Category: Investing Analysis

I woke up last Thursday to a rude surprise. My shares of Facebook had fallen 6% in a single trading session, following the company’s 2019 fourth-quarter earnings results. A big jump in expenses during the quarter was the culprit. 

However, after reassessing Facebook’s position, I think the decline was unwarranted. In fact, I feel more optimistic than ever for the social network’s long term prospects and am more than happy to hold onto my shares. 

Why investors have been put off

Before discussing the reasons why I am bullish about Facebook, let me first say that I acknowledge that there are very real reasons why the broader market is sceptical of Facebook. 

The first possible reason is that Facebook carries a degree of regulatory risk. We can’t sugarcoat that.

In recent months, Facebook incurred a US$5 billion fine from the Federal Trade Commission due to a privacy breach and had to pay a US$550 million settlement for collecting users’ facial recognition data. In addition, there have also been a few threats from European regulatory bodies.

These regulatory concerns are, in turn, the reason why Facebook’s expenses have skyrocketed. The company has spent big hiring thousands of employees to update its platform and make it safer for users. 

The second reason is Facebook’s decelerating growth. Facebook enjoyed 36% annualised top-line growth over the last 3 years. However, that growth has since decelerated. Shareholders who have been accustomed to the 30%-plus growth rate may have been disappointed by the latest figures.

Despite these two factors, I think Zuckerberg’s brainchild is still a great investment. Here’s why. 

The numbers are still really good

Despite a slight deceleration in growth in recent times, Facebook is still posting solid numbers.

In the fourth quarter of 2019, Facebook saw revenue jump 25% and income from operations grow 13%. Looking ahead, management said that it expects revenue-growth in 2020’s first quarter to decelerate by a low to a mid-single-digit percentage point compared to 2019’s fourth quarter.

Although a deceleration looks bad, that still translates to a healthy 20% increase in revenue.

The social media giant is also now sitting on US$55 billion in cash and marketable securities, and zero debt. On top of that, its cash flow from operations in 2019 was 24% higher than in 2018.

Other metrics are healthy too

Besides its financials, the company’s all-important user engagement metrics are also very healthy. Daily active users, monthly active users, and family daily active people were up 9%, 8% and 11% respectively at end-2019 compared to a year ago.

The worldwide average revenue per user also ticked up 15.6% from 2018’s fourth quarter, demonstrating that Facebook is doing an excellent job improving the monetisation of its gargantuan user base.

Facebook is addressing the regulatory concerns

Zuckerberg and his team have also taken privacy concerns very seriously. Zuckerberg emphasised in his recent conference call with analysts:

“This is also going to be a big year for our greater focus on privacy as well. As part of our FTC settlement, we committed to building privacy controls and auditing that will set a new standard for our industry going beyond anything that’s required by law today. We currently have more than 1,000 engineers working on privacy-related projects and helping to build out this program.”

Facebook is also rolling out a privacy checkup tool to close to 2 billion of its users to remind them to set their user privacy control to the level they wish for.

I think with Facebook’s size, the task of managing privacy is going to be a multi-year process but Facebook’s commitment to addressing the issue is certainly heartening for investors. 

Becoming a Super App

While advertising is Facebook’s bread and butter, the social media giant has the potential for so much more.

It now has online dating features, e-commerce, gaming, Watch and other features. Although not all of these features will cater to everyone, they each appeal to a certain segment of people. This will grow user engagement and increase ad impressions per user.

This is similar to WeChat in China. The Super app of the East has built-in functions such as payments, e-commerce, bookings, and much more. Facebook, with its billions of users, has the potential to become the Super app of the world.

New functions also give Facebook a different source of revenue. One example is through implementing a take rate for payments made on its platform. This could be a new revenue growth driver as Facebook plans to roll out WhatsApp payment and payment services to facilitate Facebook Marketplace.

History of great capital allocation decisions

Although there is a lot to like about Facebook’s business going forward, I think the most exciting thing is how Facebook will use its massive cash pile, which is growing by the day.

As mentioned earlier, Facebook is sitting on US$55 billion in cash (US$50 billion after it pays off the aforementioned US$5 billion fine). That’s an incredible amount of financial resources and the possibilities are endless.

Most importantly, Facebook has a brilliant track record of spending its cash wisely. In the past, it bought Instagram for just a billion dollars in 2012, solidifying its position as the leading social media player in the world. On top of that, the outlay for the Instagram investment should have already been more than covered by the ad revenue that Facebook has generated from it.

More recently, Facebook has been aggressively buying back shares. In its latest announcement, it said it has earmarked another US$10 billion for share repurchases, which I think is a great use of capital given its stock’s ridiculously cheap valuation (more on that later). This again shows that the decision-makers in Facebook are doing the right things with its ever-growing cash hoard.

Valuation too cheap to ignore

It is no secret that Facebook is not the most loved stock on Wall Street. Despite growing its top line by 26% in 2019 and the numerous tailwinds at its back, the stock still trades at just 23.5 times normalised earnings (after removing the one-off fines and settlement charges).

That’s the lowest multiple among the FAAMG stocks. For perspective, Alphabet, Apple, Microsoft and Amazon trade at price-to-earnings multiple of 31, 25, 29, and 87 respectively.

I simply don’t see how Facebook can suffer a further earnings multiple compression unless there’s a market-wide collapse.

Even after factoring the deceleration in growth, Facebook is still expected to grow revenue and profits by close to 20% in 2020 and beyond. Moreover, Facebook has so much cash on hand, its growth could even be boosted if Facebook decides to make an acquisition down the road.

The Good Investors’ Take

With so many opportunities for growth and the heavy fines behind it, Facebook is likely to see double-digit growth to its bottom line for years to come. Its enduring competitive moat looks unlikely to be eroded any time soon and the capital allocation decisions have been extremely sound.

Just as importantly, the stock trades at unreasonably beaten down valuations. Given everything, I’ve seen, I like my position in Facebook.

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.

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.

MercadoLibre (NASDAQ: MELI) is one of the 50-plus companies that’s in my family’s portfolio. I first bought MercadoLibre shares for the portfolio in February 2015 at a price of US$131 and subsequently made two more purchases (in May 2016 at US$129 and in May 2017 at US$287). I’ve not sold any of the shares I’ve bought.

The purchases have worked out very well for my family’s portfolio, with MercadoLibre’s share price being around US$660 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 MercadoLibre shares.

Company description

MercadoLibre – “free market” in Spanish – was founded in 1999 and has rode the growth of the internet and online retail to become the largest e-commerce company in Latin America today, based on unique visitors and page views. The company is present in 18 countries including Brazil, Argentina, Mexico, and Chile.

There are six integrated e-commerce services that MercadoLibre provides:

• MercadoLibre Marketplace: An online platform that connects buyers and sellers; it earns revenue by taking a small cut of each transaction.
• Mercado Pago: A fintech platform that primarily facilities online payments, and online-to-offline (O2O) payments. It can be used both within and outside MercadoLibre’s marketplaces.  
• Mercado Envios: A logistics solution that includes fulfilment and warehousing services. 
• MercadoLibre Classifieds: An online classifieds service for motor vehicles, real estate, and services; it also helps direct users to Mercadolibre’s marketplaces.
• MercadoLibre advertising: A service that allows advertisers to display ads on MercadoLibre’s websites.
• Mercado Shops: A solution that helps sellers establish, run, and promote their own online stores.

MercadoLibre has two business segments. The first is Enhanced Marketplace, which consists of MercadoLibre Marketplace and MercadoEnvios. In the first nine months of 2019, Enhanced Marketplace accounted for 52% of the company’s total net revenue of US$1.6 billion. The second segment is Non-Marketplace, which houses the other four of MercadoLibre’s services. It accounted for the remaining 48% of MercadoLibre’s total net revenue in the first nine months of 2019. Most of the net revenue from Non-Marketplace is from MercadoPago – in 2018, more than 80% of Non-Marketplace’s net revenue came from payment fees.

From a geographical perspective, Brazil is MercadoLibre’s most important country. It accounted for 64% of the company’s total net revenue in the first nine months of 2019. Argentina and Mexico are in second and third place, respectively, with shares of 20% and 12%. The remaining 4% are from the other Latin American countries that MercadoLibre is active in.       

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 MercadoLibre.

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

According to Satista, e-commerce sales in the Latin America region was US$53.2 billion in 2018, and represented just 2.7% of total retail sales in the region. For perspective, e-commerce was 11.2% of total retail sales in the US in the third quarter of 2019.

Forrester also expects the e-commerce market in Latin America’s six largest economies – that would be Argentina, Brazil, Chile, Colombia, Mexico, and Peru, which are all countries that MercadoLibre is active in –  to grow by more than 22% annually from 2018 to 2023. The projection of high growth for Latin America’s e-commerce space is reasonable in my eyes for two reasons.

First, there’s the aforementioned low penetration rate of online retail in Latin America’s overall retail scene. It’s worth noting too that despite Brazil, Argentina,and Mexico (MercadoLibre’s three largest markets) having similar internet-user and smartphone penetration rates as China, online retail is a much higher percentage of total retail in the Asian giant.

Second, internet penetration rates in Latin America are still relatively low: 86.0% of the US population currently has access to the internet, which is much higher than in Brazil, Argentina, and Mexico. For another perspective, Latin America has a population of around 640 million people, but has internet users and online shoppers of merely 362 million and 200 million, respectively.

Given all the numbers described above – and MercadoLibre’s current revenue of US$2.0 billion over the 12 months ended 30 September 2019 – it’s clear to me that the company has barely scratched the surface of the growth potential of Latin America’s e-commerce market.

I also want to point out that I see MercadoLibre possessing the potential to expand into new markets over time – I will discuss this in detail later.  

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

At the end of 2019’s third quarter, MercadoLibre held US$2.8 billion in cash, short-term investments, and long-term investments, against just US$732 million in debt. That’s a strong balance sheet.

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

On integrity

MercadoLibre’s co-founder is Marcos Galperin. He’s still young at just 48, but he has been leading the company as CEO, chairman, and president since its founding in 1999. Galperin is not the only young member of MercadoLibre’s senior management team with long tenure.

In fact, MercadoLibre’s Chief Financial Officer, Chief Operating Officer, Chief Technology Officer, and head of its payments operations are all between 41 and 51 years old, but have each been with the company for more than 10 years. They also joined MercadoLibre in less senior positions – it’s a positive sign for me on MercadoLibre’s culture to see it promote from within.

In 2018, Galperin’s total compensation was US$11.4 million, which is a tidy sum. But more than 90% of the compensation of MercadoLibre’s key leaders (Galperin included) for the year depended on the company’s annual business performance (including revenue and profit growth) and multi-year changes in the company’s stock price. To me, that’s a sensible compensation plan. Moreover, MercadoLibre paid its key leaders less in 2018 (Galperin’s compensation was 6% lower than in 2017) despite growing net revenue by 18%. That’s because MercadoLibre had flopped in terms of its profit-performance. I’m not worried about the profit situation – more on this later.

It’s also likely that Galperin’s interests are squarely aligned with myself and other shareholders of MercadoLibre. As of 15 April 2019, Galperin controlled 4 million MercadoLibre shares (8.1% of the total number of shares) through a family trust. These shares are worth around US$2.7 billion at the current share price.

On capability and innovation

As an e-commerce platform, there are a number of important business metrics for MercadoLibre, such as registered users, gross merchandise volume, items sold, and unique sellers. All four have grown tremendously over the years – even from 2007 to 2009, the period when the world was rocked by the Great Financial Crisis – as the table below illustrates. This is a strong positive sign on management’s capability.

A short walk through MercadoLibre’s history can also reveal the strength of the company’s management team and their innovativeness.

MercadoLibre started life in the late 1990s operating online marketplaces in Latin America. In 2004, the company established MercadoPago to facilitate online payments on its own platform. Over time, MercadoPago has seen explosive growth (in terms of payment volume and number of transactions); opened itself up to be used outside of MercadoLibre’s marketplaces; and added new capabilities that facilitate O2O payments, such as a mobile wallet, and processing payments through QR codes and mobile point of sales solutions. Impressively, during 2019’s third quarter, MercadoPago’s off-platform payment volume exceeded on-platform payment volume in a full quarter in Brazil (MercadoLibre’s largest market), for the first time ever. Then in 2013, MercadoLibre launched MercadoEnvíos, its logistics solution. MercadoEnvios has also produced incredible growth in the number of items it has shipped.

MercadoLibre’s service-innovations are intended to drive growth in the company’s online marketplaces. Right now, there are a number of relatively new but growing services at MercadoLibre:

• MercadoFondo: A mobile wallet service launched in the second half of 2018 that attracts users with an asset-management function.
• MercadoCredito: MercadoCredito, which was introduced in the fourth quarter of 2016, provides loans to merchants. Providing loans can be a risky business, but MercadoLibre is able to lower the risk since it knows its merchants well (they conduct business on the company’s online marketplaces). Furthermore, MercadoLibre can automatically collect capital and interest through MercadoPago, since its merchants’ business flows through the payment-service. MercadoCredito also provides loans to consumers.

Amazon.com is North America’s e-commerce kingpin. But it’s so much more than just online retail. Over time, Amazon has successfully branched into completely new areas with aplomb, such as cloud computing and digital advertising.

I would not be surprised to see MercadoLibre’s future development follow a similar arc as Amazon’s, in terms of having powerful growth engines outside of the core e-commerce business. Today, there are new growth areas that have already been developed outside – such as in the case of MercadoPago. MercadoLibre has an expansive and noble mission – to democratise commerce and access to money for the people of Latin America. I think MercadoFondo and, in particular, MercadoCredito, have the potential to grow significantly beyond MercadoLibre’s online marketplaces. Access to credit and investment/banking services is low in Latin America for both businesses and individuals (see chart below). It will be up to MercadoLibre to grasp the opportunity with both hands. I am confident the company will do so.

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

I think it’s highly likely that MercadoLibre enjoys high levels of recurring business because of customer behaviour. Two things to lend weight to my view:

• No single customer accounted for more than 5% of MercadoLibre’s net revenues in the first nine months of 2019, and in each of 2018, 2017, and 2016. 
• The company’s gross merchandise volume, number of items sold, number of registered users, payment volume, and number of payment transactions range from the hundreds of millions to billions. 

5. A proven ability to grow

The table below shows MercadoLibre’s important financials from 2006 to 2018:

A few things to note:

• Revenue growth has been excellent at Mercadolibre, with compound annual growth rates of 32% from 2006 to 2018, and 25% from 2013 to 2018. 
• Net profit was growing strongly up to 2016, before the situation appeared to have deteriorated dramatically on the surface. Thing is, the company had ramped up investments into its business in the form of higher marketing expenses, subsidies for shipping services for buyers on its marketplaces, and selling mobile point of sales solutions at low margins to entice off-platform usage of MercadoPago. These actions hurt MercadoLibre’s bottom-line in the short run, but I see them as positive for the long run. They draw in customers to MercadoLibre’s ecosystem, in turn creating a network effect. The more users there are on the online marketplaces, the more sellers there are, which lead to more users – and off the flywheel goes. It’s the same with MercadoPago, especially with off-platform transactions. The more merchants there are that accept MercadoPago, the more users there will be, leading to even higher merchant-acceptance – and off the flywheel goes, again. (Another reason for the drastic decline in profit in 2017 was an US$85.8 million loss related to the deconsolidation of MercadoLibre’s Venezuelan business in December of the year – more on this later.)
• Operating cash flow and free cash flow have both been consistently positive since 2006, and have also grown significantly. But in more recent years, both are pressured by the aforementioned investments into the business. It’s all the more impressive that MercadoLibre has produced positive operating cash flow and free cash flow while making the investments.
• The balance sheet has been strong throughout, with cash (including short-term investments and long-term investments) consistently been higher than the amount of debt.
• At first glance, MercadoLibre’s diluted share count appeared to increase sharply in 2008 (I start counting only in 2007, since the company was listed in August 2007). But the number I’m using is the weighted average diluted share count. Right after MercadoLibre got listed, it had a share count of around 44 million. This means that the company has actually not been diluting shareholders at all.

Impressively, MercadoLibre’s top-line growth has accelerated in 2019. In the first nine months of the year, revenue was up 60.3% to US$1.6 billion. The loss widened, from US$34.2 million a year ago to US$118.0 million, as the company continued to invest in the business in a similar manner as mentioned earlier. However, operating cash flow nearly doubled from US$196.1 million in the first nine months of 2018 to US$372.8 million. Slower, but still substantial, growth in capital expenditures resulted in free cash flow surging from US$124.0 million to US$272.0 million. The balance sheet, as mentioned earlier, remains robust with cash and investments significantly outweighing debt. Lastly, the diluted share count only crept up slightly from 44.3 million in the first nine months of 2018 to 48.4 million. 

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

Gale-level tailwinds are behind MercadoLibre’s back. The company also has a strong history of growth and innovation. These traits suggest that MercadoLibre could grow its business significantly in the years ahead.

Meanwhile, the Latin America e-commerce giant has a good track record in generating free cash flow despite heavy reinvestments into its business. I don’t expect MercadoLibre’s reinvestments to be heavy indefinitely, so there’s potential for the company’s free cash flow margin to improve significantly in the years ahead. The strong possibility of having a higher free cash flow margin in the future as well as a much larger revenue stream, means that MercadoLibre ticks the box in this criterion.

Valuation

You should hold your nose… because MercadoLibre’s traditional valuation numbers stink. Are you ready? At the current share price, the company has a negative price-to-earnings (P/E) ratio since it is sitting on a loss of US$2.65 per share over the last 12 months, while its trailing price-to-free cash flow (P/FCF) ratio is 115.

I will argue though, that MercadoLibre’s valuation numbers look so horrendous right now because it is reinvesting heavily into its business to grab the massive opportunity that it sees in Latin America’s e-commerce and digital payment markets. Management is willing to endure ugly short-term results for a good shot at producing excellent long-term business performance – I appreciate management’s focus on the long run.

The current sky-high P/FCF ratio and negative P/E ratio do mean that MercadoLibre’s share price is likely going to be volatile. But that’s something I’m very comfortable with.

The risks involved

For me, I see the instability in the political and economic landscape of the Latin America region as a huge risk for MercadoLibre.

If you look at the table on the company’s historical financials that I shared earlier, you’ll see this big drop in profit in 2014. The reason was because of impairments MercadoLibre made to its Venezuela business during the year. As recent as 2017, Venezuela was still the fourth-largest market for MercadoLibre. In fact, Venezuela accounted for 10.4% of the company’s revenue in 2014. But the country’s contribution to MercadoLibre’s business have since essentially evaporated after the company deconsolidated its Venezuelan operations in late 2017, as mentioned earlier. Venezuela has been plagued by hyperinflation, and political and social unrest in the past few years, making it exceedingly difficult for MercadoLibre to conduct business there.

On 12 August 2019, MercadoLibre’s share price fell by 10%. I seldom think it makes sense to attach reasons to a company’s short-term share price movement. But in this particular case, I think there’s a clear culprit: Argentina’s then-president, Mauricio Marci, who was deemed as pro-business, lost in the country’s primary election to Alberto Fernandez, a supporter of the Peronist movement; Fernandez ended up winning the actual presidential election a few months later. Meanwhile, Brazil’s president, Jair Bolsonaro, and his family are currently embroiled in serious corruption scandals.

MercadoLibre reports its financials in the US dollar, but conducts business mostly in the prevailing currencies of the countries it’s in. This means the company is exposed to inflation in the countries it operates in, and adverse currency movements. Unfortunately, both are rampant in Latin America (relatively speaking, compared to quaint Singapore). The table below shows the growth of MercadoLibre’s revenues in Brazil and Argentina in both US-dollar terms and local-currency terms going back to 2011’s fourth quarter. Notice the local-currency growth rates frequently coming in much higher than the US-dollar growth rates.

The silver lining here is that MercadoLibre has still produced excellent revenue growth in US dollars since 2006, despite the difficulties associated with operating in Latin America. In fact, I think MercadoLibre is a great example of how a company can still thrive even in adverse macroeconomic conditions if it is in the right business (one powered by powerful secular growth trends) and has excellent management.

Another big risk I’m keeping an eye on is related to competition. Other e-commerce giants in other parts of the world could want a piece of MercadoLibre’s turf. For instance, Amazon has been expanding its presence in Latin America; in December 2019, Amazon announced the launch of its second distribution centre in Brazil. But I also want to point out that the US-based online marketplace provider eBay decided to invest in MercadoLibre in 2001 after finding Latin America’s e-commerce market a tough nut to crack (eBay sold its MercadoLibre stake in 2016).

I’m confident that MercadoLibre has already established a strong competitive position for itself, but I’ll still be watching for the moves of its competitors.

The last risk I’m concerned with about MercadoLibre is key-man risk. Marcos Galperin has led the company since its founding, and has done a fabulous job. The good news here is that Galperin is still young. But should he depart from the CEO role for whatever reason, I will be watching the leadership transition.

The Good Investors’ conclusion

Latin America may scare many investors away because of the frequent unrest happening in the region. But MercadoLibre has grown its business exceptionally well for more than a decade despite the troubles there. The company also aces the other criteria in my investment framework:

• Latin America still appears to be in the early days of e-commerce adoption, so the region’s e-commerce market is poised for rapid growth in the years ahead.
• MercadoLibre’s balance sheet is robust with billions in cash and investments, and much lower debt.
• Through a study of the compensation structure of MercadoLibre and the history of how its business has evolved, it’s clear to me that the management team of the company possesses integrity, capability, and the ability to innovate.
• There are high levels of recurring revenue streams in MercadoLibre’s business because of customer behaviour
• MercadoLibre has been adept at generating free cash flow even when it is reinvesting heavily into its business.

There are of course risks to note. Besides the inherent political and economic instability in Latin America, I see two other key risks for MercadoLibre: Competition, and key-man risk. The company’s valuation is also really high at the moment because of what I see as depressed earnings and free cash flow due to heavy reinvestments back into the business – but the high valuation is something I’m comfortable with.

After considering both sides of the picture, I’m happy to continue allowing MercadoLibre’s business to continue flourishing 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.

Uber Technologies, Inc (NYSE: UBER) was once the most anticipated public listing of 2019. But since its initial public offering (IPO) last April, the ride-hailing giant has been a major letdown, with shares trading some 30% below its IPO price.

With that in mind, I decided to do a quick analysis of Uber using my blogging partner Ser Jing’s six-point investment framework.

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

Uber is a great example of a company that is dominant in its industry but still relatively small compared to its total addressable market. According to Uber’s IPO prospectus, the global personal mobility market consists of 11.9 trillion miles per year – or a US$5.7 trillion market opportunity in 175 countries. 

Despite Uber’s dominance in the ride-sharing space, it “only” recorded US$12 billion in ride gross bookings in the three months ended September 2019. That translates to gross bookings of just US$48 billion annually, a drop in the ocean compared to its US$5.7 trillion total addressable market.
Uber also owns minority stakes in affiliates with similar businesses, such as Didi and Grab, which serve markets that have an estimated size of US$0.5 trillion.

Besides personal mobility, Uber is also in the food delivery and freight business. Uber believes its UberEats business addresses a market opportunity of US$795 billion. The freight trucking market is estimated to be around US$3.8 trillion in 2017, which Uber believes represents its total addressable market as it will address an increasing portion of the freight trucking market.

UberEats and Uber Freight’s gross bookings of US$3.6 billion and US$223 million, respectively, are less than 1% of Uber’s total addressable opportunity for these markets.

Let’s not forget that Uber is also spending heavily on autonomous vehicles and other technologies such as Uber Elevate (aerial ridesharing). These could potentially open other avenues of growth for the company.

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

Uber ticks this box too. It is widely publicised that Uber has been burning cash at an alarming rate. However, the company managed to buy some time by raising US$8.1 billion through its IPO.

As of 30 September 2019, Uber had US$12.6 billion in cash and US$5.7 billion in debt, giving it around US$7 billion in net cash.

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

I want the companies that I invest in to be led by capable and honest people.

Uber’s CEO Dara Khosrowshahi was appointed to lead the company in April 2017. Before that, he was the CEO of online travel outfit Expedia. Khosrowshahi brings with him a wealth of experience. His track record at Expedia – he quadrupled the company’s gross bookings – speaks for itself. 

Khosrowshahi has also been able to clean up Uber’s corporate culture, promising to instill integrity and trust among stakeholders. Before he arrived, Uber’s corporate culture was said to be hostile and sexist under founder and then-leader Travis Kalanick.

I would also like to point out that a large portion of the compensation of Uber’s executives is in the form of stock-related awards. In 2018, 88% of Khosrowshahi’s compensation was in stock awards. Khosrowshahi also bought around US$6.7 million in Uber shares in November 2019, bringing his total number of shares up to 1.53 million, worth around US$48.9 million. 

His large personal stake in the company, along with his compensation package, should mean that Khosrowshahi’s interests are aligned with shareholders.

That said, Khosrowshahi has only been in charge of Uber for slightly over two years, and the company has only been listed for less than a year. As such, I think it is worth keeping an eye on management’s decisions and the company’s performance over the next few years before we can truly judge the capabilities of Uber’s leaders.

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

Recurring revenue is a beautiful thing for any company to have. A company that has recurring revenue can spend less effort and money to retain existing customers and focus on expanding its business.

In my view, Uber has recurring revenue due to repetitive customer behaviour. Uber’s customers who have experienced the efficacy of ride-sharing end up consistently using the company’s services, along with those of other ride-sharing platforms.

On top of that, Uber has built a large network of drivers and regular clients that is difficult to replicate. More drivers, in turn, leads to faster pickups, better service, and more consumers, creating a virtuous cycle.

Uber has thrown large amounts of cash at drivers to attract them to its platform in a bid to improve its ride-sharing platform and decrease the wait-time for commuters. As the network matures, Uber can theoretically start to profit by raising prices.

That said, Lyft still remains a fierce competitor in the US and has also built its own huge network of riders. While the US market is potentially big enough for two players to co-exist, if Lyft decides to try to eat into Uber’s market share, both companies may suffer.

5. Does Uber have a proven ability to grow?

From Uber’s IPO prospectus, we can see that it has indeed been growing at a decent clip. Adjusted net revenue for ride-sharing, which removes excess driver incentives, tripled from US$3 billion in 2016 to US$9 billion to 2018. Uber Eats’ adjusted revenue went from just US$17 million in 2016 to US$757 million in 2018.

Uber is still growing fast. Its total revenue for the first nine months of 2019 increased by 21% from a year ago.

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

So far we have seen that Uber ticks most of the right boxes. However, the last criterion is where Uber fails.

Uber has been unable to record a profit since its founding, and has also been burning cash at an alarming rate.

The company had operating cash outflow of US$2.9 billion, US$1.4 billion, and US$1.5 billion in 2016, 2017 and 2018 respectively. Worryingly, the cash burn has not slowed down. In the first nine months of 2019, Uber had a net cash burn of US$2.5 billion from operations.

One of the causes of Uber’s inability to generate profits or cash from operations is its relatively low gross margin of 50% for a tech service company.

Uber’s gross profit margin is low partly due to heavy insurance expenses required to operate its ride-sharing platform. This leaves the company with little room to spend on marketing expenses.

In addition, the potential for price wars could further squeeze Uber’s gross margins in the future. It remains to be seen when or if the company can eventually turn a profit and start generating cash consistently.

Other risks

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

Besides the risk of competition driving down its profit margins, Uber also faces regulatory risk. Uber’s ride-sharing operations have already been blocked, capped, or suspended in certain jurisdictions, including Argentina, Japan, and London. These restrictions may prevent Uber from entering and growing into other markets, significantly reducing its total addressable market size.

Uber is also investing heavily in autonomous vehicles and Uber Elevate. Both these initiatives require a lot of money and have widened the company’s losses and cash burn rate. In the first nine months of 2019, Uber spent a whopping US$4.2 billion on research and development, which is more than 40% of its revenue. There is a chance that these investments may not pay off in the end. 

Uber’s cash burn rate of more than US$1 billion a year is also worth watching. At this point in time, Uber’s strong balance sheet allows it to spend cash without overstretching its books. However, if the cash burn rate continues for an extended period, Uber may end up needing to raise more cash through an equity or bond issue that could potentially dilute shareholders.

UberEats also faces competition from startups such as GrubHub, Door Dash and Deliveroo. UberEats has been the biggest drag to the company’s profitability in recent quarters and a price war against these other food-delivery competitors could widen its losses.

The Good Investors’ Conclusion

There are certainly some reasons to be impressed by Uber. The ride-sharing giant has a long runway ahead of it and has set its sights on autonomous vehicles and air transportation. And with the move towards a car-lite society, ride-sharing will likely become increasingly more prominent.

However, there are also many uncertainties surrounding the company at this time. Ridesharing is effectively a commodity-like service and the presence of other big-name competitors such as Lyft may result in expensive price wars.

Another concern is Uber’s alarming cash burn rate and low gross profit margins. 

Valuation-wise, Uber is also not necessarily cheap. At its current market cap of US$57.8 billion, it trades at around four times its annualised adjusted net revenue for 2019. That’s not cheap, especially for a company that has failed to consistently generate positive cash flow from operations and is unlikely to post operating profits anytime soon.

As such, despite Uber’s growth potential, the uncertainties surrounding Uber’s road to profitability, its ability to generate free cash flow, and the potentially painful price wars, make me think that Uber is still too risky an investment for my liking.

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.

Intuitive Surgical (NASDAQ: ISRG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Intuitive Surgical shares for the portfolio in September 2016 at a price of US$237 and then again in April 2017 at US$255. I’ve not sold any of the shares I’ve bought.

The purchases have performed very well for my family’s portfolio, with Intuitive Surgical’s share price being around US$593 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 Intuitive Surgical shares. 

Company description

In recent years, there have been news articles on the da Vinci robotic surgical systems being used in some of Singapore’s major hospitals. The da Vinci systems are the handiwork of the US-based Intuitive Surgical.

Founded in 1995, Intuitive Surgical is a pioneer in robotic surgical systems. Today, the company primarily manufactures and sells its da Vinci family of robot systems and related instruments and accessories. The robots are used by surgeons around the world to perform minimally invasive surgical procedures across a variety of surgical disciplines, including general surgery, urology, gynecology, thoracic, and trans-oral surgery.

The da Vinci system, which costs between US$500,000 and US$2.5 million each depending on the model and geography, acts as an extension of a surgeon’s hands – surgeons operate the system through a console that is situated near a robot. But it is more than just an extension. The da Vinci system is tremor free, has a range of motion analogous to the human wrist, and has the ability to move at smaller length-scales with greater precision.

The US is currently Intuitive Surgical’s largest geographical market, accounting for 71% of the company’s US$3.2 billion in total revenue in the first nine months of 2019. 

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 Intuitive Surgical.

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

Intuitive Surgical is a great example of a company with revenue that is large in a fast-growing market. In 2018, the company’s revenue was US$3.7 billion, which accounted for a significant share of the global surgical robot market;  according to Mordor Intelligence, the market was US$4.1 billion then. Mordor Intelligence also expects the market to compound at nearly 22% per year between 2019 and 2024.

I believe the projection for high growth in the global robotic surgical market is sound for two key reasons.

Firstly, minimally invasive surgeries lead to better patient outcomes as compared to open surgery, such as lesser pain, faster post-surgery recovery, and lesser scarring. The da Vinci system is used to perform minimally invasive surgeries. Furthermore, the system “combines the benefits of minimally invasive surgery for patients with the ease of use, precision, and dexterity of open surgery.” I think these traits are likely to lead to long-term growth in demand for surgical robot systems from both patients and surgeon. As of 2018, there were over 18,000 peer-reviewed medical research papers published on Intuitive Surgical’s robotic surgery systems.

Secondly, just 2% of surgeries worldwide are conducted with robots today, according to medical device company Medtronic. Even in the US, which is Intuitive Surgical’s main market, only 10% of surgical procedures are performed with robots currently. These data suggest that robots have yet to make their way into the vast majority of surgical theatres across the globe.

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

Intuitive Surgical has a formidable balance sheet, with US$5.4 billion in cash, short-term investments, and long-term investments against zero debt (as of 30 September 2019).

Another big plus-point is that the company has been stellar at producing free cash flow over the years. I’ll discuss this soon.

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

On integrity

Intuitive Surgical is led by CEO Gary Guthart, Ph.D., who is currently 53. In 2018, his total compensation was US$6.4 million, which is less than 1% of the company’s profit of US$1.1 billion in the same year. There are two other big positives about the compensation structure for Guthart and the other key leaders of Intuitive Surgical.

Firstly, the majority – 75% – of Guthart’s total compensation in 2018 came from restricted stock units (RSUs) and stock options that vest over periods of 3.5 years to 4 years. It’s a similar story with other members of Intuitive Surgical’s senior management team – 78% of their total compensation in 2018 was directly tied to the long-term growth in the company’s share price through the use of RSUs and stock options that vest over multi-year periods. I typically frown upon compensation plans that are linked to a company’s stock price. But in the case of Intuitive Surgical, the compensation for its key leaders is tethered to multi-year changes in its stock price, which in turn is driven by the company’s business performance. So I think this aligns my interests as an Intuitive Surgical shareholder with the company’s leaders.

Staying on the topic of alignment of interests, I think it’s also worth pointing out that as of 31 December 2018, Guthart directly controlled nearly 339,000 Intuitive Surgical shares (not counting options that he could exercise shortly after end-2018) that are worth around US$200 million at the company’s current stock price. This is a large ownership stake that likely also puts Guthart in the same boat as other Intuitive Surgical shareholders.

Secondly, the chart below shows that the growth in Guthart’s total compensation from 2014 to 2018 has closely tracked the changes in Intuitive Surgical’s stock price over the same period.

On capability and innovation

Over the years, Intuitive Surgical’s management has done a tremendous job in growing the installed base of the da Vinci systems as well as the number of surgical procedures that have been conducted with the systems. These are two very important numbers for me when assessing the level of demand for Intuitive Surgical’s robots.

Management has also been innovative in expanding the range of surgical procedures that Intuitive Surgical’s systems can reach – see the chart below for how quickly the number of the company’s general surgery procedures around the world has expanded from 2012 to 2018 even as growth in gynecology and urology procedures have decelerated.

Staying with the theme of innovation, Intuitive Surgical has already commercialised four generations of its da Vinci family of surgical robots, so it has a strong history of improving its flagship product. There are also some interesting developments in the pipeline:

• Intuitive Surgical is in the first phase of the rollout of the da Vinci Sp system. The new system is already used in urology, gynecology, general, and head and neck surgical procedures in South Korea. But it was only cleared by US regulators in recent months for use in urologic and transoral surgical cases in the country. At the end of 2019’s third quarter, the total installed base of the da Vinci Sp was just 38. Intuitive Surgical’s management also said in the quarter’s earnings conference call that “customer response and early clinical results using Sp remain encouraging.”
• The Ion platform, Intuitive Surgical’s flexible robotics system for performing lung biopsies to detect and diagnose lung cancers, received 510(k) FDA (Food & Drug Administrattion) clearance in the US in 2019’s first quarter. “Hundreds” of procedures have been performed with the Ion platform as of 2019’s third quarter, and the initial rollout has met management’s expectations and received “strong” user feedback. Lung cancer is one of the most common forms of cancer in the world. If the Ion platform is successful, it could open a previously untapped market for Intuitive Surgical. 
• The company recently acquired an existing supplier of 3D robotic endoscopes, Schölly Fiberoptic. The acquisition boosts Intuitive Surgical’s capabilities in the areas of imaging manufacturing, design, and processing, which are important for surgeries of the future, according to the company’s management.
• Intuitive Surgical received 510(k) FDA clearance for its Iris product in 2019’s first quarter too. Iris is the company’s augmented reality software which allows 3D pre-operative images to be naturally displayed in a surgeon’s da Vinci console for use in real-time during an actual surgery.
• As recently as October 2019, Intuitive Surgical was looking to hire software engineers who have skills in artificial intelligence for its imaging and intelligence group. I see this as a sign that the company is working with AI to improve its product features. 

I think we should note that Guthart joined Intuitive Surgical in 1996 and became COO (Chief Operating Officer) in 2006. In 2010, he became CEO. In other words, much of Intuitive Surgical’s excellent track record in growing its installed base and procedure-count that I mentioned earlier had occurred under Guthart’s watch.

Many of Intuitive Surgical’s other key leaders have also been with the company for years and I appreciate their long tenures. Some last words from me on Intuitive Surgical’s management: It’s a positive sign for me on the company’s culture to see it promote from within, as has happened with many of the C-suite roles, including Guthart’s case.

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

You may be surprised to know that the one-time sale of robotic surgical systems accounts for only a small portion of Intuitive Surgical’s revenue despite their high price tag – just 29% of total revenue of US$3.2 billion in the first nine months of 2019 came from systems sales.

That’s because the robots bring with them recurring revenues through a classic razor-and-blades business model. Each surgery using the da Vinci robot results in US$700 to US$3,500 in sales of surgical instruments and accessories for Intuitive Surgical. Moreover, the robots also each generate between US$80,000 and US$190,000 in annual maintenance revenue for the company. The table below shows the breakdown of Intuitive Surgical’s revenue in the first nine months of 2019 according to recurring and non-recurring sources:

There is also an important and positive development at Intuitive Surgical in recent years: The proportion of the company’s robots that are sold on leases has been increasing. For 2019’s third quarter, 33.5% of new system placements by Intuitive Surgical were based on operating leases that include usage-based models, up from 25.1% a year ago. For more context, operating lease revenue at Intuitive Surgical has more than tripled from US$16.6 million in 2016 to US$51.4 million in 2018, and more than doubled from US$35.0 million in the first nine months of 2018 to US$72.9 million in the first nine months of 2019.

Intuitive Surgical’s management believes that providing leasing – an alternative to outright purchases of the da Vinci systems – accelerates market adoption of the company’s surgical robots by lowering the initial capital outlay for customers. I agree, and I think the introduction of leasing – which started in 2013 – is another sign of management’s capability.

Leasing also boosts recurring revenue for Intuitive Surgical, leading to more stable financial results. If leasing revenue was included, 73% of Intuitive Surgical’s total revenue in the first nine months of 2019 was recurring in nature.

5. A proven ability to grow

The aforementioned growth in the adoption of da Vinci robots by surgeons over time has led to a healthy financial picture for Intuitive Surgical. The table below the company’s important financial figures from 2006 to 2018:

A few key points about Intuitive Surgical’s financials:

• Revenue has compounded impressively at 21% per year from 2006 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower, at just 10.5%. But growth has picked up in more recent years, coming in at 15.9% in 2017, 18.7% in 2018, and 19.5% in the first nine months of 2019.
• The company also managed to produce strong revenue growth of 45.6% in 2008 and 20.3% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Recurring revenue (excluding leasing) grew in each year from 2006 to 2018, and had climbed from 44.8% of total revenue in 2006 to 70% in 2018. As I mentioned earlier, recurring revenue (again excluding leasing revenue) was 71% in the first nine months of 2019.
• Net profit has jumped by nearly 26% per year from 2006 to 2018. Although growth has slowed to ‘merely’ 10.9% over the past five years (2013 to 2018), it has accelerated in the first nine months of 2019 with a 22% jump.
• Operating cash flow has increased markedly from 2006 to 2018, with annual growth of 22.8%. The growth rate from 2013 to 2018 was considerably slower at just 6%, but things appear to be picking up again: Operating cash flow was up by 25.7% in the first nine months of 2019. 
• Free cash flow, net of acquisitions, has consistently been positive and has also stepped up significantly from 2006 to 2018. The growth in free cash flow has grounded to a halt in recent years, but I’m not worried. The absolute amount of free cash flow is still robust, and in the first nine months of 2019, free cash flow was up 14.2% from a year ago to US$730.1 million. 
• The net-cash position on the balance sheet was positive in every year from 2006 to 2018, and has also increased significantly. In fact, Intuitive Surgical has consistently had zero debt. 
• Dilution has also been negligible for Intuitive Surgical’s shareholders from 2006 to 2018 with the diluted share count barely rising in that period. It’s the same story in the first nine months of 2019, with the diluted share count inching up by just 0.6% from a year ago.

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 Intuitive Surgical excels in this criterion.

Firstly, 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) was in a healthy range of 19.7% to 38.2% from 2006 to 2018, and it came in at 22.8% in the first nine months of 2019.

Secondly, there’s still tremendous room to grow for Intuitive Surgical. This should lead to a higher installed base of surgical robots for the company over time. It’s also reasonable to assume that the utilisation of the robots (procedures performed per installed robot) will climb steadily in the years ahead; it has increased in every year from 2007 to 2018, as shown earlier. These assumptions mean that Intuitive Surgical should see robust growth in its recurring revenues (instruments & accessories; services; and leasing) – and the company’s recurring revenue streams likely come with high margins.

Valuation

I like to keep things simple in the valuation process. Since Intuitive Surgical has a long history of producing solid and growing streams of profit and free cash flow, I think both the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value.

Intuitive Surgical’s valuation ratios at its current share price may give you sticker shock: The P/E ratio is around 54 while the P/FCF ratio is around 70. The chart below illustrates the two ratios (purple for the P/E ratio and orange for the P/FCF ratio) over the past five years, and they are clearly near five-year highs.

But Intuitive Surgical’s high levels of recurring revenue also lead to relatively predictable streams of earnings and cash flows, something which I think is very valuable. This, along with the company’s excellent track record and huge growth opportunities ahead, justifies its premium valuation, in my view.

I think it’s worth noting too that Intuitive Surgical has, in my eyes, built a strong competitive position because of its first-mover advantage in the surgical robot market. Hospitals and doctors need to invest time and resources in order to use the da Vinci robots. The more da Vinci systems that are installed in hospitals, the harder it is for competitors to unseat Intuitive Surgical – so it’s good to know that there are more than 5,000 da Vinci systems installed worldwide today.

The risks involved

There are two key risks with Intuitive Surgical that I’m watching.

The first is any future changes in healthcare regulations. Intuitive Surgical’s revenue-growth slowed dramatically in 2013 (up just 4%, compared to a 24% increase in 2012); revenue even declined in 2014. Back then, uncertainties related to the Affordable Care Act (ACA) – the US’s national health insurance scheme set up by then-US president Barack Obama – caused hospitals in the US to pull back spending.

Current US president, Donald Trump, made changes to the ACA as early as 2017. Trump’s meddling with the ACA has so far not dented Intuitive Surgical’s growth. But if healthcare regulations in the US and other countries Intuitive Surgical is active in (such as Germany, China, Japan, and South Korea) were to change in the future, the company’s business could be hurt.

The second key risk is competition. Intuitive Surgical name-dropped 16 competitors in its latest 2018 annual report, including corporate heavyweights with deep pockets such as Johnson & Johnson and Samsung Corporation. Although Intuitive Surgical is currently the runaway leader in the field of robotic surgery systems, there’s always a risk that someone else could come up with a more advanced and more cost-effective surgical robot.

Medtronic, one of the competitors named by Intuitive Surgical, will be launching its own suite of surgical robots in the near future – the company earned nearly US$31 billion in revenue over the last 12 months. Meanwhile, Johnson & Johnson has been busy in this space. It acquired Auris Healthcare (another of Intuitive Surgical’s named competitors) in 2019  for at least US$3.4 billion, and recently announced the full acquisition of Verb Surgical (yet another named competitor of Intuitive Surgical). Verb Surgical was previously a joint venture between Johnson & Johnson and Alphabet, the parent company of Google.

I mentioned earlier that Intuitive Surgical has already carved out a strong competitive position for itself, so I’m not worried about the competition heating up. Moreover, I think the real battle is not between Intuitive Surgical and other makers of robotic surgical systems. Instead, it is between robotic surgery and traditional forms of surgery. As I had already mentioned, only 2% of surgeries worldwide are conducted with robots today, so there’s likely plenty of room for more than one winner among makers of surgical robots. Nonetheless, I’ll still be keeping an eye on competitive forces in Intuitive Surgical’s market – I’ll be worried if I see a prolonged deceleration in growth or decline in the number of surgical procedures that the da Vinci robots are used in.

It’s worth noting too that Intuitive Surgical is not sitting still in the face of upcoming competition. At the end of 2018, the company had over 3,000 patents and 2,000 patent applications around the world, up from over 1,300 and 1,100, respectively, in 2012.

The Good Investors’ conclusion

Intuitive Surgical shines when seen through the lens of my investment framework: 

• It is a leader in the fast-growing surgical robot market.
• Its balance sheet is debt-free and has billions in cash and investments.
• The management team is sensibly incentivised. They also have excellent track records in innovation and growing the key business metrics of the company (such as the installed base of the da Vinci robots and the number of procedures conducted with the robots).
• The company has an attractive razor-and-blades business model that generates high levels of recurring revenues with strong profit margins.
• Intuitive Surgical has a robust long-term history of growth – its revenue, profit, and free cash flow even managed to soar during the Great Financial Crisis.
• It has historically been adept at generating free cash flow, and likely can continue doing so in the years ahead.

Intuitive Surgical carries pricey P/E and P/FCF ratios right now, but I think the high valuations currently could prove to be short-term expensive but long-term cheap. Firstly, the company’s recurring revenues provide a stability to the business that I think the market values. Secondly, there are significant growth opportunities for the company.

There are important risks to watch, as it is with any other investment. In Intuitive Surgical’s case, the key risks for me are future changes in healthcare regulations and an increasingly competitive business landscape.

In all, after weighing the risks and potential rewards, I’m happy to have Intuitive Surgical shares continue to 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.