Veeva were paid the same base salary of US$322,917, and nothing else – they were not given any equity awards. Management instead derived more compensation from vesting of stock awards that were given in previous years. The base salaries paid in FY2019 to Veeva’s management are rounding errors when compared with the company’s profit and free cash flow of US$230 million and US$301 million, respectively, for the same year.
• Gassner’s base salary also increased by only 0.7% in FY2018 and 7.6% in FY2019 despite much faster growth in Veeva’s business in both years (I will be sharing a table of Veeva’s financials later).
• In FY2018, Gassner was given US$87.8 million in stock options, which started vesting in February 2020 and will only finish vesting in February 2025, provided that Gassner continues to serve as CEO.
• A new compensation structure was implemented in March 2019 for Veeva’s management. There are positives and a negative with the changes, though I think the pros outweigh the con. The positives: (1) The base salary is going to be US$325,000; and (2) there will be long-term equity incentives (in the form of stock options) that will form the lion’s share of each leader’s annual compensation and that vest over four years. The negative: There will now be a short-term incentive program made up of restricted stock awards that will vest over one year.  

I also note that Gassner controlled 16.0 million Veeva shares as of 31 March 2019. These shares are worth around US$2.9 billion at the moment. This high stake lends further weight to my view that Veeva’s key leaders are in the same boat as me. 

I want to highlight too that Gassner’s shares are all of the Class B type. Veeva has two share classes: (1) Class B, which are not traded and hold 10 votes per share; and (2) Class A, which are publicly traded and hold 1 vote per share. As a result of holding Veeva Class B shares, Gassner alone held 46.1% of the company’s voting power as of 31 March 2019. In fact, all of Veeva’s senior leaders and directors combined controlled 57.6% of Veeva’s voting rights (this percentage dipped only slightly to 53.2% as of 31 January 2020). This concentration of Veeva’s voting power in the hands of management (in particular Gassner) means that I need to be comfortable with the company’s current leadership. I am.

On capability 

Over the years, Veeva’s management has done a great job in growing the company’s customer count (up 31.7% per year from 95 in FY2012 to 861 in FY2020). This is illustrated in the table below:

But there’s more. Management has also been adept at driving more spending over time from the company’s customer base. This can be seen in Veeva’s strong subscription services revenue retention rate. It essentially measures the change in subscription revenue from all of Veeva’s customers a year ago compared to today; it includes the positive effects of upsells as well as the negative effects from customers who leave or downgrade. Anything more than 100% indicates that Veeva’s customers, as a group, are spending more. The table below shows Veeva’s subscription services revenue retention rate over the past few years. There has been a noticeable downward trend in the metric, but the figure of 121% in FY2020 is still remarkable.

Impressively, Veeva has produced subscription services revenue retention rates of significantly more than 100% for many years because the company has succeeded at (1) getting its customers to adopt more products over time, and/or (2) winning more users at a customer for the same product; the strong subscription services revenue retention rates did not come from Veeva raising prices for its software solutions.

For another perspective, we can look at the growth in the average number of products that a Veeva Commercial Cloud and Veeva Vault customer is using:

But there is a key area where Veeva’s management falls short: The company’s culture. Veeva has a 3.3-star rating on Glassdoor, and only 57% of reviewers will recommend the company to friends. Gassner has an approval rating as CEO of only 74%. Veeva has managed to post impressive business results despite its relatively poor culture, but I’m keeping an eye on things here. 

On innovation

Peter Gassner co-founded Veeva in 2007 with the view that “industry-specific cloud solutions could best address the operating challenges and regulatory requirements of life sciences companies.” He saw the market opportunity and grasped it with both arms, leading Veeva to become the first company to introduce a cloud-based CRM app – Veeva CRM – that caters to the global life sciences industry. It was not an easy ride for Gassner. Here’s a comment he gave in a 2017 interview with TechCrunch:

“Starting Veeva, I had the idea or vision you could make very industry-specific software in the cloud and it would be bigger than anyone would have thought. In 2007, [most] people thought that was incorrect.”

To me, the founding stories of Veeva are a great sign of an innovative management team.

Over time, Gassner and his team have also continued to lead successful product-innovation at Veeva. There are three examples I want to point to.

First, Veeva Vault was introduced in 2011, and has grown rapidly from around 5% of Veeva’s revenue in FY2014 to 51% of total revenue in FY2020. 

Second, Veeva has been relentless in creating new products. Here’s a chart showing the growth in the number of applications within Veeva Vault from 2011 to 2016:

Third, the company is now selling content and data management cloud-based software to regulated industries outside of life sciences, as mentioned earlier. It’s early days for this recent foray, but the signs are promising. Here’s a comment from Gassner in Veeva’s FY2020 fourth-quarter earnings conference call:

“Outside life sciences for CPG [consumer packaged goods], chemicals and cosmetics, we had a number of expansions and added some big wins with new companies, including a top 10 CPG company, who will adopt QualityOne, and a top 10 cosmetics company to standardizing on RegulatoryOne. In reflecting on the year for this business and looking ahead, we set the right course in the Veeva Way. We kept our focus on customer success and doing the right things for our early adopters, which is helping establish Veeva as a trusted provider in these new industries.”

I also want to point out the presence of Gordon Ritter as Veeva’s Chairman. Ritter is a founder of Emergence Capital, a venture capital firm that is one of the earliest backers of salesforce.com (Ritter was a driving force behind Emergence Capital’s decision to invest in salesforce.com). Emergence Capital is also one of the early investors in Veeva. Having Ritter as a director allows Veeva’s management to tap on a valuable source of knowledge. Ritter has been a director of Veeva since 2008 and he controlled nearly 3 million Veeva shares as of 31 March 2019, a stake that’s worth around US$485 million right now.

4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour

Veeva generates the lion’s share of its revenue through subscriptions to its software services, which are recurring in nature. In FY2020, 81% of Veeva’s total revenue of US$1.1 billion came from subscriptions. The majority of the company’s subscriptions with customers are for a term of 1 year. The remaining 19% of Veeva’s revenue in FY2020 was from professional services, where the company earns fees from helping its customers implement and optimise the use of its software suite.

There’s some form of customer concentration in Veeva – 36% of its revenue in FY2020 came from its top 10 customers. That’s a risk. But I’m comforted by the high likelihood that Veeva’s software services are mission-critical in nature for the company’s customers. 

For instance, the distribution of marketing and promotional material for the life sciences industry is highly regulated. This is where Veeva CRM can help through one of its applications, which enables the management, delivery, and tracking of emails from life sciences sales representatives to healthcare professionals, while maintaining regulatory compliance. In another example, the US FDA (Food & Drug Administration) requires life sciences companies to maintain full audit trails for the handling of electronic records; in fact, changes in data cannot overwrite previous records. Veeva Vault’s suite of apps helps life sciences companies meet the strict regulatory requirements for documentation.

5. A proven ability to grow

The table below shows Veeva’s important financial figures from FY2011 to FY2020. I like what I’m seeing:

A few key points about Veeva’s financials:

• Revenue has compounded impressively at 49.8% per year from FY2011 to FY2020. The rate of growth has slowed in recent years, but was still really strong at 28.7% from FY2015 to FY2020, and at 28.1% in FY2020.
• Net profit has surged tremendously since FY2011. Growth from FY2015 to FY2020 has been excellent at 49.6%; in FY2020, profit was up by a solid 31.0% too.
• Operating cash flow has consistently been positive for the timeframe I’m looking at, and has also increased significantly over time. The growth rate for operating cash flow from FY2015 to FY2020 was impressive, at 45.3% annually; in FY2020, operating cash flow climbed 40.7%. 
• Free cash flow has also (1) been consistently positive for the time period I’m studying, and (2) stepped up strongly. Veeva’s free cash flow was up by 60.5% per year from FY2015 to FY2020, and was up by 43.9% in FY2020 – these are eye-catching numbers. 
• The company’s balance sheet remained robust throughout the timeframe under study, with zero debt the entire way.
• At first glance, Veeva’s diluted share count appeared to increase sharply by 111.4% from FY2014 to FY2015. (I only started counting from FY2014 since Veeva was listed in October 2013, which is in the second half of FY2014.) But the number I’m using is the weighted average diluted share count. Right after Veeva got listed, it had a share count of around 122 million. Moreover, Veeva’s weighted average diluted share count showed a negligible growth rate of just 1.9% per year from FY2015 to FY2020.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

There are two reasons why I think Veeva excels in this criterion. 

First, the company has done very well in producing free cash flow from its business for a long time. Its free cash flow margin (free cash flow as a percentage of revenue) has also increased steadily from an already strong level of 18.5% in the year of its IPO. In FY2020, Veeva’s free cash flow margin was an incredible 39.2%. As a cloud-based software company, I don’t see any reason why Veeva cannot maintain a fat free cash flow margin in the future.

Second, there’s still plenty of room to grow for Veeva. Over time, I expect Veeva to significantly increase both its customer count and the average number of products used per customer. These assumptions mean that Veeva should see robust growth in revenue in the years ahead. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t, as I mentioned earlier – that will mean even more free cash flow for Veeva in the future. 

Valuation

I like to keep things simple in the valuation process. In Veeva’s case, I think the price-to-free cash flow (P/FCF) ratio is an appropriate metric to value the company. That’s because the SaaS company has a strong history of producing positive and growing free cash flow. 

Veeva carries a trailing P/FCF ratio of around 66 at a share price of US$181. That’s a pretty darn high valuation at first glance. But as the chart below shows, Veeva’s P/FCF ratio has been much higher in the past. Moreover, the P/FCF ratio has averaged at 54 since the company’s listing, according to Ycharts, and that is not too far from where it is now.

In addition, there are strong positives in Veeva’s favour too. The company has: (1) Revenue that is low compared to a large and possibly fast-growing market; (2) a software product that is mission-critical for users; (3) a large and rapidly expanding customer base; and (4) sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Veeva will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in time to come. 

The risks involved

I see seven big risks with Veeva. In no particular order…

First, I think there’s key-man risk with the company. Peter Gassner – and his co-founder Matt Wallach – were the ones with the vision. And over time, I think Gassner has been instrumental in leading Veeva to success. Wallach relinquished an active management role at the company in 2019. Should Gassner leave for any reason, I will be concerned.

Second, there’s customer-concentration, as I already mentioned.

Veeva’s relationship with salesforce.com is the third risk I’m watching. The two companies have a long-standing contract that ends on 1 September 2025. Based on the agreement, salesforce.com provides hosting infrastructure and data centers for portions of Veeva’s CRM applications. There is also a non-compete arrangement, where salesforce.com will not compete directly with Veeva’s CRM applications within the pharma or biotech industry. In return, Veeva has to pay salesforce.com a fee of at least US$500 million by the end of the contract. This agreement is important as parts of Veeva Commercial Cloud are built on salesforce.com’s Salesforce1 platform. (Veeva Vault is built on Veeva’s own proprietary platform.) 

Based on the change in language used in Veeva’s annual reports for FY2020, FY2019, and FY2018 to describe Veeva’s partnership with saleforce.com, there appears to be a deterioration in the two companies’ relationship in recent years. I’m watching what happens if and when Veeva’s contract with salesforce.com is terminated. Veeva has already clocked 13 years of experience in providing CRM software that is focused on the life sciences industry. This gives me confidence that Veeva will be able to stand on its own even if salesforce.com pulls the plug on the existing CRM-partnership. But only time will tell.

The fourth risk I have an eye on relates to legal wrangles between Veeva and IQVIA. Veeva named IQVIA as its most significant competitor in the CRM software market for the life sciences industry in its FY2020 annual report. It’s worth noting that IQVIA’s CRM software is also built on the Salesforce1 Platform. IQVIA competes against certain applications within Veeva Vault too. For some background, here are excerpts from a February 2020 announcement by Veeva: 

“Veeva Systems (NYSE: VEEV) today announced it is gaining widespread customer support for its antitrust lawsuit against IQVIA (NYSE: IQV). Six of the largest global pharmaceutical companies were among more than 70 depositions gathered as part of the fact discovery phase of the case. As its initial lawsuit successfully advances, Veeva filed a motion this week to expand its legal action to include additional Veeva software applications that IQVIA is excluding customers from using with IQVIA data…

…IQVIA has a long history of abusing its monopoly position to limit customers and competition. Since 2014, IQVIA has prevented companies from using OneKey reference data with Veeva’s master data management software, Veeva Network Customer Master. Over the past two years, IQVIA also began restricting the use of all IQVIA data with Veeva Nitro, a next-generation commercial data warehouse, Veeva Andi, an artificial intelligence (AI) application, and other Veeva software applications.

After three years of trying to work with IQVIA in good faith toward a resolution regarding Veeva’s master data management software to no avail, Veeva filed its first antitrust lawsuit in 2017 to end IQVIA’s long history of anti-competitive behavior. IQVIA’s motion to dismiss that case failed and fact discovery is now substantially complete. Trial is expected to take place in late 2021.”

Despite IQVIA’s fiercely anti-competitive behaviour in the past few years, Veeva has still managed to grow its business significantly. Veeva’s management commented in the company’s recent FY2020 fourth-quarter earnings conference call:

“IQVIA is our primary competitor, as you know, there’s certainly regional competitors that we have, but they’re the ones that are primary in terms of global kind of scope there. IQVIA has continued to be aggressive in terms of how they approach the market in of pricing and bundling. Some of their projects have been a bit more services oriented, instead of standard product. And I think over the short-term that sort of thing could work out. I think over the long-term custom projects are not great.

From Veeva’s perspective, we had really great success last year. I’m really proud of what we’ve accomplished. Peter highlighted that we had 63 net new CRM customers, compared with the year before, where it was 46. So we’ve grown and we’ve actually expanded our share last year. And of those wins, most of them came — most of them were head to head with IQVIA, and many of them were IQVIA replacements. So I’m really proud of what we’ve accomplished. That’s the results. The results, I think, speak for themselves in terms of what we’re doing, where — we think our strategy is the right one, which is focus on product innovation and focus on customer success. So we’re innovating within core CRM in many different ways.”

It’s hard to predict the result of the legal battle between the two companies. But even if IQVIA wins, my bet is that Veeva will still be able to continue growing, since Veeva was able to grow even though IQVIA had already been behaving aggressively for some time. Again, only time will tell.

The fifth important risk I’m seeing relates to competition in general. As Veeva expands, it’s likely that Veeva Commercial Cloud and Veeva Vault could increasingly butt heads with services from tech giants such as Oracle, Microsoft, and Amazon. These companies have substantially stronger financial might than Veeva.

Veeva’s high valuation is the sixth risk. The high valuation adds pressure on the company to continue executing well; any missteps could result in a painful fall in its stock price. This is a risk I’m comfortable taking.

Lastly, I’m watching potential impacts to Veeva’s growth from COVID-19. The outbreak of the respiratory virus has resulted in severe negative impacts to the global economy because of measures to fight the disease, such as the closing of businesses and the restriction of human movement. I think that the mission-critical nature of Veeva’s service means that its business is less likely to be harmed significantly by any coronavirus-driven recession. But there could be headwinds.    

The Good Investors’ conclusion

In summary, Veeva has:

1. A valuable cloud-based CRM and content and data management software platform that is mission-critical for companies in the life sciences industry;
2. High levels of recurring revenue;
3. Outstanding revenue growth rates;
4. Positive and growing operating cash flow and free cash flow, and fat free cash flow margins;
5. A large, mostly untapped addressable market that could potentially grow in the years ahead;
6. An impressive track record of winning customers and increasing their spending; and
7. Capable and innovative leaders who are in the same boat as the company’s other shareholders

Veeva does have a rich valuation, so I’m taking on valuation risk. There are also other risks to note, such as the company’s complicated relationship with salesforce.com, and its legal battles with IQVIA. COVID-19 could also place a dampener on Veeva’s growth. But after weighing the pros and cons, I’m happy to continue having Veeva be in my family’s investment portfolio.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.