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Is CapitaLand Mall Trust and Capitaland Commercial Trust’s Proposed Merger Good For Unitholders?

CapitaLand Mall Trust and CapitaLand Commercial Trust are set to merge to form the biggest REIT in Singapore. Does it benefit the unitholders of both REITs?

CapitaLand Mall Trust (CMT) and CapitaLand Commercial Trust (CCT) are set to combine to form the largest REIT in Singapore. The proposed merger is the latest in a string of mergers over the last few years.

Mergers may benefit REITs through greater diversification, higher liquidity, cost savings due to economies of scale and access to cheaper equity.

With that said, here are some things that investors should note about the proposed deal between the two CapitaLand REITs.

Details of the merger

CMT is offering to buy each CCT unit for 0.72 new units of itself and S$0.259 in cash. The enlarged REIT will be renamed Capitaland Integrated Commercial Trust (CICT).

Source: Presentation slides for CMT and CCT merger

The combined REIT will own both CMT and CCT’s existing portfolios, making it the largest REIT in Singapore and the third-largest in Asia Pacific. Its portfolio will include 24 properties valued at S$22.9 billion.

Source: Joint announcement by CCT and CMT regarding the merger

What does it mean for current CMT unitholders?

The best way to analyse such a deal is to look at it from the angle of both parties separately.

For CMT unitholders, the merger will result in them owning a smaller stake in an enlarged REIT. Here are the key points that investors should note:

Based on pro forma calculations, the merger is distribution per unit-accretive. The chart below shows the DPU (distribution per unit) increase had the merger taken place last year.

Based on similar assumptions, the deal is NAV-accretive. The net asset value (NAV) per unit of the enlarged REIT is expected to be S$2.11, higher compared to S$2.07 before the merger.
As debt will be used, it will cause CMT’s aggregate leverage to increase from 32.9% to 38.3%.

The question here is whether current CMT owners will be better off owning units in the merged entity. I think so. The deal will be both DPU and NAV-accretive. While the merged entity will have a higher gearing, I think the trade-off is still advantageous.

On top of that, the enlarged REIT will also benefit from economies of scale. As I briefly mentioned earlier, bigger REITs benefit from diversification, cost savings and the ability to take on bigger projects.

The downside for CMT

Although I think the deal is beneficial to unitholders of CMT, I doubt it is the most efficient use of capital.

CMT is paying 0.72 new units of itself, plus S$0.259 in cash, for each CCT unit. That works out to around S$2.131 for each CCT unit. Even though that seems fair when you consider CCT’s current unit price of S$2.13, the purchase price is much higher than CCT’s actual book value per unit of S$1.82.

Needless to say, CMT unitholders would benefit more if CMT is able to buy properties at or below their book value. Ultimately, because of the current market premium attached to CCT units, CMT will end up having to pay a 17% premium to CCT’s book value.

Although the impact of paying above book value is countered by the fact that CMT will be issuing new units of itself at close to 25% above book value, I can’t hep but wonder if CMT could gain more by issuing new units to buy other properties at or below book values.

What does it mean for CCT unitholders?

At the other end of the deal, CCT unitholders are getting a stake in the merged entity and some cash for each unit they own.

Here are the key things to note if you are a CCT unitholder:

Based on pro forma calculations, the merger is DPU-accretive for CCT, if we assume that the cash consideration is reinvested at a return of 3% per annum.

From a book value perspective, the deal will be dilutive for CCT unitholders. Before the merger, each CCT unit had a book value of S$1.82. After the deal, CCT unitholders will own 0.72 new units in the enlarged REIT and S$0.259 in cash. The enlarged REIT (based on pro forma calculations) will have a NAV per unit of S$2.11. Ultimately, each CCT unit will end with a book value of S$1.78, a slight decrease from S$1.82 before the deal.

Other considerations for CCT unitholders

For CCT unitholders, the question is whether they will be better off owning (1) units of the existing CCT, or (2) cash plus 0.72 units of the enlarged REIT.

I think there is no right answer here. Ownership of the enlarged REIT has its benefits but CCT unitholders also end up obtaining the new units at quite a large premium to book value.

Although the deal will result in DPU-accretion for current CCT unitholders, the enlarged REIT also has a higher gearing than CCT and consequently, has less financial power to make future acquisitions.

Investors need to decide whether the yield-accretion is worth paying up for (due to the new units being issued at 25% premium to book value), or whether they rather maintain the status quo of owning a decent REIT with a lower gearing and better book value per unit.

The Good Investors’ Conclusion

There are certainly reasons for both sets of unitholders to support the proposed merger between these two CapitaLand REITs. The deal will benefit CMT unitholders in terms of both DPU and NAV-accretion, while CCT unitholders will also gain in terms of DPU growth.

In addition, the enlarged REIT could theoretically benefit from economies of scale, portfolio diversification, and greater liquidity.

That said, I have my doubts on whether it is the best use of capital by CMT due to the purchase price’s 17% premium to CCT’s book value. CCT unitholders also have a lot to digest, and they will need to assess if they are comfortable that the deal will be dilutive to them from a book value perspective.

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.

If You Invest In Stocks, You Should Know These 2 Things About Interest Rates

A long look at history to decipher the real relationship between interest rates and the stock market, and how we should act as stock market investors.

The financial media pays plenty of attention to interest rates. We just have to look at the amount of commentary that pops up whenever central banks around the world make their interest rate decisions.

If you invest in stocks, like us at The Good Investors, there are two things about interest rates and their implications that you should know.

No.1: The reality behind the relationship between interest rates and stock prices

I’ve written about the theory behind how interest rates govern the movement of stock prices in a previous article at The Good Investors titled 6 Things I’m Certain Will Happen In The Financial Markets In 2020. Here’s the relevant excerpt:

“Stocks and other asset classes (bonds, cash, real estate etc.) are constantly competing for capital. In theory, when interest rates are high, the valuation of stocks should be low, since the alternative to stocks – bonds – are providing a good return.

On the other hand, when interest rates are low, the valuation of stocks should be high, since the alternative – again, bonds – are providing a poor return.”

But in the same article, I also pointed out that things are different in real life:

“There’s an amazing free repository of long-term US financial market data that is maintained by Robert Shiller. He is a professor of economics and the winner of a Nobel Prize in economics in 2013.

His data includes long-term interest rates in the US, as well as US stock market valuations, going back to the 1870s. The S&P 500 index is used as the representation for US stocks while the cyclically adjusted price earnings (CAPE) ratio is the valuation measure. The CAPE ratio divides a stock’s price by its inflation-adjusted average earnings over a 10-year period.

The chart below shows US long-term interest rates and the CAPE ratio of the S&P 500 since 1920:

Contrary to theory, there was a 30-plus year period that started in the early 1930s when interest rates and the S&P 500’s CAPE ratio both grew. It was only in the early 1980s when falling interest rates were met with rising valuations.”

No.2: Based on history, interest rates have declined as a country develops

Josh Brown is the CEO of Ritholtz Wealth Management. In a June 2019 blog post, Brown recounted a dinner he had with the polymath investor William Bernstein. During the dinner, Bernstein posed a question that had been in his mind for awhile: What if the cost of capital never rises again? (The cost of capital refers to the cost of money – in other words, interest rates.)

Bernstein’s question is fascinating to think about. That’s because a broad look at history shows us that interest rates have declined as countries mature. Here’s Bernstein on the subject in his book, The Birth of Plenty (I highly recommend it!):

“Interest rates, according to economic historian Richard Sylla, accurately reflect a society’s health. In effect, a plot of interest rates over time is a nation’s “fever curve.” In uncertain times rates rise because there is less sense of public security and trust.
Over the broad sweep of history, all of the major ancient civilisations demonstrated a “U-shaped” pattern of interest rates. There were high rates early in their history, following by slowly falling rates as the civilisations matured and stabilized. This led to low rates at the height of their development, and, finally, as the civilisations decayed, there was a return of rising rates.”

The implications

There are two implications I can draw from the graph on interest rates vs valuation, and Bernstein’s data on how interest rates change with the growth of countries. First, Shiller’s data show that changes in interest rates alone cannot tell us much about how stocks will move. “If A happens, then B will occur” is a line of thinking that is best avoided in finance. The second implication is that it is possible for interest rates in the US and other parts of the world to stay low for a very long period of time. That’s history’s verdict.

In 6 Things I’m Certain Will Happen In The Financial Markets In 2020, I also wrote:

“Time that’s spent watching central banks’ decisions regarding interest rates will be better spent studying business fundamentals. The quality of a company’s business and the growth opportunities it has matter far more to its stock price over the long run than interest rates.

Sears is a case in point. In the 1980s, the US-based company was the dominant retailer in the country…

… US long-term interest rates fell dramatically from around 15% in the early-to-mid 1980s to 3% or so in 2018. But Sears filed for bankruptcy in October 2018, leaving its shareholders with an empty bag. In his blog post mentioned earlier, Housel also wrote:
“Growing income inequality pushed consumers to either bargain or luxury goods, leaving Sears in the shrinking middle. Competition from Wal-Mart and Target – younger and hungrier – took off.
By the late 2000s Sears was a shell of its former self. “YES, WE ARE OPEN” a sign outside my local Sears read – a reminder to customers who had all but written it off.”

Warren Buffett’s Berkshire Hathaway provides an opposite example to Sears. From the start of 1965 to the end of 1984, US long-term interest rates climbed from 4.2% to 11.5%, according to Shiller’s data. But a 23.7% increase per year in Berkshire’s book value per share over the same period resulted in a 27.6% annual jump in the company’s share price. A 23.7% input led to a 27.6% output over nearly 20 years, despite the significant growth in interest rates.

You may also be wondering: What’s going to happen to global financial markets in a world that is awash in cheap credit for a long time?

We can learn something from Japan: The country has already been in a situation like this for decades. The yield for 10-year Japanese government bonds has never exceeded 2% going back to the fourth quarter of 1997, according to data from the Federal Reserve Bank of St Louis. In fact, the yield has fallen from 1.96% to a negative 0.2% in the third quarter of 2019 (see chart below).

*Source: Federal Reserve Bank of St Louis*

Interestingly, Japan’s main stock market index, the Nikkei 225, is just 40% or so higher from October 1997 to today, despite interest rates in the country having declined from an already low base in that time frame.

Yet, there’s a company in Japan such as Fast Retailing – owner of the popular Uniqlo clothing brand – which has seen its stock price increase by more than 11,000% over the same period because of massive growth in its business. From the year ended 31 August 1998 (FY1998) to FY2019, Fast Retailing’s revenue and profit grew by around 27 times and 56 times, respectively.

What it all means for stock market investors

So to wrap up everything I’ve shared earlier in this article:

Rising interest rates may not hurt stock prices by depressing valuations, as seen from the S&P 500’s CAPE ratio increasing from the 1930s to the 1960s while interest rates were rising.
Historically, interest rates have declined and stayed low as countries develop and mature, according to William Bernstein’s book, The Birth of Plenty.
Falling interest rates cannot help a stock if its business is crumbling, as seen in the case of Sears.
Rising interest rates also would not necessarily harm a stock if its business is flourishing, as Berkshire Hathaway has demonstrated.
The example of Japan’s Nikkei 225 index show that persistently low interest rates don’t always benefit stocks too.
Fast Retailing’s experience highlights how Individual stocks can still be huge winners even in a flat market, if their businesses do well over time.

And what do all these mean for us as stock market investors? It means that we shouldn’t bother with interest rates. Instead, we should focus on the health and growth of the businesses that are behind the stocks we own or are interested in. In other words, watch business fundamentals, not interest rates.

Should Investors Bet on Uniqlo?

Uniqlo has been one of the fastest growing apparel retail brands in the world. But with its stock sitting at all-time highs, is it still worth investing in?

Most of you reading this would be familiar with Uniqlo.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Source: Fast Retailing 2018 Annual Report

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

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

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

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

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

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

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

Source: Fast Retailing FY2018 annual report

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

Risks

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

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

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

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

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

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

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

Valuation

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

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

Why I Own PayPal Shares

PayPal has been in my family’s portfolio for a number years and it has done well for us. Here’s why we continue to own PayPal.

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

The first two purchases have performed well for my family’s portfolio, with PayPal’s share price being around US$116 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold PayPal shares.

Company description

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

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

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

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

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

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

Investment thesis

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

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

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

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

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

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

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

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

On integrity

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

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

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

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

On capability and innovation

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

*Source: PayPal website, and other press releases*

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

*Source: PayPal IPO document, annual reports, and quarterly filings*

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

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

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

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

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

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

5. A proven ability to grow

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

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

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

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

I see two notable traits in PayPal’s network:

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

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

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

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

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

Valuation

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

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

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

The risks involved

There are six key risks I see in PayPal.

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

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

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

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

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

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

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

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

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

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

The Good Investors’ conclusion

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

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

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

Are Lulelemon Shares Too Expensive?

Lululemon shares surged 79% last year. It now trades at more than 50 times earnings. Is it too expensive to add shares now?

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

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

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

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

Company description

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

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

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

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

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

I think Lululemon can do both.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. Are its revenue streams recurring in nature?

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

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

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

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

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

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

5. Does Lululemon have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Risks

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

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

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

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

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

Valuation

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

Why I Own MercadoLibre Shares

My family’s portfolio has held MercadoLibre shares for a few years and it has done very well for us. Here is why we continue to own MercadoLibre shares.

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

The purchases have worked out very well for my family’s portfolio, with MercadoLibre’s share price being around US$660 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold MercadoLibre shares.

Company description

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

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

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

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

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

Investment thesis

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

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

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

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

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

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

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

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

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

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

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

On integrity

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

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

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

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

On capability and innovation

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

*Source: MercadoLibre IPO prospectus, annual reports, and quarterly earnings update*

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

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

*Source: MercadoLibre annual reports and quarterly earnings update*

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

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

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

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

*Source: MercadoLibre investor presentation*

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

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

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

5. A proven ability to grow

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

A few things to note:

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

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

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

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

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

Valuation

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

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

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

The risks involved

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

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

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

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

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

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

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

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

The Good Investors’ conclusion

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

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

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

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

5 Lessons From Chuck Akre, a Modern-day Investing Great

Chuck Akre is one of the modern-day investing greats. His Akre Focus Fund has easily outpaced the S&P500. Here are some lessons I learnt from him.

Chuck Akre is fast-becoming one of the investing greats of this generation. His Akre Focus Fund (the retail class) has achieved an annualised return of 16.72% since its inception in August 2009. The fund’s return easily outpaces the 14.14% annual gain of the S&P 500 over the same time frame.

As its name suggests, the Akre Focus Fund focuses its investments on only a small number of high-quality businesses (as of the fourth quarter of 2019, the fund only had 19 holdings). These are companies that meet Chuck Akre’s high standards related to (1) the quality of their businesses, (2) the people who manage them, and (3) their ability to reinvest capital at high returns. The Akre Focus Fund holds these companies for the long-term, allowing them to compound over time. Based on his fund’s results, this relatively straightforward strategy has worked tremendously well for Akre and his investors.

With that in mind, I want to highlight five things I learnt from Chuck Akre’s interviews and writings.

He doesn’t predict where the market is going

Unlike other investors, Akre does not scrutinise or make predictions about where the stock market is going. Instead, he focuses his efforts on finding great companies that trade at reasonable prices.

In a Wall Street Journal interview in 2018, Akre explained:

“It’s not that we don’t care what the market is going to do. It’s that there is nothing in our record that suggests we have any skill in making those predictions, so we don’t bother. We just focus on what it is that we do well. That has been successful for a long period, and we do that because we think it is logical, repeatable, simple and straightforward.”

Owning good businesses is more important than simply buying and holding

It is no secret that buy-and-hold investors have outperformed those that trade frequently. However, this is only one piece of the jigsaw.

The difficult part is actually finding stocks that are worth buying and holding. From my personal experience, buying and holding a mediocre business will, as you may have guessed, produce only mediocre returns. Akre says:

“Buy and hold is not our philosophy. What we want to do is own businesses that are exceptional until they are no longer exceptional. It’s a nuance on the notion of buy and hold.”

He also emphasises the point that investors should not hold a stock simply because they prescribe in the buy and hold strategy. If an investment thesis is flawed or the company has lost its competitive edge, it may be time to let go. He explains:

“We’re not afraid to sell, but we want to know that the company really isn’t exceptional anymore, because it has often taken me a long time to understand just how good the really good ones are. And once you own them, you shouldn’t get rid of them easily, or just because something has changed right now.”

He believes indexing is a perfectly good strategy for average investors

Despite running an actively managed fund, Akre still believes owning an index fund is a decent strategy for the retail investor.

Not only has indexing produced a decent return over the long term, but it is also difficult to find good active managers who can outperform the index over time. Akre explains:

“I think it is very difficult to understand who the good managers are and what makes them good. I think about this a lot as it relates to my partners and people in other firms. It’s hard, and people need help, and the idea of using index funds is perfectly reasonable for getting an experience that is the market experience.”

He doesn’t focus on the short-term fluctuations in his portfolio

Akre’s core investing principle is to focus on long-term returns. The stock market may fluctuate wildly in the short-term. Although this can create near-term upsized returns or steep drawdowns, we should not read too much into it. Instead, we need to focus on the long-term potential of our investments.

In his semi-annual shareholder letter in March 2019, Akre and his two other portfolio managers wrote:

“You might say, ‘No one can predict stock returns even on a single day. So how can you possibly focus on long-term returns?’ The answer is we do not focus on stocks. We focus on businesses. We earn a majority of returns as portfolio businesses improve and grow, year by year. Is it so crazy to think that if we find a thriving business with strong competitive advantages and buy it at a reasonable price, it might provide us with better-than-average long-term returns?”

He believes the market’s focus on short-term goals creates investing opportunities

It is well-documented that stocks tend to be the most volatile around earnings season. An earnings miss or earnings surprise can cause a stock price to rise or fall disproportionately to its true long-term value.

This is where Akre believes long-term investors can gain the upper hand. Simply by using this price-value mismatch to pick up shares at a discount, long-term investors stand to gain above-average long-term returns. In his discussion on his investing philosophy, Akre says:

“Wall Street’s obsession with what we describe as the “beat by a penny, miss by a penny” syndrome frequently gives us opportunities to make investments at attractive valuations. We keep our focus squarely on growth in the underlying economic value per share – often defined as book value per share – over the course of time. Our timetable is five and ten years ahead, and quarterly “misses” often create opportunities for the capital we manage.”

Why Investors Tend To Make Bad Decisions

I recently read the book The Behavioural Investor by Daniel Crosby. he brought to light some reasons why investors tend to make bad decision.

I recently read the book The Behavioural Investor by Daniel Crosby. Crosby is a psychologist who specialises in behavioural finance. Through his years of research, he found that humans tend to make bad investing decisions simply because of the way our brains are wired.

But it doesn’t have to be that way. We can learn to overcome some of our behavioural tendencies that cause poor investing decisions by learning and understanding the impact of human psychology.

Crosby explains:

“Understanding the impact of human physiology on investment decision-making is an underappreciated area of study that represents a unique source of advantage for the thoughtful investor.”

With that said, here are some things I learnt from his book.

Our brains were not designed for investing

It may seem strange, but our brains are not really designed to make investing decisions. Homo Sapiens have been around for close to 200,000 years and yet our brains have barely grown since then. A 154,000 year old homo sapien skull found in Ethiopia is believed to have held a brain similar to the size of the average person living today.

Essentially, that means our brains have remained relatively unchanged – although the world around us has changed dramatically. This resulted in emotional centres that helped guide primitive behaviour now being involved in processing complex financial decisions. This has, in turn, led to poor decision making.

Crosby explains:

“Rapid, decisive action may save a squirrel from an owl, but it certainly doesn’t help investors. In fact, a large body of research suggests that investors profit most when they do the least.”
“Behavioral economist Meir Statman cites research from Sweden showing that the heaviest traders lose 4% of their account value each year to trading costs and poor timing and that these results are consistent across the globe. Across 19 major stock exchanges, investors who made frequent changes trailed buy and hold investors by 1.5 percentage points per year.”

Our brains are hardwired to be impatient

Our brains are also hard-wired to seek out immediate rewards. This can lead to impulsive behaviour and poor investing decisions.

Crosby cited research from Ben McClure and colleagues who measure the brain activity of participants who made decisions based on immediate or delayed monetary rewards. According to the study, when the choices involved immediate rewards, the ventral stratum, medial orbitofrontal cortex, and medial prefrontal cortex were used. These are parts of the brain linked with impulsive behaviour.

On the other hand, the choices involving delayed rewards used the prefrontal and parietal cortex, parts of the brain that are associated with more careful consideration.

The experiment showed that our brains made more impulsive and greedy decisions when it comes to immediate reward.

Crosby explains:

“Your brain is primed for action, which is great news if you are in a war and awful news if you are an investor, fighting to save for your retirement.”

Our brain makes assumptions

Our brains have been hardwired to make quick decisions. This involves making assumptions, extrapolating patterns, and relying on cognitive shortcuts. As you can imagine, this can be a beautiful thing when it comes to saving energy for other functions of the body.

Unfortunately, making quick decisions based on cognitive shortcuts is by no means ideal when it comes to investing. These cognitive shortcuts can lead to poor decisions, cognitive biases and, ultimately poor returns.

A great example of cognitive shortcuts is the irrational primacy effect. This is the tendency to give greater weight to information that comes earlier in a list or a sentence.

The Good Investors’ Conclusion

The Behavioral Investor brings to light some of the more common human tendencies and why the human brain is not built to make sound investing decisions. But don’t let that deter you from investing.

We can overcome these behavioural tendencies simply through an awareness of what drives unhealthy behaviour and build processes to guard against poor investing decisions.

My Chinese New Year Wish List For Improving Singapore’s Retail Bonds Market For Investors

SGX RegCo has established a working group to study how Singapore’s retail bonds market can be improved. Here are my suggestions for investor-education.

Singapore Exchange’s regulatory arm, SGX RegCo, announced recently that it has established a working group of industry professionals and investors to review the regulatory framework for Singapore’s retail bonds market.

I do not have any power to influence the decisions of the working group, but I was inspired to pen my thoughts on the matter yesterday after meeting a friend of mine who’s a veteran in Singapore’s financial journalism scene.

More specifically, my thoughts are on (1) the type of information that I think is important to be presented to investors if a company is going to issue a retail bond, and (2) the format of how the information is to be presented. Chinese New Year is just around the corner, so my early CNY wish is for my thoughts to reach the eyes of the powers that be for consideration.

Setting the stage

During our meeting, my journalist friend (he’s retired now) reminded me that Singapore has an aging population, which would likely boost the demand for retail bonds in the years ahead. This makes the issue of improving the regulatory framework for retail bonds in Singapore a critical matter to me.

Hyflux’s infamous collapse in 2018 affected 34,000 individual investors who held its preference shares and/or perpetual securities – and I’m hurt when I hear of such stories. Preference shares and perpetual securities are not technically retail bonds. But the three types of financial instruments are close enough in substance to be considered the same thing for the purpose of my discussion.

There’s no way to conduct a counterfactual experiment. But I think it’s reasonable to believe that many of the affected-investors in the Hyflux case could have made better decisions if they had access to pertinent information about the company that they can easily understand.

Right now, there are product highlight sheets that accompany retail bonds in Singapore: Here’s an example for Hyflux for its 6% perpetual securities that were issued in May 2016. But there is information that is lacking in the sheets, and it’s not easy for layman-investors to make sense of what’s provided.

With this background, let me get into the meat of this article.

Type of information to be presented to investors

If a company is going to issue a retail bond, I think there are a few important pieces of information that should be presented to investors. The purpose of the information is to allow investors to make informed decisions on the risk they are taking, without them having to conduct tedious information-gathering.

These information are:

Can the bond be redeemed? Who gets to call the shots, and at what terms?
The dollar-amount in annual interest as well as total interest that the company in question has to pay for its retail bond issue.
The operating cash flow of the company, and capital expenditures, over the past five years.
The amount of debt, cash, and equity the company currently has, and the pro-forma amount of debt, cash, and equity the company will have after its retail bond issue.
Is the bond issue underwritten by the banks that are selling the bond?
What is the money raised by the issue of the retail bond used for?

I note that the information above is meant for companies that are not banks or real estate investment trusts (REITs). Tweaks will have to be made for the banks and REITs but I believe my list above is a good place to start.

Format of information-presentation

I think that the information I mentioned above will be most useful for investors if they are presented all in one page, and are accompanied by descriptions of the information, and their significance, written in layman’s terms. Here are my suggestions.

For “Can the retail bond be redeemed? Who gets to call the shots, and at what terms?”

Description: A retail bond that can be redeemed means that the retail bond issuer (the company in question) is required to pay the retail bond holder (you) the full amount of the retail bond. Sometimes, the company in question gets to determine when to redeem the retail bond; sometimes, you get to determine when the retail bond is redeemed.
The significance: The timing of when you can get your capital back is affected by (1) whether the retail bond can be redeemed; and (2) who gets to determine when the retail bond is redeemed.

For “The dollar-amount in annual interest as well as total interest that the company in question has to pay for its retail bond issue.”

Description: A company has to pay interest on the retail bond that it is issuing – and that interest is paid with cash.
The significance: If you know how much interest the company is paying each year, and in total, for a retail bond issue, you can better understand its ability to pay the interest.

For “The operating cash flow of the company, and capital expenditures, over the past five years.”

Description: The operating cash flow of a company is the actual cash that is produced by its businesses. Capital expenditures are the cash that a company needs to maintain its businesses in their current states. Operating cash flow less capital expenditures, is known as free cash flow.
The significance: There are no guarantees, but knowing the long-term history of a company’s operating cash flow and free cash flow can give you a gauge on the company’s ability to produce cash in the future. The level of a company’s operating cash flow and free cash flow is important, because a company needs to pay the interest on its retail bond, as well as repay its retail bond, using cash. If operating cash flow is low, the company will find it tough to service its retail bond. If operating cash flow is high but free cash flow is low, it is also tough for a company to service its retail bond; a reduction in capital expenditure can increase free cash flow, but it will hurt the company’s ability to generate operating cash flow in the future.

For “The amount of debt, cash, and equity the company currently has, and the pro-forma amount of debt, cash, and equity the company will have after its retail bond issue.”

Description: A company has cash, properties, equipment, software etc. These are collectively known as its assets. A company also has bank loans, bonds that it has issued, money that it owes suppliers etc. These are collectively known as its liabilities. The equity of a company is simply is assets minus liabilities. The term “pro-forma” in this case is used to refer to how a company’s finances will look like after it issues its retail bond, based on the latest available audited information.
The significance: If a company has good financial health, it is in a stronger position to repay and service its retail bond. To gauge a company’s financial health, you can look at two things: Firstly, its cash levels relative to its debt (the more cash, the better); and secondly, the ratio of its debt to its equity (the lower the ratio, the better). Debt in this case, is the summation of a company’s bank loans and other bonds.

For “Is the retail bond issue underwritten by the banks that are selling the bond?”

Description: A retail bond that is issued by a company may be underwritten or not underwritten. An underwritten retail bond is a bond that is purchased by a bank that is then resold to you.
The significance: If you and other investors do not want to purchase an underwritten retail bond, the bank involved ends up holding it. So if a bank underwrites a retail bond, it typically means that it has more confidence in the bond as compared to one where it does not underwrite.

For “What is the money raised by the issue of the retail bond used for?”

Description: The company in question is issuing a retail bond to raise money for specific purposes.
The significance: A company can issue a retail bond to raise money for many reasons. There is one particular reason that typically tells you you’re taking on higher risk: The company is issuing a retail bond to repay a previous loan or bond that has a lower interest rate.

The Good Investors’ conclusion

Ultimately, individual investors need to be responsible for their own actions – it’s not the regulator’s responsibility to offer total protection. But in the case of Singapore’s retail bonds market, I think there is still scope for significant improvements to be made in investor-education and other aspects.

My suggestions above are meant to highlight the most crucial information about a company that is issuing a retail bond so that individual investors can quickly gain a good grasp of the level of risk they are taking on.

The working group is expected to present its recommendations to SGX RegCo sometime in the middle of this year. A public consultation will also “likely take place by the end of the year.” May the recommendations put forth by the working group lead to investors in Singapore having a better experience in the retail bonds market!

Uber: Value Stock or Value Trap?

Uber is trading some 30% below its IPO price. I took a look at its business fundamentals to see if it is worth picking up shares now.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5. Does Uber have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Other risks

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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