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My Thoughts On Square Inc

Square Inc has been one of the darlings of the stock market. Despite some risks, here’s why I think the stock has legs to run.

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.

What COVID-19 Hasn’t Changed

The emergence of COVID-19 has caused significant changes to our lives, but it does not change the fundamental nature of the stock market.

Note: This article was first published in The Business Times on 13 May 2020.

Our lives have been upended.

Where once we could walk freely and gather in groups, we’re now huddled at home and have adapted to social distancing.

Where once parents would send their kids to school in the morning before heading to work, they now have to assume the tough twin-roles of educator and working-professional at home.

Where once malls and businesses were open, we now see shuttered stores all over town.

COVID-19 has brought tremendous changes to our lives.

And there’s a massive ongoing debate about how investors should be investing because of these changes.

Interest rates are at generational lows, and even negative in some instances. Central banks are racing to keep their financial systems – particularly the credit markets – humming.

Governments are handing out cash to save their economies and many are taking on tremendous amounts of debt to do so. Unemployment has increased sharply in some cases, or are expected to rise significantly.

Adding to the confusion is the massive rally that US stocks have experienced after suffering a historically steep decline of more than 30% in February and March. In Singapore, the Straits Times Index has also bounced 16% higher after falling by 32% from its peak this year in January.

What should investors do?

Plus ça change (the more things change)…

I will humbly suggest one thing.

Instead of focusing on positioning their portfolios to handle the things that are changing, investors should focus on the things that are not changing. This inverted thinking has tremendous value for investors.

Jeff Bezos is the founder and CEO of Amazon.com, the e-commerce and cloud computing giant based in the US. He once said:

“I very frequently get the question: “What’s going to change in the next 10 years?” And that is a very interesting question; it’s a very common one.

I almost never get the question: “What’s not going to change in the next 10 years?” And I submit to you that that second question is actually the more important of the two — because you can build a business strategy around the things that are stable in time.”

Similarly, we can build a successful investment strategy around things that don’t change in the financial markets.

…plus c’est la même chose (the more they remain the same)

I believe that investors should only invest in things they understand. I only understand stocks well, so they are my focus in this article.

The first stock market in the world was created in Amsterdam in the 1600s. Many things have changed since. But stock markets around the world still share one fundamental attribute today: They are still places to buy and sell pieces of a business.

Having this understanding of the stock market leads to the next logical thought: A stock will typically do well over time if its underlying business does well too. That’s because a company will become more valuable over time if its revenues, profits, and cash flows increase faster than inflation. There’s just no way that this statement becomes false.

The fundamental attribute makes the stock market become something simple to understand.

But it also means that we have to be investing for the long run (with an investing time horizon measured in years) for us to take advantage of the relationship between businesses and stock prices.

Over the short run, the stock market is governed by the collective emotions of millions of investors. That’s not something that can be easily divined.

But over the long run, business-strength prevails.

An enduring investment framework

How then can we find businesses that can grow well over a long period of time, to utilise the unchanging long-run relationship between stock prices and business performances?

I cannot speak for everyone. But what I do is to reason from first principles. What characteristics do I want if I can design my ideal business from scratch?

There are six traits I have come up with, and they have served me well through my years of investing in both a professional and personal capacity. The six traits in a company are:

Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market.
A strong balance sheet with minimal or a reasonable amount of debt.
A management team with integrity, capability, and an innovative mindset.
Revenue streams that are recurring in nature, either through contracts or customer-behaviour.
A proven ability to grow.
A high likelihood of generating a strong and growing stream of free cash flow in the future.

A word of caution is necessary. Companies that excel in all my six criteria may still turn out to be poor investments. It’s impossible to get it right all the time in the investing game. So I believe it is important to diversify, across companies, industries, and geographies.

Don’t put your eggs in one basket

The concept of geographical diversification is particularly important for Singapore investors.

Look at the stocks in our local stock market benchmark, the Straits Times Index. There’s no good exposure to some of the important growth industries of tomorrow, such as cloud computing, DNA analysis, precision medicine, e-commerce, digital advertising, and more.

Chuin Ting Weber, the CEO of bionic financial advisor MoneyOwl, made a great point recently about global diversification. She said that as people who live in Singapore, we already have heavy economic exposure to our country through our jobs. If our investment portfolios also have a high proportion of Singapore stocks, we are taking on significant levels of concentration-risk.

The risks involved

Every investment strategy has risks, mine included.

A key risk is that companies that excel according to my investment criteria tend to carry high valuations. Even the best company can be a lousy investment if its share price is too high. So it’s important to weigh a company’s growth prospects with its valuation.

What’s not changing

The emergence of COVID-19, and the responses that countries around the world have mounted to combat the virus, may have caused huge changes to the growth prospects of many industries.

Travel-related companies, for instance, may suffer for some time until countries reopen their borders to accept international travellers at scale.

But crucially, I think that COVID-19 does not change the fundamental identity of the stock market as a place to buy and sell pieces of a business. So, I don’t think that the presence of COVID-19 changes the long-term relationship between stock prices and business performances in any way.

Most importantly, I don’t see COVID-19 changing humanity’s ability to innovate and solve problems.

There are 7.8 billion individuals in the world today, and the vast majority of us will wake up every morning wanting to improve the world and our own lot in life – COVID-19 or no COVID-19.

This is ultimately what fuels the global economy and financial markets. Miscreants and Mother Nature will occasionally wreak havoc. But I have faith in the potential of humanity – and to me, investing in stocks is ultimately the same as having this faith.

Unless stocks become wildly overvalued, I will remain optimistic on stocks for the long run so long as I continue to believe in humanity.

Economic Crashes & Stock Market Crashes

What’s behind the disconnect between Main Street & Wall Street today?

One of the most confusing things in the world of finance at the moment is the rapid recovery in many stock markets around the world after the sharp fall in February and March this year.

For instance, in the US, the S&P 500 has bounced 28% higher (as of 15 May 2020) from the 23 March 2020 low after suffering a historically steep decline of more than 30% from the 19 February 2020 high. In Singapore, the Straits Times Index has gained 13% (as of 15 May 2020) from its low after falling by 32% from its peak this year in January.

The steep declines in stock prices have happened against the backdrop of a sharp contraction in economic activity in the US and many other countries because of COVID-19. Based on news articles, blog posts, and comments on internet forums that I’m reading, many market participants are perplexed. They look at the horrible state of the US and global economy, and what stocks have done since late March, and they wonder: What’s up with the disconnect between Main Street and Wall Street? Are stocks due for another huge crash?

I don’t know. And I don’t think anyone does either. But I do know something: There was at least one instance in the past when stocks did fine even when the economy fell apart.

A few days ago, I chanced upon a fascinating academic report, written in December 1908, on the Panic of 1907 in the US. The Panic of 1907 flared up in October of the year. It does not seem to be widely remembered now, but it had a huge impact. In fact, the Panic of 1907 was one of the key motivations behind the US government’s decision to set up the Federal Reserve (the US’s central bank) in 1913.

I picked up three sets of passages from the report that showed the bleak economic conditions in the US back then during the Panic of 1907.

This is the first set (emphasis is mine):

“Was the panic of 1907 what economists call a commercial panic, an economic crisis of the first magnitude?..

… The panic of 1907 was a panic of the first magnitude, and will be so classed in future economic history…

… The characteristics which distinguish a panic of that character from those smaller financial convulsions and industrial set-backs which are of constant occurrence on speculative markets, are five in number:

First, a credit crisis so acute as to involve the holding back of payment of cash by banks to depositors, and the momen- tary suspension of practically all credit facilities.

Second, the general hoarding of money by individuals, through withdrawal of great sums of cash from banks, thereby depleting bank reserves, involving runs of depositors on banks, and, in this country, bringing about an actual premium on currency.

Third, such financial helplessness, in the country at large, that gold has to be bought or borrowed instantly in huge quantity from other countries, and that emergency expedients have to be adopted to provide the necessary medium of exchange for ordinary business.

Fourth, the shutting down of manufacturing enterprises, suddenly and on a large scale, chiefly because of absolute inability to get credit, but partly also because of fear that demand from consumers will suddenly disap- pear.

Fifth, fulfilment of this last misgiving, in the shape of abrupt disappearance of the buying demand through- out the country, this particular phenomenon being pro- longed through a period of months and sometimes years…

…For the panic of 1907 displayed not one or two of the characteristic phenomena just set forth, but all of them…

Here’s the second set:

“During the first ten months of 1908, our [referring to the US] merchandise import trade decreased [US]$319,000,000 from 1907, or no less than 26 per cent, and even our exports, despite enormous shipment of wheat to meet Europe’s shortage, fell off US$109,000,000.”

This is the third set, which laid bare the stunning declines in industrial activity in the US during the crisis:

“The truth regarding the industrial history of 1908 is that reaction in trade, consumption, and production, after the panic of 1907, was so extraordinarily violent that violent recovery was possible without in any way restoring the actual status quo.

At the opening of the year, business in many lines of industry was barely 28 per cent of the volume of the year before: by mid- summer it was still only 50 per cent of 1907; yet this was astonishingly rapid increase over the January record. Output of the country’s iron furnaces on January 1 was only 45 per cent of January, 1907: on November 1 it was 74 per cent of the year before; yet on September 30 the unfilled orders on hand, reported by the great United States Steel Corporation, were only 43 per cent of what were reported at that date in the “boom year” 1906.”

Let’s now look at how the US stock market did from the start of 1907 to 1917, using data from economist Robert Shiller.

*Source: Robert Shiller data; my calculations*

The US market fell for most of 1907. It bottomed in November 1907 after a 32% decline from January. It then started climbing rapidly in December 1907 and throughout 1908 – and it never looked back for the next nine years. Earlier, we saw just how horrible economic conditions were in the US for most of 1908. Yes, there was an improvement as the year progressed, but economic output toward the end of 1908 was still significantly lower than in 1907.

April-May 2020 is not the first time that we’re seeing an apparent disconnect between Wall Street and Main Street. I don’t think it will be the last time we see something like this too.

Nothing in this article should be seen as me knowing what’s going to happen to stocks next. I have no idea. I’m just simply trying to provide more context about what we’re currently experiencing together. The market – as short-sighted as it can be on occasions – can at times look pretty far out ahead. It seemed to do so in 1907 and 1908, and it might be doing the same thing again today.

What to Make of Singapore Airlines’s FY19/20 Earnings Results

SIA’s latest earnings saw the airline record one of its worst quarterly losses: Key points from its earnings update and what should investors do now.

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.

What We’re Reading (Week Ending 17 May 2020)

The best articles we’ve read in recent times on a wide range of topics, including investing, business, and the world in general.

We’ve constantly been sharing a list of our recent reads in our weekly emails for The Good Investors.

Do subscribe for our weekly updates through the orange box in the blog (it’s on the side if you’re using a computer, and all the way at the bottom if you’re using mobile) – it’s free!

But since our readership-audience for The Good Investors is wider than our subscriber base, we think sharing the reading list regularly on the blog itself can benefit even more people. The articles we share touch on a wide range of topics, including investing, business, and the world in general.

Here are the articles for the week ending 17 May 2020:

1. Why the Most Futuristic Investor in Tech Wants to Back Society’s Outcasts – Polina Marinova

As humans, we construct this very linear narrative where you say, “I did X, and then I did Y, and it led to Z.” If you’re really intellectually honest, it’s really this crazy ball of randomness. You just never know. So randomly, there was a guy in my investment banking group whose dad worked with a famous investor. We got to pitch that famous investor, whose name was Bill Conway, one of the co-founders of the Carlyle Group.

Bill’s disposition at the moment when we met was one of enthusiasm and support for a bunch of young entrepreneurially naive guys. And he bet on us. What that meant was helping us capitalize our management company, which would become Lux Capital.

2. Does Covid-19 Prove the Stock Market Is Inefficient? – Robert Shiller & Burton Malkiel

The economics profession has an explanation for this difficulty based on the idea that markets are “efficient.” If markets are perfect, prices will incorporate all publicly available information about the future. Speculative prices will be a “random walk,” to borrow a phrase from the physicists and statisticians. The changes in prices will look random because they respond only to the news. News, by the very fact that it is new, has to be unforecastable, otherwise it is not really news and would have been reflected in prices yesterday. The market is smarter than any individual, the theory goes, because it incorporates information of the smartest traders who keep their separate real information secret, until their trades cause it to be revealed in market prices…

… EMH [Efficient Market Hypothesis] does not imply that prices will always be “correct” or that all market participants are always rational. There is abundant evidence that many (perhaps even most) market participants are far from rational. But even if price setting was always determined by rational profit-maximizing investors, prices (which depend on imperfect forecasts) can never be “correct.” They are “wrong” all the time. EMH implies that we can never be sure whether they are too high or too low. And any profits attributable to judgments that are more accurate than the market consensus will not represent unexploited arbitrage possibilities.

3. Israeli engineers created an open-source hack for making Covid-19 ventilators – Chase Purdy

A team of scientists in Israel this week unveiled what they’re calling the AmboVent-1690-108, an inexpensive ventilator system made from a handful of off-the-shelf items. Project leader David Alkaher also heads the technology work of the Israeli Air Force’s confidential Unit 108, which is comprised of electronics specialists. Whereas a typical hospital ventilator costs around $40,000, the AmboVent system can be made for about $500 to $1,000…

… More on the makeshift side, the French sporting goods company Decathalon has been selling scuba gear to the Rome-based Institute of Studies for the Integration of Systems, where it’s being enhanced with 3D-printed valve parts to make basic ventilator systems. The institute notes the devices are only for emergencies where it’s impossible to find official healthcare supplies.

4. The Most Important Stock Investment Lessons I Wish I Had Learned Earlier – Safal Niveshak

Tony shares the story of an Arabic date farmer he met who had inherited an orchard that had about a thousand trees. As the farmer was showing Tony around his orchard, and took him to something like a hundred trees that were recently planted, Tony asked him out of curiosity, “How long will it take this tree to bear fruit?”

The farmer replied, “Well this particular variety will bear fruit in about 20 years. But that is not good enough for the market. It may be about 40 years before we can actually sell it.”

Tony replied, “I have never heard this. I did not know this. Are there other date trees that would produce faster?” Meanwhile, he looked at all those trees that were being harvested and realized that this farmer could not have possibly planted them.

The farmer tells Tony, “Okay. Here’s my grandfather and my father, great grandfather.”

5. Does Better Virus Response Lead to Better Stock Market Outcomes? – Ben Carlson

I went through each of these lists to check the year-to-date performance of each country’s stock market to see if there is any correlation between getting a handle on the virus and stock market performance in 2020. I looked at both ETF and local currency performance..

… I guess my main takeaway after going through the data is this — the stock market is rarely a good gauge of the health and strength of your country, especially when dealing with a crisis like this.

The stock market is not the economy but it’s also not its citizens or government leaders or crisis response team either.

6. The Great Depression – Gary Richardson

An example of the former is the Fed’s decision to raise interest rates in 1928 and 1929. The Fed did this in an attempt to limit speculation in securities markets. This action slowed economic activity in the United States. Because the international gold standard linked interest rates and monetary policies among participating nations, the Fed’s actions triggered recessions in nations around the globe. The Fed repeated this mistake when responding to the international financial crisis in the fall of 1931. This website explores these issues in greater depth in our entries on the stock market crash of 1929 and the financial crises of 1931 through 1933.

An example of the latter is the Fed’s failure to act as a lender of last resort during the banking panics that began in the fall of 1930 and ended with the banking holiday in the winter of 1933. This website explores this issue in essays on the banking panics of 1930 to 1931, the banking acts of 1932, and the banking holiday of 1933.

7. One Young Harvard Grad’s Quixotic Quest to Disrupt Private Equity – Richard Teitelbaum

Bain’s investment process was flawed, according to the report. For example, for a prospective target to pass muster, the firm required a projected internal rate of return of 25 percent over the life of the investment. That was a common projected IRR. “The first thing I noticed was this massive dispersion of returns,” Rasmussen says. Bain would generate seven or eight times on some of its investments, but with others, zero, and the number that hit the 25 percent return bogey was infinitesimally small. The upshot was thousands of man-hours wasted modeling investment outcomes because the forecasts were inevitably wrong.

There was another surprise. The single best predictor of future returns had nothing to do with the amount of leverage employed, operational changes, company management, or even the underlying soundness of the business. The driver of superior returns was the price paid by the private-equity firm — companies purchased at a lower ratio of price to earnings before interest, taxes, depreciation, and amortization tended overwhelmingly to outperform.

The cheapest 25 percent of private-equity deals based on price-to-Ebitda accounted for 60 percent of the industry’s profits. Cheap buys made good investments. “With the inexpensive ones, there’s a margin of safety,” Rasmussen says.

The firm’s touted skills for selecting companies, arranging financing, and improving operations proved to be a mirage. Instead the best private-equity deals relied on a simple formula — “small, cheap, and levered,” as Rasmussen puts it. He expected the study to prompt major changes at the firm. “Now that we have the data, how do we change our behavior?” he wondered.

8. Young Bulls and Old Bears – Michael Batnick

What do Bill Gross, Sam Zell, Jeremy Grantham and Carl Icahn have in common? They’re all old, they’ve all had brilliant careers, and they’re all bearish on the stock market. (From April 2016)

Whether it be in music or in sports or in markets, the prior generation never thinks “kids” will ever measure up. Even Benjamin Graham- the man who basically invented value investing- fell victim to the “get off my lawn syndrome.”

From Roger Lowenstein’s Buffett: The Making of an American Capitalist.

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook “Graham & Dodd” was first published; but the situation has changed”

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.

Is This Fast-Growing SaaS Company Worth Investing In?

Pushpay Holdings has seen its share price rise dramatically since listing in Australia in 2016. Here’s why I’m paying attention to it.

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.

Source: FY2020 earnings investor presentation

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.

Webinar: “SeedlyTV S2E05 – Picking Winning Stocks”

An appearance on Season 2, Episode 5 of Seedly TV to discuss the art and science behind how we can succeed in picking winning stocks.

Last month, I participated in an investment-focused webinar together with my friends Stanley Lim (co-founder of investment education portal, Value Invest Asia) and Sudhan P (investment content strategist at the personal finance platform, Seedly).

The three of us had so much fun talking about stocks and investing during the webinar that we decided to do another one. This time, it was for Season 2, Episode 5, of the Seedly TV series! The title of the episode is: Picking Winning Stocks. It was hosted by Clara Ng (Seedly’s Community Manager) and was streamed live on 13 May 2020 at 8pm.

We – Clara, Stanley, Sudhan, and myself – had a wonderful chat during the episode. Our discussion included the following topics and questions from viewers:

How Stanley, Sudhan, and myself first got to know each other
A really fun rapid fire Q&A about our personal lives
Why it’s important to accept that volatility is a feature of the stock market, and not a sign that something is broken
A benchmark that a stock must beat
Why time in the market is more important than timing the market
Our favourite Singapore REIT (real estate investment trust)
How to invest $1,000
Our thoughts on the Straits Times Index – we touched on its underperformance, its composition, and its valuation
The best time to invest for a dollar cost averaging (DCA) strategy
Our thoughts on the bank stocks in Singapore
If the “smart” money is sitting on the sidelines, should individual investors wait for the dip to invest?
Is it better to take a quick profit on a stock and look for a new stock to invest in, or is it better to buy and hold?
Our thoughts on Singapore Airlines (SGX: C6L) and Singapore’s aviation industry
How to think about the right time to sell a stock
The trading platforms we’re using
How to approach diversification in stocks
What is something about money that we wish we had known sooner

Enjoy the video of our chat below!

What Cancer Can Teach Us About Investing

The field of cancer research shows us that simple but highly effective things are often overlooked. It’s the same in investing.

Cancer and investing are topics that seem so distant. But you can learn a lot about something by studying other areas and finding parallels. There’s an important lesson that cancer can teach us about investing.

Simple way to win cancer

Robert Weinberg is an expert on cancer research from the Massachusetts Institute of Technology. In the documentary The Emperor of All Maladies, Weinberg said (emphases are mine):

“If you don’t get cancer, you’re not going to die from it. That’s a simple truth that we [doctors and medical researchers] sometimes overlook because it’s intellectually not very stimulating and exciting.

Persuading somebody to quit smoking is a psychological exercise. It has nothing to do with molecules and genes and cells, and so people like me are essentially uninterested in it – in spite of the fact that stopping people from smoking will have vastly more effect on cancer mortality than anything I could hope to do in my own lifetime.”

Studying mutations, DNA, and cutting-edge drugs to find ways to beat cancer is engaging and fascinating for scientists and physicians. But it’s not necessarily the most effective way to defeat the dreadful disease. Unfortunately, what is really effective – simple prevention – is largely ignored because it is so simple.

Similarly, I have observed that investors seem to often ignore the simple because they favour the complex.

Simple way to win the investing game

Ben Carlson helps manage the investment plans for institutions such as foundations, endowments, pensions, and more. He’s also an excellent financial blogger – check out his blog A Wealth of Common Sense.

In a 2017 blog post, Carlson compared the long-term returns of US college endowment funds against a simple portfolio he called the Bogle Model.

The Bogle Model was named after one of my investment heroes, the late index fund legend John Bogle. It consisted of three, simple, low-cost Vanguard funds that track US stocks, stocks outside of the US, and bonds. In the Bogle Model, the funds were held in these weightings: 40% for the US stocks fund, 20% for the international stocks fund, and 40% for the bonds fund.

Meanwhile, the college endowment funds were dizzyingly complex. Here’s Carlson’s description:

“These funds are invested in venture capital, private equity, infrastructure, private real estate, timber, the best hedge funds money can buy; they have access to the best stock and bond fund managers; they use leverage; they invest in complicated derivatives; they use the biggest and most connected consultants…”

Over the 10 years ended 30 June 2016, the Bogle Model produced an annual return of 6.0%. But even the college endowment funds that belonged to the top-decile in terms of return only produced an annual gain of 5.4% on average. The simple Bogle Model had bested nearly all the fancy-pants college endowment funds in the US.

K.I.S.S (Keep it simple, silly!)

One of my favourite stories about the usefulness of simplicity in investing comes from an old 1981 speech by investor Dean Williams. In his speech – one of the best investment speeches I’ve come across – Williams shared the story of the fund manager Edgerton Welch (emphasis is mine):

“You are familiar with the periodic rankings of past investment results published in Pension & Investment Age. You may have missed the news that for the last ten years the best investment record in the country belonged to the Citizens Bank and Trust Company of Chillicothe, Missouri.

Forbes magazine did not miss it, though, and sent a reporter to Chillicothe to find the genius responsible for it. He found a 72 year old man named Edgerton Welsh, who said he’d never heard of Benjamin Graham and didn’t have any idea what modern portfolio theory was. “Well, how did you do it?” the reporter wanted to know.

Mr. Welch showed the report his copy of Value-Line and said he bought all the stocks ranked “1” that Merrill Lynch or E.F. Hutton also liked. And when any one of the three changed their ratings, he sold. Mr. Welch said, “It’s like owning a computer. When you get the printout, use the figures to make a decision–not your own impulse.”

The Forbes reporter finally concluded, “His secret isn’t the system but his own consistency.” EXACTLY. That is what Garfield Drew, the market writer, meant forty years ago when he said, “In fact, simplicity or singleness of approach is a greatly underestimated factor of market success.””

My own investing process can also be boiled down to a simple sentence: Finding great companies that can grow at high rates for a long period of time. I focus on understanding individual companies, and I effectively ignore interest rates and most other macroeconomic developments. It has served me well.

Taking lessons from cancer research, as investors, we should never overlook a simple investment idea or process just because it’s intellectually uninteresting. Simple can win in investing.

A Look At One of Australia’s Best Performing Stocks Of The Decade

a2 Milk Company (ASX:A2M) has been a top-performing Australia stock over the past few years. Does it have the legs to continue growing?

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.

Source: a2 Milk Company FY2019 earnings presentation

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:

Source: a2 Milk Company interim FY2020 earnings presentation

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.

Is Domino’s Pizza, Inc A Good Investment?

Domino’s Pizza Inc shareholders have been massively rewarded over the past decade or so. Can the company continue to deliver?

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.