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Twilio (NYSE: TWLO) isn’t a household name, but many of us unknowingly use it every day. The software company provides developers with an in-app communication solution. By integrating phone numbers and messaging communications, Twilio offers communication channels including voice, SMS, Messenger, WhatsApp, and even video. 

When your Uber arrives and you receive a text, that’s Twilio. Airbnb uses Twilio to automate messages to hosts to alert them of a booking. eBay, Twitter, Netflix, Wix, Mecardo Libre each use Twilio in some form or other. 

With in-app communications set to boom and Twilio the top dog in this space, is Twilio worth investing in? To answer this, I will use my blogging partner’s six-point investment framework to dissect Twilio’s growth potential.

1. Is Twilio’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?

Twilio recently surpassed US$1 billion in annualised revenue run rate in the third quarter of 2019. That’s tiny compared to its market opportunity. The CPaas (communications platform as a service) segment is forecast to grow from US$3.3 billion in 2018 to US$17.2 billion in 2023- a 39% annualised growth rate.

International Data Corporation said in a report that CPaaS companies are driving this growth by “integrating new segments, churning out new use cases, and piquing the interest of enterprise developers with innovative digital solutions for customer engagement.”

With the acquisition of SendGrid last year, through an all-shares purchase, Twilio added email communication into its array of products. SendGrid also brought with it 84,000 customers, giving Twilio a new base of developers to cross-sell existing products to.

2. Does Twilio have a strong balance sheet with minimal or a reasonable amount of debt?

Twilio is financially sound. As of 30 September 2019, it had US$1.9 billion in cash and marketable securities and around US$450 million in debt (in the form of convertible senior notes). That translates to a net cash position of around US$1.5 billion.

That said, Twilio’s cash flow from operations has been lumpy over the past few years as it chased growth over profitability or cash flow.

While its relatively large cash position should provide it with a buffer to last a few years, investors should continue to monitor how Twilio is using its capital.

Twilio already ended up having to issue new shares in a secondary offering in 2019 to raise money. This diluted existing shareholders, and current shareholders of Twilio should not rule out further dilution in the future.

The table below shows Twilio’s cash flow over the past four years.

3. Does Twilio’s management team have integrity, capability, and an innovative mindset?

Twilio’s founder Jeff Lawson has overseen the company from the start (the company was founded in 2008). As mentioned earlier, Twilio has a US$1 billion revenue run rate. That’s an impressive achievement, and a testament to Lawson and the rest of the management team’s ability to scale the company.

I also believe Twilio’s executive compensation structure promotes long-term growth in the company.

Lawson’s base salary in 2018 was only 2% of his target pay mix. 51% was in restricted stock units and the other 47% was in stock options. As the stock options vest over a few years, it encourages planning towards increasing shareholder value over the long term.

Lawson’s base salary of just US$133,700 in 2018 is also low in comparison to what other CEOs are getting.

So far, Twilio’s management has also been able to strategically acquire companies to expand its product offering and customer base. Its purchase of SendGrid brought with it email communication capabilities and more than doubled Twilio’s existing active users.

Twilio’s management has also taken the opportunity to raise more capital as its shares trade at relatively high multiples. This, to me, seems like a prudent move, considering that Twilio needs some cash buffer as it looks to grow its business.

Twilio is also proving to be led by innovative leaders as the company has consistently introduced new products. In 2018, Twilio introduced Twilio Flex, a programmable contact centre that integrates multiple tasks into a single user interface. Twilio Flex opened a new door of opportunity to tap into.

4. Are Twilio’s revenue streams recurring in nature?

Twilio’s enjoys a sticky customer base. Its existing customers have a history of becoming increasingly dependent on Twilio’s services over the years.

The communication software company’s net dollar base expansion rate, a metric measuring net spend by existing customers, was 132% in the quarter ended 30 September 2019. What that means is that existing customers spent 32% more on Twilio’s services in the last 12 months compared to a year prior. 

More importantly, Twilio’s net dollar expansion rate has been consistently north of 100% for years. Its net dollar expansion rate was 140%, 128%, 161%, and 155% for 2018, 2017, 2016 and 2015.

The beauty of Twilio’s business model is that there are no built-in contracts. Customers simply pay as they use the company’s software. The more messages they send using Twilio’s API, the more Twilio charges them.

As customers such as Uber, Lyft, Airbnb grow their own customer base, the need for in-app messaging increases, and Twilio grows along with its clients. The model also allows small enterprises to start using Twilio at the get-go due to the pay-as-you-go model.

It is also heartening to see that there is little concentration risk as the top 10 accounts contributed around 13% of Twilio’s total revenue in the most recent quarter.

5. Does Twilio have a proven ability to grow?

With a steady base or recurring revenue, Twilio has been able to focus its efforts on expanding its services and winning over new customers. Its customer account has risen more than six-fold from 2013 to 2018.

The growth in customer accounts is also reflected in its financial statements. Revenue increased from below US$100 million in 2013 to more than US$600 million in 2018.

That growth still has legs to run with base revenue (excluding the impact of its acquisition of SendGrid) in the first three quarters of 2019 increasing by 47% year-on-year.

6. Does Twilio have a high likelihood of generating a strong and growing stream of free cash flow in the future?

While Twilio’s topline has shown impressive growth, it has neither been able to generate consistent profit nor free cash flow.

Twilio has been spending heavily on research and development and marketing. In fact, the company has consistently spent around a quarter of its revenue of research and development.

However, I believe that there is a clear path towards profitability and free cash flow generation, as Twilio can eventually cut back its R&D and marketing expenses.

That being said, the company is still laser-focused on top-line growth at the moment and consistent profitability and free cash flow generation may take years.

Risks

One of the big risks I see in Twilio is succession risk. Lawson is the biggest reason for Twilio’s success so far. He is the founder and has led Twilio every step of the way. 

That said, Lawson is only 42 this year and is likely to continue at the helm for the foreseeable future.

I also believe that the high cash burn rate is still a concern. Investors should keep a close watch on Twilio’s free cash flow levels and hopefully, we can see it turn positive in the coming years.

Twilio also faces competition that could eat into its market share. Its competitors such as Nexmo, MessageBird, and PLivo are also growing quickly. Twilio will need to consistently upgrade its APIs to ensure that it defends its competitive edge. For now, Twilio’s competitive moat includes the high switching cost to a competitor.

Twilio also enjoys a network effect. In its 2018 annual report, Twilio said:

“With every new message and call, our Super Network becomes more robust, intelligent and efficient…Our Super Network’s sophistication becomes increasingly difficult for others to replicate over time as it is continually learning, improving and scaling.”

Valuation

Valuing a company is always tricky- especially so for a company that has no profits or consistent free cash flow.

As such, we will need to estimate what is the company’s long term growth potential and mature-state profit margins.

While some best-in-class SaaS companies enjoy profit and free cash flow margins of around 30%, that does not seem feasible for Twilio.

Twilio’s gross profit margin is only around 54%, much lower than other software companies such as Adobe which has a gross margin north of 80%. As such, I think that Twilio’s steady-state profit margin could potentially be closer to 10%.

Given the total addressable market of US$17 billion, and assuming Twilio can achieve a market share of around 50%, revenue can increase to around US$8 billion. Using my 10% net profit assumption, net profit will be around US$800 million. If growth can sustain at current rates of around 35%, Twilio will take around seven years to hit this size.

We also have to estimate a reasonable multiple to attach to its earnings. Adobe has a price-to-earnings (P/E) ratio of 58 but it is still growing. Let’s assume a discount to that multiple and assume Twilio can command a P/E ratio of 40. That translates to a US$32 billion market. Given all these assumptions, Twilio will have a market cap that is twice its current market cap in seven years, which translates to a decent 10% annualised return for existing shareholders.

The Good Investors’ conclusion

There are certainly compelling reasons to like Twilio as a company. Its 40%-plus top-line growth, huge market opportunity, dominant position in the CPaaS industry, and capable management team, are just some of the reasons why I think Twilio has a bright future ahead.

However, its stock is richly priced, trading at more than 16 times revenue. It has yet to record a profit and has been burning cash. There is a lot of optimism baked into the stock already and the company needs to live up to the high expectations if investors are to make a decent annualised profit from the stock.

While my valuation assumptions predict a decent return, there are certainly risks involved. Any stumble in those growth projections or an earnings multiple compression will result in mediocre returns to investors. I suggest that investors who want to take a nibble off of Twilio’s growth should size their position to reflect the risk involved.

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.

Ulta Beauty (NASDAQ: ULTA) is a retailer defying the odds. While many retailers have struggled since the introduction of e-commerce, Ulta’s sales have risen sharply over the last decade. Its share price has mirrored its business performance, rising nearly 1300% over that time frame, making it one of the top-ten performing US stocks of the decade. But Ulta’s stock lost some of its shine towards the end of last year- with the share price falling 25%-  after the company cut its full-year outlook for 2019.

Investors were also spooked by an industry-wide slow-down in cosmetic sales. But with Ulta Beauty shares trading at only 23 times earnings now, I believe it is way too cheap to ignore.

What caused the sell-down?

The first thing to note is Ulta still remains a fine business. Ulta has consistently won market share from other beauty retailers in the country and that has not changed. The only problem now is Ulta could suffer some near-term earnings volatility due to the downcycle of cosmetic sales in the US.

In the latest 2019 third-quarter earnings conference call, CEO Mary Dillion explained:

“Like other consumer categories, makeup has experienced a number of up and down cycles. The most recent growth cycle began in 2014, driven by new application techniques and looks like contouring, highlighting and brow styling, and new products such as pallets, minis, and travel sizes. The rise of social media influencers, video tutorials and selfies also contributed to strong growth in the category.

After several years of robust growth, the category began to decelerate in 2017 and turn negative in late 2018, resulting from a lack of engaging newness and incremental innovation. This negative trend has continued through 2019 with further deceleration in the most recent quarter.”

But there are reasons to be positive…

Despite the near-term challenges, there are still good reasons to be bullish about Ulta. 

The numbers are still really good

First, even though Ulta had a poor third quarter by its high standards, the company still delivered decent results. Total sales increased by 12% and comparable store sales increased by 6.2%. Diluted earnings per share, excluding last year’s tax benefit, increased by 11.5%.

Despite the decline in cosmetics sales in the broader US market, Ulta still posted low single-digit growth in that category. That just goes to show that Ulta continues to drive meaningful market share growth across the cosmetics category.

According to data for February through July, Ulta captured 24.5% of the prestige beauty market (as tracked by NPD Group, an American Market research company). That’s 2.1 percentage points better than last year.

Cosmetic sales will rebound

Cosmetics remains Ulta’s largest revenue contributor at around 50%, so a market-wide sales decline will no doubt impact Ulta’s business. But the downcycle will eventually come to an end.

Dillion, who has been extremely candid and frank with shareholders, believes that innovation and new products will help aid the turnaround. She said in the latest earnings conference call:

“We continue to believe that the headwinds facing the makeup category are largely cyclical, resulting from a lack of incremental innovation and compelling newness. We remain confident that makeup category will return to growth, but recognize that it will take time.”

Other categories picking up the mettle

Yes, cosmetics is an important part of Ulta’s business but Ulta is not just about cosmetics. In fact, its other segments in total make up about 50% of sales. One of the strongest growth categories in recent years is skincare. Suncare, prestige, and mass-market skincare products each delivered double-digit growth in Ulta’s most recent reporting quarter. 

Gen Z spending habits are also shifting towards skincare as young women increasingly decide to go for a more natural look. The Gen Z demographic is more engaged in skin care products than other cohorts were at the same age.

Haircare and fragrance are also both expanding. The performance of these other categories should help to reduce the impact of the slowdown in cosmetic sales.

Ulta is growing its membership base

At the end of the 2019 third quarter, Ulta had 33.9 million active members in its Ultamate Rewards program. That’s 11% higher than it was last year. The growing member base shows that Ulta is still attracting new customers to its shops.

On top of that, once customers sign up, they receive points, which can then be redeemed for gifts, giving them extra incentives to shop at Ulta.

The beauty segment is not as impacted by e-commerce

While Ulta’s online sales increased by around 20% per year in the latest quarter, brick and mortar sales still make up the bulk of the company’s business.

Fortunately for Ulta, according to a survey by Piper Jaffray, 91% of female teens still prefer in-store shopping for beauty products versus online. Consumers still prefer the in-person experience of testing colours, fragrances, and textures when it comes to beauty products.

As such, until augmented reality (AR) can truly replace the in-person experience, I don’t foresee Ulta losing significant market share to online sales channels.

Rewarding shareholders

Ulta has also been rewarding shareholders by using the cash generated from its business to buyback shares. The total number of outstanding shares dropped by close to 4% in the quarter ended 2 November 2019 from a year ago. With shares trading at a low valuation (I will touch on this later), I think it makes perfect sense for the company to continue using its spare cash to buy back shares.

Ulta is sitting on slightly over US$200 million in cash and has no debt (if we exclude its operating lease liabilities), giving it the financial muscle to continue to pursue share buybacks in the future.

More importantly, its business remains a cash cow. The beauty retail giant generated operating cash flow of US$634 million, US$779 million, and US$956 million in fiscal 2016, 2017, and 2018, respectively. And in the first 39 weeks of fiscal 2019, Ulta’s operating cash flow was up 2.8% from the year before to US$558 million.

The reliable stream of cash flow will enable the beauty retailer to continue reducing its outstanding share count further.

Valuation

As you can see, despite Wallstreet’s skepticism about Ulta, I think there are still numerous reasons to believe its long-term growth is intact.

On top of that, shares of Ulta are trading at what I would consider extremely low valuations. The company expects to earn diluted earnings per share of at least US$11.93 in fiscal 2019. Ulta currently trades at US$273, which translates to around 23 times that earnings projection.

An earnings multiple of 23 is much lower than LVMH (which owns Sephora), Loreal, and Estee Lauder – they trade at 33, 38 and 42 times earnings respectively. 

As such, barring a market-wide collapse, it is hard to see how Ulta can suffer a further compression in its earnings multiple.

More importantly, Ulta’s problems are likely short-term in nature. Cosmetics sales will rebound in the future and in the meantime, other beauty segments are picking up the slack.

On top of that Ulta looks likely to continue to win market share as it targets to open more stores in the coming years.

Over the longer term, Ulta has built lasting brand appeal and partnerships with some of the most loved beauty brands in the world. Despite being a dominant retailer in the US beauty industry, Ulta’s market share in the beauty products market was just 7% in 2018. This small share means the company should have room to grow much bigger.

With all that said, while I think it is reasonable for investors to be cautious about near-term sales volatility, I think Ulta’s valuation and long-term prospects are just too good to ignore.

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.

Most of you reading this would be familiar with Uniqlo.

The Japanese clothing brand is one of the fastest-growing apparel retailers in the world. I experienced first hand how much Uniqlo has thrived over the past few years. Its popularity in our homeland, Singapore, has exploded, with Uniqlo outlets appearing at most major malls in the country (I’m a big fan of its products too).

The numbers speak for themselves. Sales at Fast Retailing (Uniqlo’s parent company) increased by 179% from its financial year 2011 to its financial year 2019. Its shares have reflected that growth, climbing 320% during that time.

But with Fast Retailing’s share price sitting near a record-high, have investors missed the boat? I decided to take a closer look at its business to see if its current share price still presents a good investment opportunity. I will use my blogging partner Ser Jing’s six-point investment framework to dissect Fast Retailing. 

1. Is Fast Retailing’s revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market?

As mentioned earlier, Fast Retailing is now the third-largest apparel retailer in the world. It recorded 2.3 trillion yen (US$20.8 billion) in sales in the year ended 31 August 2019. On paper that seems huge. You may be thinking: “How could it possibly grow much larger?”

However, looking under the hood, I realised that Fast Retailing’s US$20 billion in revenue is tiny in comparison to its global market opportunity.

The global apparel market is expected to hit US$1.5 trillion this year. More importantly, Uniqlo is well-placed to grab a growing share of this tremendous market. Uniqlo International saw sales of around 1 trillion yen (US$9.34 billion). That’s a drop in the ocean when you compare it to the global apparel market.

Putting that in perspective, Uniqlo’s revenue in Japan was 872.9 billion yen (US$7.9 billion) in the 12-months ended August 2019. Japan has a population of roughly 126.8 million and yet revenue from Japan made up 36% of the company’s total revenue. China’s population alone is more than 10 times as big as Japan. That gives us an idea of the massive international opportunity that Uniqlo can potentially tap into.

With Uniqlo opening its first shops in India recently and expanding its presence in Europe, China, the United States, and Southeast Asia, I expect Uniqlo International’s sales to become much more important for the company in the coming years.

In his FY2017 annual letter to shareholders, Tadashi Yanai, CEO of Fast Retailing, said:

“My focus is to ensure solid growth in Greater China and Southeast Asia, which have the potential to grow into markets 10-20 times the size of Japan’s. We have announced five-year targets of increasing revenue from current ¥346.4 billion to ¥1 trillion in Greater China, and from ¥110 billion to ¥300 billion in Southeast Asia and Oceania.”

2. Does Fast Retailing have a strong balance sheet with minimal or a reasonable amount of debt?

A robust balance sheet enables a company to withstand any economic slowdowns. It also enables the company to use its extra cash to expand its business.

Uniqlo ticks this box easily. The Japanese retail giant boasted around  ¥1.1 trillion (US$10 billion) in cash and cash equivalents and around ¥660 billion (US$6 billion) in debt as of 30 November 2019. That translates to a healthy US$4 billion net cash position.

Equally important, Fast Retailing is a serious cash machine. The company has consistently generated around US$1 billion in cash from operations at the minimum in each year since FY2015. The table below shows some of the important cash flow metrics.

3. Does Fast Retailing’s management team have integrity, capability, and an innovative mindset?

To me, management is the single most important aspect of my stock investments. 

Fast Retailing’s founder and CEO, Tadashi Yanai, has proven himself to be everything you can ask for in a leader.

He founded the first Uniqlo store back in 1984 and has since built it into an internationally recognised brand with a network of more than 2,000 stores globally. Uniqlo is also one of the most innovative companies in apparel retail. It has patented some of its unique materials such as Heat tech and Airism. 

Yanai was also able to transform the company’s brand image. Previously, Uniqlo was perceived as a discount retailer selling cheap and low-quality apparel. Seeing this, Yanai decided to open a 3-story iconic store in Harajuku in central Tokyo in 1998. This was the turning point for the brand as consumers’ perceptions shifted. Uniqlo became viewed as a brand that offered affordable but high-quality products. Yanai’s willingness to spend big to improve the brand-perception is testament to his foresight and capability.

More recently, Fast Retailing has embraced technology to improve its work processes and decision making. The Ariake Project, which aims to transform the company digitally, was initiated two years ago and is beginning to bear fruit. Through the Ariake project, Fast Retailing restructured its decision-making process and now small, flat teams are able to faster analyse the business, make decisions, and implement ideas. Fast Retailing also has automated warehouse processes such as stock receipts, sorting, packing, and inspection.

The company has been treating shareholders fairly too, by paying around 30% of its profits as dividends. 

It is also heartening to see that Yanai owns around 44% of Fast Retailing. With such a large position in the company, his interests will likely be aligned with shareholders.

4. Are Fast Retailing’s revenue streams recurring in nature?

Recurring revenue is an important yet often overlooked aspect of a business. Recurring revenue allows a company to spend less effort and money to retain existing clients and instead focus on other aspects of the business.

In Fast Retailing’s case, I believe a large portion of its revenue is recurring in nature. The company has built up a strong brand following and repeat customer purchases are highly likely.

5. Does Fast Retailing have a proven ability to grow?

Fast Retailing has been one of the fastest-growing apparel retailers in the world. The chart below shows Fast Retailing’s sales compared to other leading apparel retailers since 2000.

The red line shows Fast Retailing’s annual sales. As you can see, Fast Retailing started from the lowest base among the top five global apparel retailers. However, it has since seen steady growth and has overtaken traditional powerhouses such as Gap and L Brands.

It is worth noting that the most recent quarter saw a slight dip in revenue and operating profit. However, I believe the long-term tailwinds should see the company return to growth in the longer-term.

6. Does Fast Retailing have a high likelihood of generating a strong and growing stream of free cash flow in the future?

A company’s true worth is not based on its accounting profits but on the cash flow it can generate in the future. That is why Ser Jing and I have an eye on companies’ free cash flow numbers. 

I believe Fast Retailing has all the ingredients in place to consistently generate increasing free cash flow in the years ahead.

The company is expanding its store count internationally, with China and Southeast Asia set to become important drivers of growth. As mentioned earlier, Fast Retailing’s free cash flow has been increasing from FY2015 to FY2019.

Fast Retailing’s management is also cautiously optimistic about its International market expansion prospects, and showed the chart below in its FY2018 annual report:

Based on the chart, management is expecting Uniqlo International sales revenue to double from 2018 to 2022. That tremendous runway of growth will likely provide the company with a growing stream of free cash flow.

Risks

A discussion on a company will not be complete without assessing the risks.

I think the most important risk for the company is key-man risk. The current CEO and founder, Yanai, is the main reason for Fast Retailing’s growth. His vision and ability to grow the brand, develop new products, and enter new markets is the driving force behind Uniqlo’s success.

As a major shareholder of the company, he has also made decisions that have been favourable towards other shareholders. Moreover, Yanai is not getting any younger and will be turning 71 in February this year.

That said, I believe Yanai is still going strong. Despite ranking as the 31st richest man in the world, and the richest in Japan, he still has the ambition to drive the company further. Yanai is aware of succession planning for the company and is confident that the new leaders will step up to the plate. He said in late 2018:

“Okazaki (current CFO) and others in management have been progressing to where, even if I am not here, the company will be run properly.”

In its bid to expand internationally, Uniqlo also needs to properly manage its brand image. Mismanagement of the brand can have a detrimental effect on sales, as was the case with Under Armour.

In addition, I think a large part of Fast Retailing’s sales growth will have to come from new product offerings. Uniqlo needs to maintain its high standards while developing new fabrics and designs to keep its customers coming back.

Valuation

Valuing a company usually requires a wee bit of estimation and assumptions, so bear with me here.

In Fast Retailing’s case, I will assume it can hit management’s targets of doubling its International sales to around ¥1.6 trillion by 2023. This assumption seems fair, given the potential for China and Southeast Asia alone to hit around ¥1.3 trillion in sales by that time.

For this exercise, I also assume that its sales in Japan will maintain at around ¥900 billion. In addition, I assume that operating margins for Japan and International sales are 11.5% and 13.5% respectively (based on historical margins).

Given all these assumptions, Fast Retailing can expect profits after tax in the region of around ¥225 billion yen (30% tax rate on pre-tax operating profits).

Nike currently trades at a price-to-earnings multiple of around 35. Attaching that multiple to my 2023 earnings estimate, I estimate that Fast Retailing can have a market cap of ¥7.9 trillion in the next few years.

That is 17% higher than its current market cap, despite assuming a fall in the price-to-earnings multiple from its current 39 to 35.

The Good Investors’ Conclusion

Fast Retailing is undoubtedly a company that possesses many great qualities. A visionary leader, a powerful brand, an enormous addressable market, patented products that consumers love, and more. Its finances speak for themselves, with strong cash flow, earnings, and revenue growth.

Based on my estimates, the company’s valuation has room to grow over the next four years even if there is an earnings-multiple compression. In addition, investors should also consider that Fast Retailing can extend is growing streak well beyond the next four years.

As such, despite the company trading near all-time highs, and with the existence of some execution risks, I believe there is enough positives to warrant picking up shares of Fast Retailing today.

If you enjoyed this article, I wrote a similar article on another apparel brand, Lululemon.

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.

PayPal Holdings (NASDAQ: PYPL) is one of the 50-plus companies that’s in my family’s portfolio. I first bought PayPal shares for the portfolio in June 2016 at a price of US$38, again in November 2018 at US$83, and yet again in June 2019 at US$117. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with PayPal’s share price being around US$116 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 PayPal shares. 

Company description

PayPal was first listed in the US stock market in February 2002, but it was acquired by e-commerce site eBay just a few months later. The acquisition made sense for PayPal, as the company could tap on eBay’s larger network of users and gross merchandise volume.

Interestingly, PayPal outgrew eBay over time. Eventually, PayPal was spun off by eBay in mid-2015 through a new IPO. On the day of PayPal’s second listing, its market capitalisation of around US$47 billion was larger than eBay – and has since nearly tripled.

It’s likely that even for us living in Singapore, we have come across PayPal’s online payment services. But there is more to the company. PayPal’s payments platform includes a number of brands – PayPal, PayPal Credit, Braintree, Venmo, Xoom, and iZettle – that facilitate transactions between merchants and consumers (and also between consumers) across the globe. The platform works across different channels, markets, and networks.

PayPal recently added discount-discovery services for consumers to its portfolio. It announced a US$4 billion acquisition of Honey in November 2019 that closed earlier this month. According to PayPal, Honey “helps consumers find savings as they shop online.” Honey has around 17 million monthly active users, partners with 30,000 online retailers across various retail categories, and has helped its user base find more than US$1 billion in savings in the last 12 months.

PayPal’s revenue comes primarily from taking a small cut of its platform’s payment volume. This transaction revenue accounted for 90.3% of PayPayl’s revenue of US$12.8 billion in the first nine months of 2019. Other business activities including partnerships, subscription fees, gateway fees, service-related fees, and more (collectively known as other value added services) comprise the remaining 9.7% of PayPal’s net revenue. 

The US was PayPal’s largest country by revenue in the first nine months of 2019 with a 53.2% share. In a distant second is the UK, with a weight of 10.5%. No other single country made up more than 10% of the company’s net revenue.

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for PayPal.

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

PayPal’s business is in digital and mobile payments. According to a 2018 PayPal investor presentation, this market is worth a staggering US$110 trillion, as shown in the chart below. For context, PayPal raked in just US$17.0 billion in revenue in the 12 months ended 30 September 2019 based on US$676.2 billion (or just US$0.676 trillion) in payment volume that flowed through its platform.

Around 80% of transactions in the world today are still settled with cash, which means digital and mobile payments still have low penetration. This spells opportunity for PayPal. 

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

PayPal’s balance sheet looks rock-solid at the moment, with US$5.0 billion in debt against US$6.9 billion in cash, as of 30 September 2019. The picture is likely to change with the aforementioned US$4 billion acquisition of Honey, but we will only know when PayPal announces its 2020 first-quarter results (which should take place sometime in April this year).

I’m not worried though, because PayPal has a storied history of producing strong free cash flow which I’m going to discuss later.

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

On integrity

PayPal’s key leader is CEO Dan Schulman, who’s 61 this year. In 2018, the lion’s share of the compensation for PayPal’s key leaders (including Schulman and a handful of other senior executives) came from the following:

• Stock awards that vest over a three-year period
• Restricted stock awards that depend on the growth in PayPal’s revenue and free cash flow over a three-year period
• (Specifically for Schulman) Stock awards that depend on the performance of PayPal’s share price over a five-year period

PayPal’s compensation structure for its key leaders has emphases on free cash flow, multi-year-vesting for stock awards, and a dependence on the company’s long-term share price movement. I think this structure aligns my interests as a shareholder with the company’s leaders.

Moreover, PayPal requires its CEO and other senior executives to hold shares that are worth at least three to six times their respective base salaries. This results in skin in the game for PayPal’s leaders. As of 29 March 2019, Schulman himself controlled 719,297 PayPal shares that are collectively worth around US$80 million at the current share price; other members of the company’s senior management team each controlled around US$11 million to US$14 million worth of shares.

On capability and innovation

Some members of PayPal’s senior management team have relatively short tenures with the company, as illustrated in the table below. But together, they have accomplished plenty since PayPal’s separation from eBay.

First, the company has grown its network of users impressively since the spin-off. The table below shows how PayPal’s transactions, payments volume, and active accounts have changed from 2014 to the first nine months of 2019.

Second, PayPal has made a number of impressive acquisitions in recent years under Schulman. They are:

• Digital international money-transfer platform Xoom (acquired in November 2015 for US$1.1 billion). The platform’s money-transfer network covers more than 160 countries.
• iZettle, a provider of solutions to small businesses for the acceptance of card payments and sales management and analytics (acquired in September 2018 for US$2.2 billion).  PayPal acquired iZettle to strengthen its payment capabilities in physical stores and provide better payment solutions for omnichannel merchants. I believe that a retailer’s ability to provide a seamless omnichannel shopping experience is crucial in today’s environment. When iZettle was acquired, it operated in 12 countries across Europe and Latin America, and was expected to deliver US$165 million in revenue and process US$6 billion in payments in 2018.

Third, PayPal has been striking up strategic partnerships in many areas since becoming an independent company. The slides below from PayPal’s 2018 Investor Day event says it all: PayPal had no strategic partners when it was still under eBay!

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

I mentioned earlier that PayPal’s primary revenue source is payments that take place on its platform. And when I discussed PayPal’s management, I also pointed out that the company had processed 8.9 billion transactions in the first nine months of 2019 from 295 million active accounts (at the end of 2018, PayPal had 267 million active accounts, of which 21 million are merchants).

I think that these high numbers highlight the recurring nature of PayPal’s business. It’s also worth noting that there’s no customer-concentration: No single customer accounted for more than 10% of PayPal’s revenues in 2016, 2017, and 2018.

5. A proven ability to grow

PayPal returned to the stock market only in 2015, so I don’t have a long track record to study. But I’m impressed by what the company has.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” PayPal fits the bill. A few key things to note:

• Revenue has increased in each year from 2012 to 2018, and has compounded at a healthy clip of 18.2% per year.
• Net profit was always positive, and has increased by 17.6% per year.
• PayPal has not diluted shareholders too. Its 68% growth in net profit from 2015 to 2018 is similar to the 71% jump in diluted earnings per share (EPS) over the same timeframe. 
• Operating cash flow and free cash flow were always positive in each year, and the two important financial metrics have compounded at impressive annual rates of 23.2% and 28.1%, respectively. 
• PayPal’s operating cash flow and free cash flow in 2018 had enjoyed a one-time boost from the sale of the company’s US consumer credit receivables portfolio in July that year. But even after making the relevant adjustments, PayPal’s operating cash flow and free cash flow for the year would still be strong at US$4.1 billion and US$3.3 billion, respectively. 
• PayPal’s balance sheet was stellar throughout, given the high net cash position. 

PayPal continued to grow in the first nine months of 2019. Revenue was up 14.1% to US$12.8 billion, driving a 32.5% jump in net income to US$1.95 billion (diluted EPS grew 34.4% to US$1.64). Operating cash flow and adjusted free cash flow came in at US$3.3 billion and US$2.8 billion, respectively; adjusted free cash flow was up 25% from US$2.2 billion a year ago.

I see two notable traits in PayPal’s network: 

• PayPal has a global reach. It is able to handle transactions in over 200 markets, and allow its customers to receive money in 100 currencies, withdraw funds in 56 currencies, and hold PayPal account balances in 25 currencies.
• I believe PayPal’s business exhibits a classic network effect. Its competitive position strengthens when its network increases in size. When I discussed PayPal’s management earlier, I showed that the volume of payments and number of transactions increased faster than the number of accounts. This means that PayPal’s users are using the platform more over time – to me, this indicates that PayPal’s platform is becoming more valuable to existing users as more users come onboard.

I also want to point out two payment services providers that are in PayPal’s portfolio; I think that they are crucial for the company’s future growth:

• The first is mobile payments services provider Braintree, which was acquired in 2013 for US$713 million. Braintree provides the technological backbone for the payment tools of many technology companies, including ride-hailing app Uber, cloud storage outfit DropBox, and accommodations platform AirBnB. Braintree helps PayPal better serve retailers and companies that conduct business primarily through mobile apps.
• The second is digital wallet Venmo (acquired by Braintree in 2012), which allows peer-to-peer transactions. Venmo is highly popular among millennials in the US, and PayPal reported that there were more than 40 million active accounts for the digital wallet in 2019’s first quarter. During 2019’s third quarter, Venmo’s total payment volume surged by 64% from a year ago to US$27 billion (and up more than five times from just three years ago in the third quarter of 2016). The annual run rate of Venmo’s total payment volume has also now exceeded US$100 billion. Meanwhile, monetisation of Venmo has progressed at a rapid clip. The digital wallet’s annual revenue run rate in 2019’s third quarter was nearly US$400 million, double the US$200 million seen in 2018’s fourth quarter.

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

PayPal has excelled in producing free cash flow from its business for a long time, and has huge growth opportunities ahead. There’s no reason to believe these will change any time soon. 

Valuation

I like to keep things simple in the valuation process. In PayPal’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value. That’s because the payment services outfit has a strong history of producing positive and growing free cash flow.

PayPal carries a trailing P/FCF ratio of around 38 at a share price of US$116, after adjusting for the one-time boost to the company’s free cash flow in 2018. This ratio looks a little high relative to history. For perspective, PayPal’s P/FCF ratio was only around 28 in the early days of its 2015 listing.

But I’m happy to pay up, since PayPal excels under my investment framework. 

The risks involved

There are six key risks I see in PayPal.

First, the payments space is highly competitive. PayPal’s muscling against other global payments giants such as Mastercard and Visa that have larger payment networks. Then there are technology companies with fintech arms that focus on payments, such as China’s Tencent and Alibaba. In November 2019, Bloomberg reported that Tencent and Alibaba plans to open up their payment services (WeChat Pay and Alipay, respectively) to foreigners who visit China. Let’s not forget that there’s blockchain technology (the backbone of cryptocurrencies) jostling for room too. There’s no guarantee that PayPal will continue being victorious. But the payments market is so huge that I think there will be multiple winners – and my bet is that PayPal will be among them.

Second, there’s eBay’s relationship with PayPal. When the two companies separated, they signed a five-year deal – expiring in July 2020 – for PayPal to help eBay process payments. eBay announced in 2018 that it would not renew the deal when it expires (although PayPal will still be a payment-button on eBay’s site through July 2023). eBay accounted for 8% of PayPal’s total payment volume (TPV) in 2019’s third quarter. But PayPal’s management expects the percentage to fall to “well under 5%” by the end of 2020. eBay’s also a waning presence in e-commerce, so I don’t think it holds any importance to PayPal’s future growth. During 2019’s third quarter, PayPal’s total TPV (excluding currency movements) grew by 27% despite the 3% decline in eBay’s TPV (similarly excluding currency movements) on PayPal’s platform.

The third risk I’m watching is regulations. The payments market is heavily regulated. What PayPal can take per payment-transaction could be lowered in the future by regulators for various reasons.

The fourth risk concerns recessions. I don’t know when a recession (in the US or around the world) will occur. But when it does, payment activity on PayPal’s platform could be lowered. PayPal’s business was remarkably resilient during the last major global economic downturn in 2008 and 2009. Back then, eBay had no revenue-growth from its main e-commerce platform. But the segment that consisted primarily of PayPal produced strong double-digit revenue growth in both years. PayPal’s a much larger company today, so it may not be able to grow through a future recession that easily – but its historical track record is impressive.

The US$4 billion acquisition of Honey represents the fifth risk. I want to be clear: I like the deal and I think it will work out great. But it’s still a risk. Let me explain. Honey’s revenue in 2018 was over US$100 million, with growth of more than 100% –  and the company was already profitable. In a recent article, Ben Thompson from Stratechery shared how the acquisition can lead to upside for PayPal’s business:

“The most important effect, according to Schulman, was on PayPal’s relationship with consumers. Now, instead of being a payment option consumers choose once they have already committed to a purchase, PayPal can engage with consumers much higher in the purchase funnel. This might be one step higher, as would be the case with coupon search, but it could also be around discovery and calls-to-action, as might be the case with the app or notifications and price-tracking…

…Honey is also an intriguing way for PayPal to actually make money on Venmo in particular. Honey’s audience skews heavily female and millennial, which means there is a lot of overlap with Venmo, and there is a good chance PayPal can really accelerate Honey’s adoption by placing it within its core apps (which it plans to do within the next 6 to 12 months)…

…If PayPal, via Honey, knows exactly what you are interested in buying, and can make it possible for merchants to offer customized offers based on that knowledge, well, that may be a very effective way to not only capture affiliate revenue but also payment processing revenue as well. Demand generation remains one of the most significant challenges for merchants… And here the fact that PayPal has 24 million merchant partners versus Honey’s 30,000 is a very big deal.”

But Honey is PayPal’s largest acquisition ever, and the deal comes with a steep price tag of US$4 billion. Assuming Honey can grow its revenue by 100% in 2019, PayPal is effectively paying 20 times revenue for the discount discovery company. I will have to face a situation of PayPal writing down the value of Honey if the integration of the two fails to live up to expectations.

Lastly, I’m mindful of succession risk. PayPal’s CEO, Dan Schulman, is already 61 this year. Fortunately, PayPal’s key leaders are mostly in their mid-fifties or younger.

The Good Investors’ conclusion 

I think the transition from cash to cashless payments holds immense opportunities for companies. I also think a payment company with a wide network of consumers and merchants (PayPal, for instance) stands a good chance of being one of the eventual winners. 

Furthermore, PayPal has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. PayPal’s P/FCF ratio is on the high end, but I’m happy to pay up for a top-quality business.

Every company has risks, and I’m aware of the important ones with PayPal. They include competition, regulation, and more. But after weighing the risks and rewards, I’m still happy to allow PayPal to be pally with 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.

To say that Lululemon (NASDAQ: LULU) has been on a hot streak is a major understatement. The Canadian athletic apparel maker’s revenue and earnings per share soared 21% and 34% respectively in the first nine months of 2019.

Consequently, market participants have driven Lululemon’s shares up by 79% in the last year. That brings its five-year gain up to 273%.

But with its share price sitting near its all-time high, have investors missed the boat?

I decided to do a quick assessment of Lululemon’s investment potential based on my blogging partner Ser Jing’s six-point investment framework. 

Company description

Before diving into my analysis, here is a quick brief on what Lululemon does. Lululemon is one of the first companies to specialise in athletic apparel for women. Its products are distributed through its network of company-operated stores and direct online sales channels.

Lululemon’s products are unique in that it has its own research and design team that source advanced fabrics that feel good and fit well. Customers of Lululemon tell me that its products indeed feel more comfortable than other brands.

With that, let’s take a look at how Lululemon fits into our investment framework.

1. Is its revenue small in relation to a large and/or growing market, or is its revenue large in a fast-growing market

One of the key things we look for in companies is whether they have the ability to grow. A company can grow either by increasing its market share in a large addressable market or by participating in the growth of a growing market.

I think Lululemon can do both.

Lululemon’s revenue is tiny compared to its current total addressable market size in the sports apparel space. According to Allied Market Research, the sports apparel market was valued at US$167.7 billion in 2018 and is estimated to reach US$281 billion by 2026. Comparatively, Lululemon’s net revenue of US$3.7 billion is just 2% of the total addressable market in 2018.

In particular, the athletic apparel brand has set its sights on enlarging its menswear segment and has seen some solid progress in recent years. In the most recent quarter ended 3 November 2019, sales of Lululemon’s men’s category increased by 38%.

The Canadian brand is also increasing its international presence, which presents a huge market opportunity for the company. Revenue from countries outside of the US and Canada increased by 35% in the three quarters ended 3 November 2019. And yet, sales outside of North America still contributed just 12% of Lululemon’s total revenue. 

In 2019, management introduced its “Power of Three” plan to grow revenue by the low double-digit range annually over the next five years. To do so, it plans to double its men’s and digital revenues and quadruple its international revenue.

Based on Lululemon’s addressable market size, I think these are very achievable goals. Given that traditional sports apparel powerhouses such as Nike and Adidas derive most of their sales outside of their home turf, I foresee that Lululemon’s sales outside of North America will also eventually outgrow its North American sales. 

2. Does Lululemon have a strong balance sheet with minimal or a reasonable amount of debt?

Lululemon has a pristine balance sheet. As of 3 November 2019, the Canadian company had US$586 million in cash and no debt. 

It has also been consistent in generating cash from its operations. Lululemon generated US$386 million, US$489 million, and US$743 million in operating cash flow in fiscal 2016, 2017 and 2018 respectively.

Lululemon’s strong balance sheet and steady cash flow have allowed it to use internally generated funds to open new stores, invest in research for new products, and to open new geographical markets.

The company has also used some of its spare cash to reward shareholders through share buybacks. In the last three full fiscal years, Lululemon used more than US$700 million for share buybacks.

3. Does Lululemon’s management team have integrity, capability, and an innovative mindset?

Calvin McDonald was appointed as chief executive officer of Lululemon in August 2018. So far, McDonald has overseen Lululemon’s steady growth in sales over the last one and a half years, while building the brand in Asia and Europe. 

I think he has done a good job so far and his plans to grow internationally and in the menswear segment seem sensible.

On top of that, McDonald brings with him a wealth of experience. He was the president and CEO of Sephora Americas, a division of LVMH group of luxury brands in the five years prior to joining Lululemon. During his tenure there, LVMH enjoyed double-digit growth in revenue.

I also believe that the management team has done well in maintaining Lululemon’s brand image. The company is also consistently upgrading and increasing its product offerings.

The top executives are currently paid a performance bonus based on financial performance goals, weighted 50% on operating income and 50% on revenue. I think the performance goals are in line with shareholder interest. That being said, I would prefer that the executives also have long-term goals in place that would encourage management to think of long-term strategies.

But overall, I still think that Lululemon’s management has proven itself to have integrity and capability in increasing shareholder value.

4. Are its revenue streams recurring in nature?

Recurring revenue is a beautiful thing for a company. Besides providing a reliable revenue stream, it also allows the company to spend less time and money to secure past sales and focus on other aspects of its business.

As Lululemon has built up a strong brand in its core markets in North America, I think that repetitive customer behaviour will result in recurring revenue for the company.

Another good indicator that customers are spending more at Lululemon’s stores is its substantial comparable-store sales growth. Its comparable-store sales soared by 18% for the fiscal year ended February 2019. Importantly, that figure has held up well this year too, increasing by 10% (excluding the 30% growth in direct-to-consumer channels) in the three quarters ended 3 November 2019. 

While it is difficult to say how much of this was from existing customers, the fact that same-store sales have grown at a double-digit pace certainly bodes well for the company.

Lululemon also managed to increase its gross margin by 70 basis points to 55.1%, which illustrates the brand’s strong pricing power.

Its same-store sales growth is made even more impressive when you consider that Lululemon has been ramping up its store count by around 10-plus percent per year.

5. Does Lululemon have a proven ability to grow?

Lululemon is becoming the envy of retail. While numerous others are struggling to cope with the emergence of e-commerce, Lululemon has been growing both its brick and mortar sales, as well as its direct-to-consumer business.

Its net revenue and net income have increased at a compounded annual rate of 12% and 15%, respectively, from fiscal 2015 to fiscal 2018.

More importantly, that growth looks unlikely to slow down any time soon, with revenue and net profit for the first three quarters of fiscal 2019 increasing by 21% and 34%, respectively.

Lululemon’s focus on international growth and men’s apparel should see it comfortably hitting its target of low double-digit growth over the next five years.

6. Does Lululemon have a high likelihood of generating a strong and growing stream of free cash flow in the future?

The true value of a company is determined not on profits but on the cash that it can generate in the future. That is why Ser Jing and I look for companies that will not only generate profits but a growing stream of free cash flow per share.

In Lululemon’s case, it has already been generating a steady stream of free cash flow each year. The table below shows Lululemon’s operating cash flow and capital expenditure over the past three years.

Another point worth noting is that Lululemon’s management has been sensible in the way it has reinvested its cash. It is consistently using around a third of its operating cash flow generated for new store openings and expansion of existing stores. It is also returning excess capital to shareholders through share buybacks.

As such, investors can rest easy that the company will not be unnecessarily hoarding cash that it doesn’t need. Its net cash position has hovered between US$664 million to US$990 million at the end of the past five fiscal years.

Risks

A discussion on a company will not be complete without talking about risks. The biggest risk to Lululemon’s business is the mismanagement of its brand. 

A good example of a growing sports apparel brand that ultimately lost traction with consumers is Under Armour. Under Armour devalued its brand by trying to cater to both the high-end and the low-end markets at the same time. Unfortunately selling cheaper products ended up hurting its brand appeal in the premium market.

Lululemon will need to manage its brand and price-point to prevent a similar scenario from hurting its sales. The company will need to be extra careful as it ramps up its menswear apparel. Lululemon had previously positioned itself as a brand for women. Increasing its men’s apparel sales could devalue this proposition and end up eroding the goodwill it has built with some of its existing customers.

Competitors can also eat into Lululemon’s existing market share. Currently, Lululemon enjoys strong brand loyalty and boasts a product that customers are willing to pay up for. If competitors develop new products that have similar look and feel to Lululemon’s core offerings, it may be faced with eroding margins and difficulty retaining or growing its business.

Lululemon also faces the risk of keeping itself relevant. So far, the company has adapted well to the changing business conditions and have been one step ahead of competitors through new product offerings. For it to continue to grow at its projected five-year pace, Lululemon needs to continue expanding its product offering to retain customer loyalty.

Valuation

What is a good price to pay for Lululemon? As with any company, this requires a reasonable amount of estimation and judgment.

The fast-growing retailer said that it expects to grow at a low double-digit pace over the next five years. If it manages to grow its earnings by around 15% per annum, it will be generating around US$931 million in net income in five years’ time.

Nike shares currently trade at a price-to-earnings ratio of around 36. Using that same multiple on Lululemon, I calculate that the Canadian sports apparel giant could be worth around US$33.5 billion by then.

Using that estimate, Lulelemon shares have a 5% upside based on its current market cap of around US$31.8 billion. That doesn’t seem like much.

However, let’s assume the company also grows its bottom line by 15% annually from year 6 to year 10. Given the huge addressable market outside of North America, a 15% annualised growth rate over a 10-year period seems possible. By 2030, Lululemon will have a net profit of US$1.9 billion. Taking a 35 times earnings multiple, it will have a market cap of US$65.3 billion. That’s more than twice its current market cap, which translates to a decent 8% or so annualised return over 10 years.

The Good Investors’ Conclusion

Lululemon ticks all six boxes of Ser Jing’s investment framework. It has a history of strong growth and is still small in comparison to its total addressable market. Management has also been proactive in returning excess capital to shareholders.

In addition, my valuation projection is fairly conservative. Lululemon could potentially grow its bottom line by more than 15% annually.

On top of that, investors may be willing to pay a larger premium than 35 times its earnings, especially if Lululemon continues to grow at fast rates. 

As such, even though its shares are trading at a seemingly rich valuation of around 56 times trailing earnings, if the company can sustain its growth over the next 10 years, investors who pick up shares today could still be well-rewarded over the long term.

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.