Category: Investing Analysis

The term, multi-baggers, when applied to the stock market, was coined by legendary investor Peter Lynch in his book One up on Wall Street. 

It refers to a stock that delivers more than a 100% return on our investment. Seasoned investors will tell you that just having a few multi-baggers in your portfolio can make a world of a difference.

Imagine if you had used just 1% of your portfolio to buy Netflix in 2007 at US$2.57 per share. You’d have a 163-bagger in your portfolio today. That 1% position will now be worth 163% of your initial portfolio. Even if the other 99% of your portfolio went to zero, you’d still be sitting on a positive return.

But how do we unearth such long-term winners? Here are some things that I consider when looking at which stocks can be multi-baggers over the next few years.

Potential market opportunity

The amount of revenue that a company can earn in the future is a key factor in how valuable the company will be worth.

As an investor, I’m not focused on quarterly results or what percentage year-on-year growth a company achieves in the short-term. Instead, I’m more focused on the total addressable market and how much the company could make a few years out.

Let’s take Guardant Health as an example. The company is one of the leading liquid biopsy companies. It has non-invasive tests to identify cancers with specific biomarkers for more targeted therapy. In addition, the company is developing non-invasive tests that could detect early-stage cancer, which has a market opportunity of more than US$30 billion a year. Together with its late-stage precision oncology test, Guardant Health has a market opportunity of more than US$40 billion in the US alone.

Guardant Health is still in its infancy with just US$245 million in revenue in the last 12 months. If its early-stage cancer tests gain FDA approval and is adopted by insurance companies, Guardant Health could easily increase its sales multiple folds.

Clear path to profitability

Besides increasing revenue, companies need to generate profits and cash flow too. As such, investors need to look at free cash flow and profit margins.

For fast-growing companies that are not yet profitable, I tend to look at gross margins. A company that has high gross margins will be more likely to earn a profit during its mature state.

Using Guardant Health as an example again, the liquid biopsy front-runner boasts 65% gross margins on its precision oncology testing. Such high margins mean that the company can easily turn a profit with sufficient scale as other costs decrease as a percentage of sales.

An enduring moat

To fulfil its potential, the company needs to be able to fend off its competition. A moat can come in the form of a network effect, a superior product, a patent or other competitive edges that a company may have over its competitors.

On a side note, I don’t consider first-mover advantage a moat unless it operates in an industry where a network effect is a valuable moat.

In Guardant Health’s case, the company’s tests are protected by patents, which prevents other companies from copying their products. 

Management that can execute

Potential is one thing, but can the company execute its plans? This is where management is important. The company’s CEO needs to have a clear vision and execution plan. 

Management is a touchy subject and requires a lot of subjective analysis. My blogging partner, Ser Jing, wrote an insightful article recently on how we can assess the quality of management.

Comparing current market cap with the potential market cap

Finally, after identifying a company that has a high probability of growing sales and profits multiple folds, we need to assess if its current market cap has room to grow into a multi-bagger.

It’s no use buying into a company that has all its future earnings baked into its market value.

If Guardant Health can increase its sales to just 20% of the US$40 billion addressable market in the US alone, and generate a 25% profit margin, it will earn US$2 billion in profit annually.

Assuming the market is willing to give it a price-to-earnings multiple of 30, that translates to a US$60 billion market cap.

At the time of writing, Guardant Health’s market cap is around US$8.3 billion. If Guardant Health can execute its growth strategy well over the next 5 to 10 years, it can become a multi-bagger.

Final words

Multibaggers can be the difference between a market-beating portfolio and an average one.

However, finding a multi-bagger is not easy. The company needs to tick many boxes. And even so, there is always the risk that the company does not fulfil its potential. In Guardant Health’s case, biopharmaceutical companies have to jump through many hoops to earn the honey pot at the end of the rainbow.

For the liquid biopsy market, Guardant Health needs its early-stage cancer test clinical trials to (1) meet its primary end goals, (2) gain regulatory approval, (3) earn trust from insurance companies and finally ,(4) be adopted by clinicians. These hurdles will not simply fall over and there are risks that the company will fall flat in any one of these.

As investors, we therefore, need to consider the risk-return profile of a company before deciding if the it makes sense for our 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.

I’ve made my share of mistakes while investing that ended up as expensive lessons.

In this article, I share one particularly painful mistake and three lessons that I took from it.

What happened?

In October 2015, I bought shares of Chipotle Mexican Grill Inc (NYSE: CMG). At that time, Chipotle’s share price had fallen 25% from its peak following a Salmonella outbreak at one of its outlets. As such, I managed to pick up shares at US$564 per share, compared to the previous high of US$749.

I had been eyeing Chipotle for some time and thought that it was a great opportunity to buy shares.

Chipotle was a fast-growing fast-casual restaurant chain in the US that still had a huge market opportunity to expand into. Its food – Mexican fare- were popular and its comparable sales stores were consistently in the mid-to-high single digits or higher. The company was ambitiously expanding its store footprint in North America. I also thought the decline in its share price was unwarranted and that its sales would not be that greatly impacted due to an isolated food-safety incident.

Unfortunately, Chipotle suffered a few more setbacks shortly after I bought my shares. The company reported another four separate E- Coli and norovirus outbreaks at its restaurants.

The news spread across the country and customers started being cautious about going to Chipotle.

A challenging period for Chipotle and selling my shares

What I thought was going to be a mild bump on the road for Chipotle, ended up being an extended period of depressed sales. The effects of negative publicity hurt Chipotle’s bottom line hard. Chipotle reported its first quarterly loss as a public-listed company in the first quarter of 2016.

Same-store sales declined 30% from a year ago. Marketing campaigns to get customers back in stores were not cheap either.

Stores that once had long queues were now empty and Chipotle had to resort to country-wide marketing campaigns and offering 1-for-1 burrito deals to bring customers back. The efforts had minimal impact and I was getting worried that customers will not come back.

Unsurprisingly, investors were getting nervous too. Chipotle’s share price fell from the price I bought to a low of US$370 in mid-2016. 

Chipotle’s share price eventually climbed to US$483 in May 2017 and I took the opportunity to sell my shares. At that time, Chipotle’s shares – despite having a price 15% lower than my purchase – still seemed too expensive for me. Chipotle’s shares traded at 48 times forward earnings (due to the depressed earnings at that time) and I lost confidence in the company’s growth prospects.

A turn of fortunes

This is not a story of me buying a company that ended up a poor investment. It actually is a tale about me not giving my investment time to fulfill its potential. 

I knew from the get-go that Chipotle was well-loved by customers. An American friend of mine who was living in Europe at that time constantly told me the thing he missed most about the US was Chipotle.

Chipotle was a brand that was loved – and its customers would eventually come back. After a change in CEO in March 2018, Chipotle’s fortunes changed dramatically. Its marketing efforts started to pay dividends. The company grew its online sales channels, and drive-throughs fueled an increase in sales.

Same-store sales improved. In the fourth quarter of 2019, Chipotle’s same-store sales increased by 13.4%, a third consecutive quarter of double-digit growth. 

You can probably guess what has happened to its share price. Chipotle’s shares today trade at around US$1,050 apiece, more than double the price I sold my shares at.

Lessons learnt

Although I technically lost only 15% of my investment in Chipotle, I had in fact missed out on a near-100% gain by selling early. That’s an extremely expensive mistake, especially when I consider that I would have been much better off doing nothing, rather than actively trying to manage my portfolio.

From this experience, I took away three important lessons.

Lesson 1: Companies with great products are more resilient

Customers love Chipotle. That’s an important reason why Chipotle was well-placed to recover from the bad press after the food-safety outbreaks at its restaurants. In addition, Chipotle was determined to improve its food safety and the steps taken also regained customer confidence. 

Lesson 2: Give companies time to prove their worth

I held Chipotle’s shares for a mere one-and-a-half years. That’s not enough time to allow a company to prove itself. I should have been more patient and given management more time to turn the company around. Given that Chipotle was a brand that customers loved, it was only a matter of time before queues started returning. 

A well-known Warren Buffett quote comes to mind: “Time is the friend of the wonderful company, the enemy of the mediocre.”

Lesson 3: Forget about quarterly results- think long term

Wall Street’s focus on quarterly results can lead to wild gyrations in the stock prices of companies. This miss by a penny, beat by a penny compulsion can lead to a significant price-value mismatch between a company’s long term value and its share price.

Clearly, my decision to sell Chipotle’s shares was because I was focused on the company reporting negative same-store sales growth over a year, rather than looking much further into the future.

Final thoughts

“The trick is, when there is nothing to do, do nothing.”

Warren Buffett

It is often tempting to actively manage our portfolios. But moving in and out of stocks due to short-term gyrations in price and earnings is a fool’s game. It is not only time-consuming, but may also end up as expensive mistakes. I certainly learnt that the hard way with Chipotle.

I hope that by sharing some of the lessons I learnt from this mistake, other investors will not fall victim to the same expensive mistake that I made.

My blogging partner, Ser Jing, also wrote a great article about why he owns Chipotle shares. His fortunes with this company were very different from mine. You can head here to find out why he still owns shares in Chipotle.

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.

Square Inc (NYSE: SQ) is a fintech company that provides seller tools, financing for small businesses, and peer-to-peer payments for individuals.

It started life as a company that enabled small businesses to accept card payments with a mobile phone and an attached square “scanning device”. Since then, Square has widened its offering to sellers, and launched Cash App, a mobile payment service that allows individuals to transfer money to each other using just their phone.

Square has been one of the darlings of the US stock market, with its share price up around six-fold since the first day it went public in late 2015. The strong adoption of Square’s POS (point-of-sales) system and Cash App’s surging popularity have led to that strong stock performance.

But I think there is still more to come from this fast-growing Fintech firm.

Huge market opportunity for payment growth

As with other payment solutions, Square takes a cut of every dollar transacted using Square’s software. 

The more payments Square processes, the more it earns. In 2019, despite a 25% increase in transaction-based revenue growth, Square still accounted for only a small fraction of the total gross payment volume (GPV) in the US. In 2019, Square’s GPV was US$106.2 billion, compared to total US gross sales of more than US$10 trillion.

Square started off as a payment tool for small businesses but has since begun targeting larger businesses, which provides a much larger market opportunity.

Square has done quite well in reaching out to larger businesses. In the first quarter of 2020, percentage of GPV from larger sellers (more than US$125k in GPV) increased to 52%, up from 47% and 51% in the same quarter in 2018 and 2019, respectively.

Cash App growing in popularity

Square launched Cash App in 2013 to compete with peer-to-peer payment services and e-wallets such as Paypal’s Venmo.

Since then, Cash App’s popularity has exploded and has been one of the key drivers of growth for Square. The beauty of payment solutions is that the bigger the network, the more value the system holds for users. Cash App’s growing popularity will be a virtuous cycle for more users and transactions in the future.

The Covid-19 pandemic has also led to an increased adoption for Cash App services. Users now use Cash App as a tool to send funds for fundraising, donations, and to reimburse one another for supplies during this period of social distancing.

Square disclosed that Cash App’s gross profit skyrocketed 115% year-over-year in the first quarter of 2020.

That’s a continuation of a longer-running trend. The charts below show the growth in Cash App’s monthly active users.

In addition, Square has been able to increase the monetisation rate of each active customer it has on its platform.

Cash App is currently available in the US and the UK. However, it was only in March that Cash App allowed cross-border payments, further increasing the value proposition that Cash App brings to the table.

Cash App started small, but has since grown astronomically and now accounts for close to 40% of Square’s total net revenue.

Product-focused management

Square’s CEO and co-founder, Jack Dorsey, is one of the most respected entrepreneurs today. He is also known as the visionary leader behind the popular products that his companies produce. Besides Square, Dorsey is also the co-founder and CEO of the social media platform, Twitter.

While some argue that Dorsey should focus his energy squarely (sorry) on one company, so far the results of Square have been extremely strong. And there is nothing to suggest that Dorsey is out of wits leading two companies at the same time. 

Square has also been successful in implementing new features into both its POS software and its Cash App. The increase in revenue and user growth are also testament to Square’s solid execution of its growth strategy.

Solid free cash flow and decent balance sheet

While Square is still reporting a GAAP loss, the company has turned free cash flow positive. The payment solutions provider generated US$101 million, US$234 million and US$403 million in free cash flow in 2017, 2018 and 2019 respectively.

In 2019, it recorded a free cash flow margin of 8%. For a company that is growing revenue fast, I expect its margins to improve in the future.

Square’s balance sheet also remains strong with US$2.5 billion in cash, cash equivalents, and short-term investments in debt securities, as of 31 March 2020. It only held US$1.8 billion in long-term debt, giving it good financial standing to continue to invest in growth.

Black marks?

However, Square is not perfect. Despite reporting strong free cash flow generation, Square’s only GAAP profit was in 2019. The company then returned to the red in the first quarter of 2020 as increase in expenses exceeded revenue growth.

One of the big reasons why the company has been reporting losses but generating cash is its heavy stock-based compensation. Stock-based compensation does not burn cash but it increases the number of outstanding shares and dilutes existing shareholders.

In Square’s case, stock-based compensation has resulted in an increase in the number of diluted shares from 341.6 million in 2016 to 466.1 million in 2019. The dilution has resulted in existing shareholders owning a smaller fraction of the company.

It is normal for fast-growing tech companies to pay out a large chunk of its compensation in shares. That said, Square’s revenue has increased at a faster rate than its stock-based compensation which is a good sign. But the company’s stock-based compensation is still something I’m watching.

In addition, Square also sports an expensive-looking valuation to me. As of the time of writing (20 May 2020), Square had a market cap of US$34.8 billion. That translates to around nine times trailing sales and more than 90 times free cash flow, assuming a 10% free cash flow margin.

I think that Square can justify such a high valuation, but it needs to execute its growth strategy perfectly and any hiccups could see a valuation compression in the stock.

Final words

There are risks, as I mentioned earlier. But there is also much to admire about Square. From a company with ambitions to help small businesses accept credit card payments, Square has grown to a company that offers a wide range of fintech services and now serves individuals through its Cash App.

The company boasts a strong track record of growth, has an innovative leader who is willing to invest in new products, and a balance sheet that is flushed with cash. All of which puts it in a strong position to ride on the tailwinds of the expanding payments ecosystem.

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.

Last week, Singapore Airlines (SGX: C6L) announced a sobering set of results for the quarter ended 31 March 2020. SIA’s latest earnings showed an operating loss of S$803 million on the back of a 21.9% fall in revenue.

I’ve got to say, though, that these figures were not unexpected. Earlier this year, SIA announced that it had grounded more than 90% of its passenger fleet as the COVID-19 pandemic effectively halted most passenger air travel around the world. 

To prepare for the sudden drop in revenue, the airline also announced that it was raising up to S$15 billion from existing shareholders. The timely injection of cash will save the company from insolvency but shareholders will still have to endure a tough few quarters ahead.

Government support cushioned the blow

Things could have been much worse had the Singapore government not stepped in to support the aviation industry. Under the jobs support scheme, the government co-funds 75% of the first S$4,600 of wages paid to each local employee for 9 months. SIA was one of the beneficiaries of this scheme.

Through the scheme, its employee expenses for the quarter were lower by 62% to S$273 million. However, this was not enough to save the company from reporting a loss for the quarter.

Part of the reason was that SIA reported a large mark-to-market loss from surplus hedges that arose due to the recent sharp fall in oil prices. This reversed most of the cost savings that SIA got from government support, capacity cuts, and other cost-savings measures. In addition, despite a fall in activity, SIA still has a lot of fixed costs, and recorded high depreciation and aircraft maintenance expenses of S$798 million.

How does the loss impact shareholders

The huge bottom-line deficit resulted in a sharp decline in the company’s book value per share. The book value per share fell from S$10.25 on 31 December 2019 to S$7.86 as of 31 March 2020.

That’s a 24% drop in just three months. In addition, the 3-for-2 rights issue at S$3 per rights share will further dilute the company’s book value per share.

Based on my calculation, and excluding further losses in coming quarters, the dilution will cause SIA’s book value per share to drop to around S$5. 

A difficult path ahead

Unfortunately for SIA shareholders, the path ahead is uncertain. In its press release, management said:

“There is no visibility on the timing or trajectory of the recovery at this point, however, as there are a few signs of an abatement in the Covid-19 pandemic. The group will maintain minimum flight connectivity within its network during this period while ensuring the flexibility to scale up capacity if there is an uptick in demand.”

In addition, management highlighted that there could be more fuel hedging losses due to weak near term demand. With half of the second quarter of 2020 over, and SIA still grounding most of its planes, I think that the next reporting quarter could be even worse than the last.

More worryingly, with no end in sight, SIA could see poor results up to the end of 2020 and beyond.

The worse is not over for the airline and I expect revenue to be much lower in the second quarter of 202,0 and losses to exceed the S$803 million recorded in the first quarter. Given this, diluted book value per share could even fall to the mid-S$4 range (or worse) after the losses are accounted for next quarter. 

Final thoughts

The aviation industry is one of the most badly-hit sectors from the COVID-19 pandemic. Warren Buffett announced earlier this month that he sold all his airlines stock after admitting he did not factor in the risk that airlines faced. Their low-profit margins and capital intensive nature made them highly susceptible to cash flow problems should disaster strike.

SIA has certainly not been spared. 

The only comfort that shareholders can take is that, with Temasek promising to buy up all of the company’s non-exercised rights, SIA will have sufficient capital to see it through this difficult period. But even so, the airline looks likely to suffer more losses and book value per share declines. Given all this, shareholders are unlikely to see its share price return to its former glory any time soon.

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.

Pushpay Holdings (ASX:PPH) may not be a company that rings a bell with many investors but it certainly warrants some attention. 

The little-known software-as-a-service (SaaS) company, which is dual-listed in Australia and New Zealand’s stock markets, has seen its share price rise by around 300% since 2016. That’s a really strong performance.

In this article, I use my blogging partner Ser Jing’s six-point investment framework to assess if Pushpay has the makings of a good investment.

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

Pushpay operates in an extremely niche market.

It provides churches and non-profit organisations with the tools to create an app to engage their communities. Customers use Pushpay to customise the design and feel of their app-interface. Customers can also communicate with their community members through the app by posting videos, audios and notifications.

Through the app, community members can make donations too. In addition, customers can access donor data, allowing church leaders to take effective next steps for better engagement with donors.

The growing popularity of Pushpay’s app service has been evident with customer numbers increasing steadily since its iOS launch in 2012. As of 31 March 2020, Pushpay boasts 10,896 customers.

Pushpay has two revenue streams: (1) Subscription revenue for its services; and (2) processing revenue, which consists of volume fees based on a percentage of the total dollar value of payments processed.

Despite operating in a niche market, Pushpay actually has quite a large addressable market opportunity. Chris Heaslip is the co-founder and ex-CEO of Pushpay; he stepped down from the CEO role in May 2019. In an interview with Craigs Investment Partners in late 2018, Heaslip said:

“Giving to churches alone is about $130 billion a year, which represents a TAM (total addressable market) of just under a couple of billion dollars. And as we continue to make good inroads in that market and expand our product functionality, we’ll look to expand into other verticals as well, such as the education or non-profit verticals which are about one and two billion dollars respectively of TAM opportunity, for about $5 billion in total.”

Pushpay’s latest annual report – for the year ended 31 March 2020 (FY2020) – mentioned that “Pushpay is targeting over 50% of the medium and large church segments [in the long term], an opportunity representing over US$1 billion in annual revenue.”

For FY2020, Pushpay processed just US$5 billion and earned a total operating revenue of US$130 million, which is still small compared to its total addressable market size.

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

Pushpay does not have the strongest balance sheet with a net debt position of US$48 million as of 31 March 2020. This is largely due to it spending US$87.5 million in FY2020 to acquire Church Community Builder, a church management system software provider.

That said, Pushpay has recently become cash flow positive and should be generating a good amount of cash in the future. In FY2020, Pushpay produced US$23.2 million in free cash flow, a marked improvement from the negative US$3.1 million seem in the prior year.

As the company continues to grow in scale, I foresee free cash flow growth in the years ahead (more on this later).

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

I think Pushpay’s executive team have so far demonstrated all of the above. The team has been extremely transparent about their goals and targets for years, and have set revenue and earnings guidance that they have been able to consistently meet or beat.

I appreciate management teams that set realistic guidance and can deliver on their targets, and so far Pushpay has done exactly that.

I believe Pushpay’s rapid growth is also a testament to management’s capability to expand the company, reach new customers, and increase the average revenue per customer.

Management has also been actively seeking to improve the company’s product. In 2019 alone, Pushpay launched numerous new functions on its app, including Donor Development, which delivers donor insights and streamlines reporting to organisation leaders.

Pushpay also launched Pushpay University in May 2019, It is an education website for Pushpay’s customers to “learn from leading experts in leadership, communication and technology, while also deepening their Pushpay product knowledge.”

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

Recurring revenue is a beautiful thing. It enables a company to focus its energy on expanding the business, knowing that it can rely on a stable source of revenue. It also means that the company can spend a bit more to acquire new customers due to the long lifetime value of its customers.

In FY2020, recurring subscription revenue made up 27.7% of Pushpay’s overall revenue. The rest was derived from commissions that the company earns for processing money that is donated through its app.

I see both sources of revenue as recurring in nature. Subscription revenue recurs as long as customers continue using Pushpay’s platform. Meanwhile, payment processing revenue recurs as long as donors keep making donations via the company’s platform; many donors tend to make repeat donations so payment processing revenue tends to recur. In FY2020, Pushpay’s total processing volume increased by 39% to US$5 billion, as the company likely increased its market share in the donor payment market.

Another metric that demonstrates the recurring nature of Pushpay’s revenue is the annual revenue retention rate. This measure the amount collected per customer compared to the previous year. This figure has consistently been north of 100%, suggesting that existing customers are paying Pushpay more each year as the amount of money they raise through the platform grows.

5. Does Pushpay have a proven ability to grow?

The SaaS company is growing quickly. The chart below illustrates its revenue growth from FY2015 to FY2020.

The growth has been driven both by an increase in the number of customers using the company’s platform, as well as the average revenue per customer.

Equally important, as Pushpay scales, more of that revenue can be filtered down to the bottom line and converted to cash flow.

The company reported its first net profit before tax in FY2020 as costs rose much slower than revenue. The relatively long customer lifespan that Pushpay has enables the company to spend more on customer acquisition, as it can reap the returns over a few years.

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

In FY2020, Pushpay demonstrated that with sufficient scale, it can turn a profit and generate free cash flow.

Previously, the company was in a high growth phase and spent a significant proportion of revenue on marketing. However, as the recurring revenue base grows, the amount spent on marketing decreases as a percentage of revenue and the young SaaS company can turn a profit and generate free cash flow.

In FY2020, Pushpay had a free cash flow margin of 17.8%, a very decent return for a company that is still growing strongly. 

Pushpay expects to earn between US$48 million and US$52 million in EBITDAF (earnings before interest, tax, depreciation, amortisation, and foreign exchange fluctuations) in FY2021. This represents 90% growth in EBITDAF from FY2020. As revenue and EBITDAF grows, we will naturally see free cash flow follow suit.

Given the large addressable market to grow into, I believe Pushpay’s free cash flow is likely to grow even faster than revenue as margins improve.

Risks

As a young SaaS company, Pushpay has a lot of potential. However, actually fulfiling that potential depends on the company’s execution. Therefore, execution risk is a major factor in its growth. The company’s ability to scale, attract and retain customers, and fend off competition, will be put to the test in the coming years.

Pushpay also spent a large chunk of cash to acquire Church Community Builder. The acquisition brought with it a ready set of new customers. However, it also stretched Pushpay’s balance sheet.

With growth a priority, management’s ability to put capital to use wisely will be crucial. Given that Pushpay has a very short history, I will monitor how management allocates its capital in the future. Poor allocation of capital could derail the company’s growth.

In addition, competition can be a major threat to Pushpay’s business. For now, Pushpay boasts a loyal set of customers who likely will find it tedious to switch apps. However, there is still a risk that other players may encroach into Pushpay’s territory.

Valuation

Valuation is perhaps the most tricky part of assessing a company. Pushpay is currently valued at around US$1.1 billion. That translates to around 70 times trailing earnings and 8.5 times sales.

On the surface that seems quite expensive. However, the company is growing its sales and profits fast. It also has a large opportunity to grow into. As mentioned by co-founder, Chris Heaslip, donors give around $130 billion to churches alone.

The currency for the $130 billion is unclear – it could be US dollars or New Zealand dollars. But either way, Pushpay’s revenue of US$130 million (NZ$216 million) is much lower than its addressable market size. Given its dominant position in its space, Pushpay can easily grow its market share.

The recent COVID-19 pandemic is also likely to accelerate the migration of donations from being made offline to online, with Pushpay the beneficiary of this trend. Indeed, Pushpay shared the following in its FY2020 annual report:

“Pushpay expects the increase in digital giving as a proportion of total giving resulting from COVID-19, to outweigh any potential fall in total giving to the US faith sector.”

The bottom line

Pushpay may not be the most recognisable SaaS company in the world, but it has got my attention. The company is revolutionalising the way churches interact with their communities.

Not only is it a great business financially, but it is also doing its part to help donors and campaigners raise funds for causes they believe in.

Despite some risks, I still think Pushpay’s risk-return profile looks really attractive right now.

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.

a2 Milk Company Ltd (ASX: A2M) is one of Australia’s best-performing stocks. If you had bought shares in 2015 after its listing in Australia’s market, you would be sitting on a gain of over 3,000%.

In this article, I’ll take a look at how the company got to where it is and what’s in store for the future.

A checkered past

a2 Milk Company may be one of Australia and NewZealand’s most successful business stories, but its journey has been anything but smooth.

a2 Milk Company is actually the successor of the much-maligned A2 Corporation, which was co-founded by scientist Dr Corran McLachlan. In 1994, McLachlan began his research on the effects of milk consumption and heart disease and concluded that there was a correlation between A1 beta-casein protein (found in milk) and ischaemic heart disease, childhood type 1 diabetes, and other ailments. 

Inspired by his research, McLachlan co-founded A2 Corporation in 2000. He used genetic testing to identify cows that produced milk that contained only A2 beta-casein protein.

However, Dr McLachlan’s research on the harmful effects of A1 beta-casein protein in milk was not widely accepted by scientists. They felt the findings were correlative, rather than causative. Even today, a lot of the research done on milk with A2 beta-casein protein is funded by a2 Milk Company and there is insufficient data to prove that A1 beta-casein protein predisposes consumers to these ailments.

Moreover, A2 Corporation ran into more significant problems along the way. In 2003, both Dr McLachlan and co-founder Howard Peterson passed away. The company was also facing financial difficulties. Just five months after it went public in May 2003, A2 Corporation had to go into administration in October and was liquidated in November.

A2 Corporation set up a new subsidiary to license and sell A2 milk in Australia. It sold a stake of that to Fraser and Neave and focused on expanding its international business. By 2006, A2 Corporation was able to buy back most of the stake it sold to Fraser and Neave and by 2011, A2 Corporation finally made a profit for the first time in its history.

It raised another $20 million through a secondary listing in New Zealand and used the funds to expand its business.

A2 Corporation changed its name to a2 Milk Company in April 2014 and has since seen remarkable growth (more on this later).

Catalysts that propelled its business

Although data about the harmful effects of A1 beta-casein protein in milk is still inconclusive, a2 Milk company enjoyed two key catalysts that saw a spike in demand for A2 beta-casein milk.

First, the publication of a book titled Devil in the Milk by Keith Woodford in 2007 caused a spike in A2 milk sales in New Zealand and Australia. Woodford discussed A1 beta-casein protein and the perceived health risks.

Next, the Chinese milk scandal in 2008, which resulted in six baby deaths and 54,000 hospitalisations, led to a spike in demand for infant milk formula from trusted Australian milk companies. a2 Milk Company was one of the beneficiaries from that scandal as its milk formula sales in China exploded.

Steady growth 

FY2011 (financial year ended 30 June 2011) was the turning point for the company. After turning a profit 11 years after its founding, a2 Milk Company was able to grow its revenue and profit steadily, leading to a significant jump in its share price.

Revenue has jumped 30-fold from NZ$42 million in FY2011 to NZ$1.3 billion in FY2019. Earnings per share increased by almost 100-fold from NZ$0.004 in FY2011 to NZ$0.39.  Crucially, that growth has been fairly consistent and has continued in recent times.

The charts below show a2 Milk Company’s revenue, EBITDA (earnings before interest, taxes, depreciation, and amortisation), and basic earnings per share over the last four financial years.

Strong sales momentum

Today, a2 Milk Company is more than just a liquid milk company. As mentioned earlier, the company has its own infant milk formula and other nutritional products, such as pregnancy and Manuka products.

All its three product segments saw significant growth in FY2019. Liquid milk sales increased 23% from NZ$142.4 million in FY2018 to NZ$174.9 million. Infant nutrition has grown to become the most important product segment; in FY2019, infant nutrition revenue was up 47% to NZ$1,063 million.

a2 Milk’s three key geographic markets- (a) Australia & New Zealand; (b) China & other Asian markets; and (c) the US – saw sales growth of 28.3%, 73.6%, and 160.7%, respectively, in FY2019.

Huge potential in China & Asia and the US

a2 Milk Company already has a strong presence in Australia and New Zealand with its a2 Milk brand of fresh milk achieving an 11.2% market share in its segment. Meanwhile, its infant formula brand, a2 Platinum, is the leading brand in its category.

So the main driver of the company’s growth should come from its less developed markets in the US, China, and other parts of Asia.

a2 Milk Company’s main product in China is infant milk formula (IMF). In FY2019, infant nutrition revenue from China and Asia was NZ$393.1 million. This is still a fraction of the NZ$652.9 million in revenue that the same business-line generated in the Australian and New Zealand market. Considering that Australia and New Zealand have a combined population that is about 2% the size of China’s, you can just imagine the huge addressable market in China that a2 Milk Company could grow into.

Investing in growth

To management’s credit, a2 Milk Company is investing prudently to unlock this vast potential in China. The company has increased its physical footprint. As of 31 December 2019 its products are now sold in 18,300 stores in China, up from 16,400 in June 2019.

There’s been a steady increase in the company’s distribution store count in China, which is partly fueling the increase in brand awareness and sales in the country.

The chart below shows the store count numbers from 2017:

a2 Milk Company’s China label IMF products has also grown from a mere 2% of the product-category’s total sales in FY2016 to 22% in the first half of FY2020. This suggests that the company’s investments in marketing in China is paying dividends in terms of brand recognition.

a2 Milk Company’s infant nutrition consumption share in China has also increased from 4.8% in June 2018 to 6.6% in December 2019. That’s still a small number, and there’s potential for the company to increase wallet share in China considerably in the future.

Growth in the US has also been steady, as revenue in the first half of FY2020 jumped 116% to NZ$28 million. Although the US still represents a small fragment of a2 Milk Company’s total sales, the size of the US market could result in it becoming a more important revenue contributor in the future.

Lots of cash…

Since 2011, a2 Milk Company has completely turned its business around. From a company that had to be liquidated back in 2004, a2 Milk Company now stands on solid ground, financially. 

It boasts NZ$618 million in cash and no debt (as of 31 December 2019). It also milked NZ$286 million in free cash flow in FY2019. Its capital-light business model, decent margins, and strong free cash flow should enable it to reward shareholders with buybacks and dividends in the future.

Final words

a2 Milk Company has certainly come a long way since its bumpy start in the early 2000s. Since 2011, the company has seen tremendous growth and is in a great position to capitalise on its strong brand in China. On top of that, the company boasts lots of cash on its balance sheet that can be reinvested into growing internationally. 

Although it is currently not paying a dividend, I believe it is in a great position to start rewarding shareholders in the near future.

a2 Milk Company does come with risks though. Its stock trades at a high valuation of around 46 times trailing earnings. There are also concerns about regulatory changes in China. International expansion also has an element of risk, and a2 Milk Company has had its own share of failures, including its inability to expand meaningfully in the UK. It ultimately ended up announcing the closure of its UK business in 2019.

Nevertheless, despite the risks and high valuation, I think a2 Milk Company still has a favourable risk-reward profile. Its huge market opportunity in China alone could provide a significant tailwind for the company and I think shares at these rich valuations still have a decent risk-return profile.

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.

Many of us would have heard of Domino’s Pizza before but did you know that Domino’s has also been a great stock to own? As the leading global quick-service restaurant in the pizza category, the share price of Domino’s Pizza Inc (NYSE: DPZ) has increased a phenomenal 2600% from 2004, easily outpacing the S&P 500 in the US.

Here are some of my thoughts on this amazing company.

A capital-light business model

Just to make sure we are on the same page, the Domino’s I am referring to is the brand owner that is listed on the New York Stock Exchange. There are other Domino’s Pizza franchisees that are the master franchisees in different countries. These companies are also listed on their respective exchanges. 

Domino’s the brand owner derives its revenue from (1) royalties and fees it charges its franchisees, (2) providing the supply chain to its restaurants, and (3) franchise advertising.

Most of Domino’s restaurants are franchised outlets so the company has very little capital outlay requirements. The company spent only US$85 million in capital expenditures in 2019, while raking in US$496.9 million in operating cash flow.

This capital-light business means that most of the company’s cash flow from operations can be returned to shareholders either through share buybacks or dividends.

Strong track record of growth

Domino’s has a steady track record of growing its business. Same-store sales in the US has increased in 35 consecutive quarters, since 2010, at an average pace of 6.9%. More impressively, same-store sales in its international stores have increased for 104 consecutive quarters.

The charts below show same-store sales growth since 1997:

On top of that, the number of Domino’s stores has grown considerably over the years. Today there are over 17,000 stores in more than 90 markets worldwide. Net store numbers increased by more than 1000 each year from 2016 to 2019.

Increase in net store numbers and same-store sales growth have ultimately translated into healthy revenue growth for Domino’s. The chart below shows the global retail sales growth from 2012 to 2019.

A resilient business model

The COVID-19 pandemic has demonstrated the resilience of Domino’s business. Domino’s United States business has actually improved during the current lockdown in many parts of the US. Same-store sales in the US were up 7.1% in the first four weeks of the second quarter of 2020, and US retail sales were up 10.7% over that same period.

Internationally, Domino’s business has also done better than most. Despite many of its International stores being temporarily closed or having some operating restrictions, international retail sales were still down only 13.2% during the first 3 weeks of the second quarter.

These are impressive figures and highlights that Domino’s has the ability to keep raking in the money even in a difficult operating climate.

Potential for more growth

Although Domino’s 17,000+ store count may seem like a lot, there’s still a large market opportunity for more growth.

Domino’s currently has 6,126 stores in the US and 10,894 stores internationally. The company believes that the US market can accommodate 8,000 stores, which means Domino’s can open another 1,800+ stores in the US alone.

On top of that, its 15 largest international markets have the potential for another 5,500+ stores. The chart below shows Domino’s estimates of where their expansion opportunities lie internationally.

Domino’s is targeting to have 25,000 stores worldwide and US$25 billion in annual global retail sales by 2025. That’s a 47% increase in store count and a 71% growth from 2019’s revenue.

The risks

Domino’s is not perfect though. The company has the unwanted distinction of having negative shareholder equity.

That’s because the company has been returning more cash to shareholders than what it rakes in each year. It is tapping aggressively into the debt market to finance its share buybacks and dividends.

Management believes that its resilient business model, steady cash flows and capital-light business enables it to function well with leverage.

While I agree, I still think that the company could be a little bit more conservative to prepare itself against unforeseen circumstances.

As of 22 March 2020, Domino’s had US$389 million in cash and restricted cash, and a staggering US$4 billion in debt. It had negative shareholder equity of US$3.4 billion.

If Domino’s has an extended period of disruption to its business, it may end up running into liquidity issues.

Final words

There is much to admire about Domino’s Pizza Inc. It has an admirable track record of growth and still has room to grow into. On top of that, its capital-light and resilient business model enables the company to continually reward shareholders with dividends and share buybacks.

However, the company is not perfect and its highly-leveraged balance sheet poses some risk. Even though I think Domino Pizza Inc can provide shareholders with good returns, investors should still proceed with caution.

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.

Recently, I found out that MSCI Inc (NYSE: MSCI) is a listed company. That got me really excited.

MSCI is one of the major index providers in the world. It formulates and provides indexes – such as the MSCI World index and the MSCI US equity – to financial institutions. In total there are more than 1,200 ETFs (exchange-traded funds) that track MSCI indexes. As of 31 December 2019, there was a mind-boggling US$934 billion in assets under management that are benchmarked to MSCI indexes.

With the rise of passive investing, I believe that index providers stand to benefit the most. Index providers such as MSCI collect a small cut of every dollar invested in an ETF that tracks its index. That’s a great business model and one that will likely continue to grow as more money flows into index-tracking ETFs. In addition, MSCI also offers other subscription services that recur each year.

Steady track record of growth

Passive investing has been on the rise for years now. So its no surprise to see that MSCI has been growing steadily along with the broader industry.

From 2015 to 2019, operating revenue increased at a decent clip of 7.7% per year. Operating income ticked up by 13% annually, while the company’s dividend increased by 25% a year.

The chart below illustrates the company’s sales growth over the last five years.

Fat margins

But what makes MSCI a truly solid business is its fat profit margin. In 2019, the index provider earned net income after taxes of US$563 million from revenue of US$1.56 billion. That translates to a healthy net profit margin after tax of 36%.

It achieved this partly because of its low cost-of-revenue, as its gross margin was around 81% for the year. This is a margin that investors usually associate with software-as-a-service companies.

MSCI’s high profit margin means that the company can afford to spend more money expanding its business, as more of that top-line growth filters down to the bottom line.

Recurring business

If you’ve read this blog before, you would know that one of the six main factors that Ser Jing and I look out for in companies is recurring revenue. Businesses that have recurring revenue can focus their efforts on winning new clients and developing other areas of the business.

MSCI is an example of a business that ticks this box. The index provider offers recurring subscriptions to clients under renewable contracts. Recurring subscription revenue made up 75% of MSCI’s total revenue in 2019. 

In addition, asset-based fees, which includes the fees it charges ETFs for tracking any of its MSCI indexes, made up 23% of revenue.

Both these sources of revenue will likely recur year after year.

Another important metric to note is the retention rate. The retention rate is the percentage of clients that renew existing contracts with MSCI. MSCI boasted a retention rate of 94.7% as of the end of 2019. Impressively, the company’s retention rate has been above 90% in recent history, highlighting the crucial role that MSCI plays for its clients.

Steady cash flow

MSCI’s cash flow has also grown along with its profits. The company generated US$709.5 million in cash from operations in 2019. Its business requires very little capital expenditures, which was only around US$33 million. 

That means most of the cash generated from the business is in the form of free cash flow that can be returned to shareholders or used to buy back shares.

A black mark?

There are many things I like about MSCI as a business. However, one negative is that the company has been, in my opinion, too aggressive in rewarding shareholders. This is causing its balance sheet to weaken.

MSCI spent US$949.9 million and US$292 million buying back its own shares in 2018 and 2019, respectively. In addition, it paid US$170.9 million and US$222.9 million as dividends in those years. Together, this is more than the cash the company generated from operations.

It’s great that MSCI is returning money to shareholders, but I think it is a little too aggressive.

MSCI took on an additional US$1 billion in debt last year, partly because it spent so much on repurchasing shares. It now has US$1.5 billion in cash and US$3 billion in debt. While its net debt position is still manageable, I prefer management to be more cautious and not take on so much debt.

Closing thoughts

MSCI is a company that has many merits. It boasts recurring revenue and is one of the leaders in a growing market. On top of that, MSCI generates copious amounts of cash flow, has a fat profit margin, and is a very capital-light business, meaning it can grow without burning a hole in its pocket.

However, there are some risks to note such as its heavily leveraged balance sheet. From a potential investor’s standpoint, I can forgive management for taking an aggressive approach to maximising shareholder value, given its recurring revenues. However, if management is not careful and continues to be overly aggressive by taking on too much debt in the future, I may have to change my view on the company.

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.

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

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

Company description

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

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

Investment thesis

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

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

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

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

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

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

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

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

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

On integrity

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

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

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

On capability and innovation

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

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

First portion of the story

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Second portion of the story

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

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

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

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

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

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

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

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

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

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

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

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

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

5. A proven ability to grow

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

A few key points about Chipotle’s financials:

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

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

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

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

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

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

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

Valuation

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

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

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

The risks involved

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

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

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

My conclusion

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

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

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

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

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

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

Well capitalised

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

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

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

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

Diversified loan book

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

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

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

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

Will Singapore banks cut their dividend?

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

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

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

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

Final thoughts

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

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

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

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