Jeremy Chia, Author at The Good Investors : Page 10 of 20

How Netflix is Capitalising On Operating Leverage

2021 is set to be a turning point for Netflix. The company expects to become free cash flow neutral and will be self-sustaining from here on out.

Netflix Inc (NASDAQ: NFLX) is ushering in a new era in its business.

The streaming video giant delighted investors in January when it announced in its 2020 fourth-quarter earnings update that after years of burning cash, it is finally close to being self-sustainable

Subscription video on demand (SVOD) as a business had previously been a highly contested topic among investors. Although there is no denying that there is product-market fit, Netflix has burnt through billions in cash to build original content each year, raising questions about the unit economics of the business model.

But cash-burn may soon be a thing of the pass for the undisputed king of SVOD.

For 2021, Netflix said that it anticipates free cash flow to be around break-even. It is so confident in its ability to be self-sustaining that it plans on repaying some of its bonds and even toyed with the idea of returning cash to shareholders through share buybacks.

Unsurprisingly, Netflix’s optimism was met with enthusiasm from stock market participants. On the day after the announcement of its fourth-quarter results, Netflix’s share price spiked by more than 10%.

So, what’s driving Netflix’s change in fortunes?

The short answer is scale and operating leverage.

Since the start of 2018, Netflix’s paid memberships have risen from 111 million to 204 million. In addition, price hikes have made each member more valuable to Netflix. Its average monthly revenue per member has grown from US$9.88 to US$11.02.

Consequently, Netflix’s revenue has increased by 113.7% from US$11.7 billion in 2017 to US$25 billion in 2020.

At sufficient scale, Netflix can fund its original content production entirely from the cash earned from subscriptions.

In early 2020, I wrote an article titled What Investors Don’t Get About Netflix titled. In it, I explained:

“To improve its free cash flow metric, Netflix needs to spend much less as a percentage of its revenue. And I think its entirely possible that this scenario will play out sooner rather than later. The math is simple.
There is a fixed cost to producing content but the value of the content scales as the user count grows.
For instance, the content that Netflix is producing today can reach its 167 million global subscribers. But as the number of subscribers grows, the content it is producing will reach a larger subscriber base. Put another way, the fixed amount spent on each movie or series will be spread out across a much larger revenue base as user count grows.
Over time, the amount of cash spent on content will take up a much lower percentage of revenue and, in turn, free cash flow should eventually be positive.”

This scenario seems to be playing out exactly as I wrote. Netflix, now with its 204 million members paying monthly subscriptions, can start to internally fund its content production each year.

And it likely gets better from here…

With Netflix hitting this breakeven milestone in its business, the company will likely start to exhibit extremely strong unit economics moving forward.

Put another way, from 2022 onwards, we are likely to see a high free cash flow margin generated from each net member addition.

How much can Netflix potentially earn? Well, looking at the market opportunity, I believe the company’s annual free cash flow could be in the tens of billions.

With around 1.6 billion television households worldwide and an estimated 45% of those having broadband internet access, Netflix has an addressable market of roughly 720 million households. If we assume that Netflix manages to penetrate just 50% of that market, it will have 360 million members – or around 155 million more than it reported for the fourth quarter of 2020.

Let’s also assume that Netflix has factored in 20 million new members in 2021, which will bring its free cash flow number to break even.

To be conservative, let’s also say the contribution margin of every subsequent member added is 90%. Using average revenue per user of US$11, we can calculate that by the time Netflix hits 360 million subscribers, it could potentially be generating US$16 billion* in free cash flow annually. That’s a hefty sum – bear in mind too that I did not even factor in any price hikes.

Ending thoughts…

Netflix has long been a highly debated company among investors. Although it is normal for a young technology company to be burning money, Netflix is far from a young tech startup. Its streaming service has been around for more than a decade and yet it has been lighting up cash for years, raising doubts about the sustainability and unit economics of its business.

But the early criticism from outsiders is starting to look misplaced. Netflix, despite the competition from Disney Plus, and other content-giants, is still the top dog when it comes to SVOD. Steady member growth and low churn speak to that. It’s early (and steady) investments in producing original content are starting to reap the rewards, driving new memberships and increasing the value of its service to existing members.

Netflix’s co-CEO and co-founder, Reed Hasting, perhaps knew it all along. In Netflix’s 2017 fourth-quarter letter to shareholders, a time when it was still burning billions of dollars each year, the company wrote:

“We are increasing operating margins and expect that in the future, a combination of rising operating profits and slowing growth in original content spend will turn our business FCF positive.”

Netflix is one of the modern era’s great examples of how long-term investing pays off. The company was willing to endure years of cash burn and even tapped into the high-interest debt market to fund its growth. But these investments will likely more than pay off in the years to come.

To me, Netflix is a poster child of the benefits of long-term investing, and a shining example for any serious long-term investor to learn from.

* Calculated by using 224 million as the breakeven number of members. The equation is (360 million-224 million)*US$11*12*0.9.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Netflix Inc. Holdings are subject to change at any time.

Unpopular Truth: Reddit Investors Are Not Saving GameStop

This is not the way to save Gamestop.

You’ve likely heard about the Gamestop Corp (NYSE: GME) saga. I didn’t want to write a post on it but I realised that there is one glaring misconception among Reddit investors that should be addressed.

Many users within the Wallstreet Bets group in Reddit have mentioned that they want to save Gamestop from short sellers.

It’s as if they believe that pumping up the share price of Gamestop will somehow save or help the company.

I appreciate the noble thought, but the concept that driving a company’s share price higher will help it is not how stocks work.

What’s really going on

The stock price is simply the last traded price of the company’s stock. It is the amount that the latest buyer paid to purchase the stock from the previous stock owner.

Buying and selling shares on the stock exchange does not in any way impact the underlying business fundamentals of the company. The money you are paying to buy Gamestop’s stock actually goes to the person who sold you the stock, and not to Gamestop, the company.

Likewise, there is a misconception that short sellers are destroying a company by trying to drive a company’s stock price down.

This is not the case. Even if a company’s stock price declines, the fundamentals of the company will not change. A fundamentally solid company with a low stock price may, in some cases, even be a good thing for its long-term shareholders: The company can take advantage of the low stock price by buying back its shares to reduce the outstanding share count.

A great example is Restoration Hardware Holdings (NYSE: RH), which was targetted by short-sellers in 2017 and 2018. Seizing the opportunity presented by a low stock price, Restoration Hardware’s management team used the company’s cash to buy back its shares, resulting in a 59.8% decline in its outstanding share count. This created massive fundamental long-term value for its remaining shareholders. Its stock is now up 1,600% since the start of 2017.

How to really save Gamestop?

If you really want to help Gamestop, you can purchase merchandise directly from Gamestop’s retail stores. This hands money over to Gamestop directly.

Similarly, if Gamestop offers a secondary offering or issues a bond, investors who buy into these offerings will be handing money directly to the company.

These are the real ways that you can help Gamestop’s business.

The unpopular truth is that just buying Gamestop’s stock on the stock market is not really helping Gamestop at all.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned.

The Sources of Cheap Capital And Why It Matters

Having access to cheap capital is a huge competitive advantage that is often overlooked by investors. Here’s how and why it matters.

The company with the deepest pockets often wins.

Having more money than your competitors can further your technology advantage, allow you to market more aggressively to get a stronger network effect, or simply to scale up production more quickly.

This is why founders can be found scrambling around Silicon Valley trying to raise capital. But raising capital is not reserved solely for privately held startups.

In fact, many fast-growing public companies are increasingly looking for ways to raise capital cheaply, be it through debt or secondary equity offerings.

Raising capital through secondary equity offerings

One of the more common ways to raise money in today’s market is through a secondary offering. A secondary offering is simply the sale of new shares to investors by an already public-listed company. This is especially appealing for a company when its stock price has increased to a lofty valuation, a likely phenomenon for tech stocks in today’s market.

We need to look no further than one of 2020’s hottest stocks, Tesla Inc (NASDAQ: TSLA). The electric vehicle company took advantage of its rising stock price to raise money no less than three times last year. Tesla first raised US$2 billion in February at a split-adjusted share price of around US$153. It quickly followed that up in September and December, raising another US$5 billion each time as its share price soared.

Despite raising around US$12 billion in capital through secondary offerings in 2020, Tesla’s effective dilution to shareholders was likely less than 5% from all the offerings combined. This is a huge advantage that Tesla has over its competitors.

The leading electric vehicle company now has deeper pockets, giving it the ability to scale production faster and to invest more to improve its battery and software technology.

Tesla is not the only company that has taken advantage of soaring stock prices. Singapore’s e-commerce and gaming company, SEA Ltd (NYSE: SE), and communications API leader, Twilio Inc (NYSE: TWLO), are just two other examples of prominent large companies that have pounced on their soaring share prices to raise relatively inexpensive capital through secondary share offerings.

Debt markets

Another way to raise money is through the debt markets. Rather than diluting shareholders, bond offerings and bank loans are another way to raise capital.

Even though companies incur interest expenses and will eventually need to pay back their creditors, debt does not dilute shareholders. In addition, the current low-interest-rate environment enables companies to issue bonds or take up loans at very competitive rates.

Netflix Inc (NASDAQ: NFLX) is an example of a company using the debt market effectively. In the past few years, Netflix’s operating cash flow was negative, as it was spending heavily on content creation. As such, the company needed more capital. Netflix CEO Reed Hastings and his team decided that rather than dilute shareholders through equity offerings, it would issue high yield bonds to pay for its expenses. The result was that the company managed to get the required capital, whilst not diluting existing shareholders.

Although Netflix’s balance sheet may look weak because of the debt, the streaming giant has a clear path to free cash flow generation and should be able to start paying off some of its debt this year.

Over the longer term, Netflix shareholders could start reaping the returns of management’s careful planning and the fact that they were not diluted from Netflix’s debt offerings.

A mix of both?

So far I have discussed companies that have raised capital through secondary share offerings and debt. Another way for companies to raise capital is through an instrument that could be considered a mix of both – and it may be the best way to raise capital.

Convertible bonds are bonds that can be converted to shares at a certain date or when a certain event occurs. These bonds tend to have very low coupon rates and if converted, are usually done so at a large premium to current share prices.

For instance, leading website creation company, Wix.com Ltd (NASDAQ: WIX) raised US$500 million in August 2020 by issuing convertible bonds that are due in 2025.

Get this. The bonds have a 0% coupon, meaning that Wix does not pay any interest to bondholders. On top of that, these bonds convert to Wix shares at a whopping 45% premium to Wix’s last reported share price prior to the announcement of the sale of the bonds.

As such, if the bonds do get converted to shares, the amount of dilution is lower than if the company simply offered a secondary offering which is usually priced at a discount to current share prices.

Why then would anyone want to buy such an instrument? Personally, I much rather buy equity directly than to own convertible bonds. Nevertheless, convertible bonds do serve a purpose for more risk-averse investors.

First of all, bondholders will get their principle back even if the company’s shares fall below the conversion price. They also have a more senior right to the company’s assets should the company run into financial trouble – this provides additional downside security for investors. The convertible aspect of the bonds also offers bondholders “equity-like” upside if Wix’s share price rises beyond the conversion price. However, bondholders are paying a huge premium for the hedge, which I personally would not want to do for my portfolio.

Closing words

The ability to raise capital cheaply is a competitive advantage for a company that is often overlooked by investors.

Having deep pockets could give companies a leg up against their competition in a time when scale and technology are increasingly important.

Shareholders may sometimes frown on companies that are issuing new shares or taking on more debt. But if the company uses its newfound financial muscle to good effect, the new capital could be the difference between emerging a winner or ending up as an obsolete wannabe.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Tesla, Twilio, Netflix, and Wix.com. Holdings are subject to change at any time.

Investable Tech Trends To Watch In The Next Decade

The world and the demands of consumers are changing rapidly. In this article, I identify some investable technology trends and companies that could benefit.

Technology is changing the world, fast. The COVID-19 pandemic has accelerated software and other technology adoption around the globe. And this is likely just the beginning of a multi-year trend. With this in mind, here are some tech trends that I am keeping an eye on.

Programmatic advertising

Programmatic advertising is a way to automatically buy digital advertising campaigns across a wide spectrum of publishers rather than from an individual publisher. Instead of going to a specific vendor to reserve a digital space on their website, advertising real estate is aggregated in ad exchanges where they can be bought or sold. Programmatic advertising software, in turn, communicates with these ad exchanges to buy and sell these advertising spaces, streamlining and optimising the advertising campaigns for advertisers.

In 2021, a whopping 88% of all digital display advertising in the USA is projected to be transacted via programmatic advertising.

According to Research And Markets, the global market for programmatic advertising platforms is estimated at US$5.2 billion in 2020 and is expected to reach US$33.7 billion in 2027, a nearly 31% compounded annual growth rate.

Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG), the parent company of Google, is likely going to be a key beneficiary of this as they dominate the programmatic advertising space with their Adwords platform. Amazon Inc’s (NASDAQ: AMZN) demand-side platform for advertisers has also gained market share in recent years. But we shouldn’t write off independent specialised programmatic advertising companies such as The Trade Desk (NASDAQ: TTD).

A key advantage that an independent programmatic advertising platform such as Trade Desk has over Google Adwords is that it is truly independent, so it will help ad buyers purchase the best digital ad-spaces the platform can find for the buyers’ needs. Google Adwords, on the other hand, may have a preference for Google properties, which may not be the best properties for ad buyers on certain occasions.

Whatever the case, with programmatic advertising exploding in popularity, there will likely be room for multiple winners in this space.

Solar energy

Under the Paris Agreement, participant countries have set a goal to limit global warming to an increase of preferably less than 1.5 degrees celsius compared to pre-industrial levels. This can only be achieved if more of the electricity the world produces comes from clean sources.

One of the most reliable sources of clean energy will be the sun. Solar power is 100% clean, renewable, and reliable. As such, governments around the world are creating policies to incentivise greater use of solar energy for homes and for commercial purposes.

Just as importantly for uptake, the cost of solar energy is coming down. According to the International Renewable Energy Agency, since 2010, the cost of energy production has dropped by 82% for photovoltaic solar and 47% for concentrated solar energy.

Global solar production capacity has also risen from 40GW in 2010 to 580 GW in 2019, suggesting the global demand for solar energy is taking effect. China continues to lead this space, accounting for 35.4% of the global market in 2018. This is driven by huge government initiatives in China in a bid to accelerate clean energy adoption.

In the USA, with the environment-conscious Democratic party taking the majority of the Senate, political observers expect greater impetus for the US government to support solar power.

Companies such as First Solar (NASDQ: FSLR), SolarEdge (NASDAQ: SEDG), JinkoSolar (NYSE: JKS), Enphase Energy (NASDAQ: ENPH), and ReneSola (NYSE: SOL) could stand to benefit.

Electric vehicles

In a similar vein to solar energy, electric vehicles are a cleaner alternative to ICE (internal combustion engine) vehicles. In the past, electric vehicles were slow to gain adoption due to the high cost of batteries and slow charging times. There were also the concerns of short range (distance that can be driven before the vehicle requires charging again) and poor charging infrastructure for electric vehicles due to a lack of charging stations.

But all of this has changed.

The infrastructure in many countries have slowly taken shape while the specifications of electric vehicles are improving at a tremendous pace. Most prominently, charging times, range, and cost have all improved, leading to greater demand from environmentally conscious consumers.

In addition, governments have stepped in to implement policies to encourage the sales of electric vehicles. California has gone as far as to ban the sale of new gasoline-powered vehicles by 2035.

Global passenger electric vehicle sales jumped from 450,000 in 2015 to 2.1 million in 2019. But there is still huge room for growth. In 2020, only 2.7% of total vehicle sales were electric. That figure is expected to rise to 10% by 2025. In the next decade, more than 100 million electric vehicles are expected to be sold around the world.

Tesla (NASDAQ: TSLA) is the largest electric vehicle player in the market, delivering close to 500,000 vehicles in 2020. But this is just the beginning. Tesla is ramping up production quickly, breaking ground on new factories in Berlin and Texas. It is also expected to start production of vehicles in its New York factory which used to be solely for solar panels.

On top of that, its Shanghai and Fremont factories are both not producing at full capacity yet. The two existing factories can increase their annual output in the next few years. Some are projecting Tesla to deliver between 840,000 to 1 million cars in 2021.

With no shortage of demand and no need for advertising (due to incredible consumer mind share), ramping up production will lead to more car sales and more revenue and gross profits for Tesla.

Tesla has also recently taken advantage of its soaring share price to raise new capital. It raised at least US$10 billion in the second half of 2020 through issuing new shares, and these moves provides the company with ammunition to accelerate its production capacity further.

But Tesla is not the only electric vehicle company in town. In the USA, legacy automobile manufactures such General Motors Company (NYSE: GM) and Ford Motor Company (NYSE: F) have been investing in their own electric vehicle models.

Global giants, Toyota (TYO: 7203) and Volkswagen (ETR: VOW3), have also signalled their intent to pivot their business. Other pure play electric vehicle startups in China such as Nio (NYSE: NIO), Li Auto (NASDAQ: LI), and Xpeng (NYSE: XPEV) are also jostling for a piece of the pie. Analysts estimate that there will be 500 different models of electric vehicles globally by 2022.

Whatever the case, multiple winners are set to emerge from this fast-growing space.

Conscious eating

Sticking to the same theme of environmentally conscious consumers, fake meat is becoming the next big trend in conscious eating.

Fake meat refers to either plant-based protein, or lab-grown cell-based protein. In the plant-based space, proteins are extracted and isolated from a plant and then combined with plant-based ingredients to make the product taste and look like meat. Examples of plant-based proteins are Beyond Meat (NASDAQ: BYND) and Impossible Meat.

In lab-grown cell-based meat, an animal cell is extracted from an animal and grown in lab culture. This technology is still not yet in mass production as far as I know, but Singapore was the first to approve lab-grown meat for commercial sales.

Although fake meat is clearly better for the environment, consumer take up has not been rapid due to the high cost of production. Like electric vehicles, in order for fake meat to truly become mainstream, it needs to reach or exceed cost parity with traditional meat – and it needs to taste good.

Temasek-backed Impossible Foods is on the path to reduce cost to consumers. Earlier this year, Impossible Foods announced that it will be lowering prices by around 15% for its open-coded food service products, its second price cut since March 2020.

Another key driver of growth is the sale of fake meat in restaurant chains. McDonald‘s (NYSE: MCD) has decided to debut its own plant-based meat alternative called McPlant in 2021, which Beyond Meat helped to co-create.

According to the research firm, Markets and Markets, the plant-based meat market is estimated to be US$4.3 billion in 2020 and is projected to grow by 14% per year to US$8.3 billion by 2025.

Final words

We are indeed living in exciting times. The world is so dynamic and with new technologies and trends emerging, companies at the forefront of these shifts in demand are primed to reap the rewards.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Amazon, Alphabet, The Trade Desk and Tesla. Holdings are subject to change at any time. Holdings are subject to change at any time.

Why Hour Glass Should Aggressively Buyback Its Shares

With a chronically depressed share price, loads of cash and an ability to self sustain its business, share buybacks seem a good fit for Hourglass.

Singapore-listed luxury watch retailer The Hour Glass (SGX: AGS) has frustrated shareholders for a few years now. Its share price peaked at S$0.88 in 2015 and has been bouncing sideways since. Today, Hour Glass’s shares trade at just S$0.80 each.

The curious thing is that Hour Glass’s business fundamentals have actually improved since 2015.

While many traditional brick and mortar retailers have struggled due to the introduction of e-commerce, this luxury watch retailer has bucked the trend. The reason is that the supply of Swiss luxury watches is tightly controlled. Hour Glass has long-standing relationships with brands such as Rolex and Patek Phillipe, giving it near-exclusive rights in Singapore to sell their highly coveted models.

As such, watch collectors who want to buy first-hand watches in Singapore have little choice but to come to Hour Glass. This has been reflected in its financial statements.

Profit has increased from S$53.5 million in FY2016 (fiscal year ended 31 March 2016) to S$77.5 million in FY2020. Because Hour Glass retains much of its earnings, its net asset value per share has similarly increased from S$0.62 as of March 2016 to S$0.90 as of 30 September 2020.

Hour Glass’s business is also very resilient. A good exhibit is its strong performance from April 2020 to September 2020, a period that included Singapore’s COVID-19 lockdown. In these six months, despite having to close its shops for two months during the circuit breaker we have here in Singapore, Hour Glass still managed to be profitable, generating S$38 million in profit, down just 15% from a year ago.

So what is holding back its share price?

Despite all of this, Hour Glass’s share price is still short of its all-time high price reached way back in 2015. Even the most patient shareholders will likely be getting frustrated by the lacklustre performance of the stock. I was one of these investors, buying its shares in 2014 and holding it till early 2020.

In my view, one of the reasons why its share price has fallen is that there is a lack of cash-reward for investors to buy its shares.

Although the company has grown its profits substantially over the years, it has not used the cash it earned to reward shareholders. In fact, Hour Glass has only been paying out a very small portion of its earnings as dividends to shareholders, opting instead to retain its cash on its own books.

Retaining cash can be a useful thing for a company that has the option of using the cash to generate high returns on capital. Unfortunately, in Hour Glass’s case, this cash has been left in the bank, generating very little returns to shareholders.

With little capital appreciation and a relatively low dividend yield of just 2.5%, there has not been much reason for investors to hold shares of the watch retailer.

The solution?

I think there is a solution to this problem: Hour Glass can simply start to reward its shareholders by returning some of its excess capital to them. One way to do this is to pay a higher regular dividend or a fat one-time special dividend.

Returning cash to shareholders as dividends give investors confidence that they will be paid while owning the company’s shares, hence giving investors a reason to pay up for those shares.

Another way for Hour Glass to reward shareholders is to use its spare capital to buy back its shares.

Share buybacks result in a lower cash balance, but it also reduces the outstanding share count. Remaining investors will end up with a larger stake in the company after the buybacks. This can be hugely rewarding for shareholders, especially when share buybacks are made at depressed prices.

The power of share buybacks

A great example of the power of share buybacks is the story of one of Warren Buffett’s investments, RH, formerly known as Restoration Hardware.

There are many similarities between RH and Hour Glass. Like Hour Glass, RH is a specialist retailer that has generated consistent free cash flow and profits despite the emergence of e-commerce. RH’s share price was also hammered down back in 2017 and 2018 – market participants shorted the company because they were skeptical about the longevity of such a retailer in the face of the emerging threat from online retailers.

The management team of RH were, however, confident of the company’s brand appeal and the strength of its business. Believing that the market was discounting the value of its business, RH began an aggressive share buyback spree. Within three years, RH had used all of its net cash to buyback shares and even borrowed money to acquire more shares. In all, RH reduced its share count by a staggering 59.8%.

This resulted in RH’s remaining shareholders owning close to 2.5 times the stake that they previously had. As a result of the buybacks, the company’s earnings per share skyrocketed and investors started to sit up and take notice. RH’s share price is today up 15-fold since the start of 2017 when the company initiated its share repurchase program.

So what if Hour Glass repurchases its shares?

Hour Glass could do something very similar to RH. It could potentially use a large chunk of its net cash to buy back some of its shares. As of 30 September 2020, Hour Glass had S$136 million in net cash sitting in its coffers. Using just 70% of its net cash to buy shares, at current prices, will result in a 17% decrease in its outstanding shares. In addition, by keeping 30% of its current net cash as reserves, it will still have plenty of firepower for working capital and expansion needs.

Such a buyback plan will not just increase Hour Glass’s earnings per share, but will also increase its book value per share, as Hour Glass is currently trading at an 11% discount to book value. It is also worth noting that Hour Glass trades at just 7.4 times FY2020 earnings.

Share buybacks will, in turn, give Hour Glass the ability to pay a much higher dividend per share in the future (since the total dollar outlay will be lower with a lower share count).

Final thoughts

The importance of good capital allocation decisions should never be underestimated. Even though its business fundamentals have improved, Hour Glass’s reluctance to return capital to shareholders, and its inability to generate good returns on retained earnings, has resulted in an extremely disappointing share price.

I can’t fault market participants for being reluctant to pay any higher for Hour Glass’s shares given the lack of impetus for sound capital allocation and a dividend yield of just 2.5%.

But I think there is a simple solution to the problem. With a resilient business that generates cash year after year, copious amount of excess cash on its books, and a chronically depressed share price, share buybacks seem like a rather easy problem-solver in my view.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have any vested interest in the shares of any companies mentioned in this article. Holdings are subject to change at any time.

How the Distribution of Outcomes Affect Portfolio Construction

Company-specific risk can be decreased by building a portfolio of diversified companies. Here’s the math behind it.

Positive returns in stocks are never a guarantee. Stay far, far away from anyone who tells you otherwise.

Company-specific risks, such as competition or regulatory risk, plus market-wide systemic risks, such as interest rates hikes and global recessions, pose risks to a stock’s long-term return. These risks result in what I call a wide distribution of outcome probabilities.

And yet, in today’s stock market, it seems that more and more investors are starting to ignore these risks and go big or even all-in on just a single stock. Some argue that the large spread in returns between winners and laggards makes a concentrated portfolio more appealing.

But before diving headfirst into building a super-concentrated portfolio, consider the following risk.

What is the distribution of outcomes?

Let’s start with the basics.

When I talk about the distribution of outcomes, I am referring to the probability-distribution of the long-term returns of a stock. For example, a company can have a 20% chance to go to zero, a 60% chance to double up and another 20% chance to triple in value over five years (note that the probability percentages add up to 100%).

As such, there is a distribution of outcome possibilities, each with its own probability of occurring.

In the example above, over a five year period, investors in the company have a 20% chance to lose all their money, a 60% chance to double their money, and a 20% chance to triple their money.

Every stock has a different distribution of outcomes. The probabilities of returns and the range of returns will also differ drastically from stock to stock.

You found a great investment… now what?

Most stocks have a curve of different outcomes but for simplicity’s sake, let’s give the example of a stock that has just two possible outcomes.

This particular stock, let’s call it Company A, has a 30% chance to go bankrupt and a 70% chance to triple in value in five years. Simple mathematics will tell you that this is an amazing bargain. A gambler will take these odds any day.

We can calculate the average expected return we get from this stock by multiplying the probabilities with the outcomes. In this scenario, the expected return is 110%* (calculation below) in five years. Annualised, that translates to an excellent 15.9% return per year, which easily outpaces the returns of the S&P 500 over its entire history.

As such, any investor should happily take this bet. But don’t get too carried away. Even though this stock is a great investment, there is still a 30% possibility that we lose our entire investment in this stock. Would you be willing to take that risk?

Diversification reduces the risk

This is where diversification comes into play.

Instead of making a single bet on Company A, we can add another company into the portfolio.

Let’s say we find another company, Company B, that has slightly lower expected returns than Company A. Company B has a 35% chance of going broke and a 65% chance to triple in value, giving it an expected return of 95%**(calculation below).

The table below shows the probabilities of investing solely in Company A or Company B or investing half into each company.

	Company A Only	Company B Only	Half Each
Expected Annual Return	15.9%	14.3%	15.2%
Chance to Lose it All	30%	35%	10.5%

Source: My computation

From the table above, we can see that the odds of losing your entire portfolio drops to 10.5% after splitting it between the two companies.

This seems counter-intuitive. Even though you are adding Company B into the portfolio, a stock that has a higher chance of going bust than Company A, the combined portfolio still ends up with a lower chance of going to zero.

The reason is that in order for the combined portfolio to go to zero, both companies need to go broke for you to lose your entire portfolio. The probability of both companies going bankrupt is much smaller than either of Company A or Company B going broke on its own. This is true if the two companies have businesses and risks that are not co-related.

What this shows is that we can lower our risk of suffering portfolio losses by adding more stocks into the portfolio.

Even though investors sacrifice some profits by adding stocks with lower expected returns, the lower risks make the portfolio more robust.

The sweet spot

This leads us to the next question, what is the sweet spot of portfolio diversification? Ultimately, this depends on the individual’s risk appetite and one’s own computation of an investment’s probability of outcomes.

For instance, venture capital firms bet on startups that have a high chance of failing. It is, hence, not uncommon for venture capital funds to lose their entire investment in a company. But at the same time, the fund can still post excellent overall results.

For instance, venture investments in any single company may have a 95% chance of going to zero but have a small chance of becoming 100-plus-baggers in the future. A single winning bet can easily cover the losses of many failed bets. Given this, venture capital funds tend to diversify widely, sometimes betting on hundreds of companies at a time. This is to reduce the odds of losing all their money while increasing the odds of having at least some money on a spectacularly winning horse.

Similarly, in public markets, the same principle applies. Some early-stage companies that go public early have significant upside potential but have relatively high risks. If you are investing in these stocks, then wide diversification is key.

Key takeaway

Many young investors today see the stock market as a place to get rich quick. This view is exacerbated by the raging bull of 2020 in some corners of the stock market across the world.

They are, hence, tempted by the allure of making huge wins by concentrating their portfolio into just one or two companies. (You likely have heard stories of many Tesla shareholders becoming millionaires by placing their whole portfolio on just Tesla shares)

Although expected returns may be high, a concentrated portfolio poses substantial risks to one’s portfolio.

I can’t speak for every investor, but I much rather sleep comfortably at night, knowing that I’ve built a sufficiently diversified portfolio to lower my risk of losing everything I’ve worked for

Nevertheless, if you insist on building a concentrated portfolio, it is important to learn the risks of such a strategy and make sure that you are financially and emotionally prepared with the very real possibility of losses.

*(0x0.3+300%x0.7-100%)=110%

**(0x0.35+300%x0.65-100%)=95%

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have any vested interest in the shares of any companies mentioned in this article. Holdings are subject to change at any time.

Shopify, Amazon, Costco or Alibaba? A Price-to-sales Analysis

When choosing a company to invest in, the first thing we may filter for is a low valuation multiple. But that may be too simplistic…

Investors often use the price-to-sales multiple to value a company. This makes sense as sales is a proxy for how much cash the company can generate for its shareholders (there’s no way to generate cash without sales). It is also more useful than price-to-earnings when a company is not yet profitable.

However, in the stock market, there is a disparity between the price-to-sales ratios that various companies have.

Take a look at the table below. It shows the price-to-sales multiples of some prominent “retail” companies around the world.

Company	Current price-to-sales multiple
Shopify Inc (NYSE: SHOP)	51.7
Alibaba Group Holdings Ltd (HKG: 9988)	8.9
Amazon.com Inc (NASDAQ: AMZN)	4.6
Costco Wholesale Corporation (NASDAQ: COST)	0.96

Source: Compilation from Ycharts based on data as of 14 December 2020

As you can see, these four companies trade at remarkably different sales multiples. Costco trades at the lowest price-to-sales multiple of less than 1. This means that if you buy Costco’s shares now, you are paying less than a $1 for every dollar of sales that the company earns.

On the other end of the spectrum is Shopify, which trades at a price-to-sales multiple of 51.7. For every dollar of revenue that Shopify generates, investors need to pay $51.70.

Just looking at this table, you will likely assume that the shares of Costco are much cheaper than Shopify’s.

But the truth is that the price-to-sales multiple is just one part of the analysis. There are often good reasons why paying a premium multiple may make sense. In this article, I describe some of the main considerations and why you should never look at the price-to-sales multiple at face value without considering these other factors.

Growth

Perhaps the most obvious reason to pay a premium price-to-sales multiple is for growth. A company that is growing revenue quickly should command a higher multiple.

For instance, take two companies that are generating $1 in sales per share. One company is growing at 50% over the next five years, while the other is growing at 10%. The table below shows their revenues over five years.

	Fast Grower Revenue per share	Slow Grower Revenue per share
Year 0	$1	$1
Year 1	$1.50	$1.10
Year 2	$2.25	$1.21
Year 3	$3.37	$1.33
Year 4	$5.06	$1.46
Year 5	$7.59	$1.61

Source: Author’s calculations

In this scenario, even if you paid a price to sales multiple of 20 for the fast grower and a price-to-sales multiple of 10 for the slow grower, the fast-grower still ends up as the company with the better value for money. The table below illustrates this.

	Fast Grower Revenue per share	Price paid	Price-to-sales multiple	Slow Grower Revenue per share	Price Paid	Price-to-sales multiple
Year 0	$1	$20	20	$1	$10	10
Year 5	$7.59	$20	2.6	$1.61	$10	6.2

Author’s Calculations

By the fifth year, the price-to-sales multiple based on your share price at cost is actually lower for the fast-grower than the slow grower, even though it started off much higher.

Let’s relate this back to the four companies mentioned earlier.

The table below shows their revenue growth in the last reported quarter.

Company	Current price-to-sales multiple	Year-on-year revenue growth rate for the last reported quarter
Shopify	51.9	96%
Alibaba	8.9	30%
Amazon	4.6	37%
Costco	0.96	17%

Source: Author’s compilation from various quarterly reports

Based on the figures above, we can see that Shopify has the highest growth rate, while Costco has the slowest.

Margins

The next factor to consider is margins. Of every dollar in sales per share that a company earns, how much free cash flow per share can it generate?

The larger the margins, the higher the price-to-sales multiple you should be willing to pay.

As some companies are not yet profitable, we can use gross margins as an indicator of the company’s eventual free cash flow margin.

Here are the gross margins of the same four companies in the first table above.

Company	Current price-to-sales multiple	Gross Profit Margin
Shopify	51.7	53%
Alibaba	8.9	43%
Amazon	4.6	25%
Costco	0.96	13%

Source: Compilation from Ycharts as of 14th December 2020

There is a clear trend here.

Based on current share prices, the market is willing to pay a higher multiple for a high margin business.

This makes absolute sense as the value of every dollar of revenue generated is more valuable to the shareholder for a high margin business.

Shopify is a software business that charges its merchants a subscription fee. It also provides other merchant services such as transactions and logistics services. As a software and services business, it has extremely high margins.

On the other end of the spectrum, Costco is a typical retailer that has its own inventory and sells it to consumers. It competes in a highly competitive retail environment and sells its products at thin margins to win market share. Due to the razor-thin margins, it makes sense for market participants to price Costco’s shares at a lower price-to-sales multiple.

Predictability of the business

Lastly, we need to look at other factors that impact the predictability of the business. Needless to say, a company with a more steady revenue stream that recurs every year should command a premium valuation.

There are many factors that can impact this. This includes the business model that the company operates, the company’s brand value, the presence of competition, the behaviour of customers, or any other moats that the company may have.

A highly predictable revenue stream will be valued more highly in the stock market.

Shopify is an example of a company that has a predictable revenue stream. The e-commerce enabler charges merchants a monthly subscription fee to use its platform. It provides the software to build and run an e-commerce shop. As such, it is mission-critical for merchants that built their websites using Shopify. Given this, it’s likely that many merchants will keep paying Shopify’s subscription fees month-after-month without fail. Investors are therefore willing to pay a premium for the reassurance of the predictability of Shopify’s existing revenue stream.

Final thoughts

There is no exact formula for the right multiple to pay for a company. As shown above, it depends on a multitude of factors.

But the main takeaway is that we should never look at a company’s price-to-sales or price-to-earnings multiples in isolation.

Too often, I hear investors make general statements about a stock simply because of the high or low multiples that a stock is priced at.

These multiples may be a good starting point to value a company but it is only one piece of the puzzle. It doesn’t capture the nuances of a company’s business model, its growth, or its unit economics… Only by considering all these factors together can we make a truly informed decision.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Amazon, Costco Wholesale Corporation, and Shopify. Holdings are subject to change at any time.

Is Index Investing Really Passive?

Wallstreet terms index investing as a passive strategy. But is investing in an index fund truly passive? Personally, I don’t think so.

The finance community often use the term “passive investing” to apply to investing in index funds. But is investing in an index fund really a “passive” strategy?

Actually not.

Most indexes actually have an active method of selecting their stocks. For example, the S&P 500 only includes the top 500 stocks by market capitalisation that are listed and headquartered in the USA. In addition, the stocks need to have at least four consecutive quarters of profitability.

The S&P 500 is also market-cap weighted. As such, bigger companies have a larger weight in the S&P 500 index, and their returns have a bigger impact on the index’s overall return.

I consider this method of selection and weighting as an active method of selecting stocks. Moreover, the selection criteria are determined by a committee and the committee also has the final say on whether a stock should be included in the index. This was the case for Tesla Inc (NASDAQ: TSLA), which was only included after it reported its fifth profitable quarter (instead of fourth).

Portfolio weighting

Ultimately, these active decisions made by a committee impact the index’s returns. For instance, the simple act of choosing to weight the index based on market cap has had a profound impact on the S&P 500 index over the last 10 years.

The table below shows the returns of the S&P 500 index against the S&P 500 equal-weighted index.

Source: My compilation from data from S&P

As you can see, the market-cap weighted index far outpaced the equal-weighted one. This is because larger stocks, which have a bigger weighting in the market-cap-weighted index, have outperformed their smaller counterparts over the last 10 years.

Choosing the right index

All of which points to the fact that not all indexes are made equal.

Each index has specific selection criteria and a specific method of weighting its constituent stocks. Ultimately, these are active choices made by the committee building the index.

As investors, we may think that “index investing” is a passive strategy.

But indexes are not completely passive. The stocks within an index have been picked based on criteria that are “actively” chosen.

Even in Singapore, the Straits Times Index (STI), which is a commonly used indicator of the health of Singapore’s stock market, may not be truly representative or passive.

The rules for inclusion into the STI are based on a stock’s market cap, liquidity, and a minimum amount of voting rights in public hands. As such, the stocks selected in the STI are actually picked by the committee based on a selection methodology that they have actively chosen.

Index investing is actually “active”

Ultimately, investing in any index is not a truly passive way to invest. The exposure you gain is based on active decisions made by the index committee that built the index.

In addition, with so many indexes available, choosing an index to invest in is also an active decision made by the investor. Within the US alone, there are funds that track the S&P 500, S&P 500 Equal Weight, MSCI USA, MSCI USA Equal Weighted Indexes, and many more. Each of these indexes has performed differently over the last 10 years.

Index investing is, hence, not truly “passive”.

By investing in any index, you are actually making an “active” decision that the “active” selection and weight criteria used in that particular index will work best for your investment needs.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in the shares of any companies mentioned. Holdings are subject to change at any time.

Is It Too Late to Buy Moderna and BioNTech Shares?

Moderna and BioNTech’s share prices have increased by 621% and 237% year-to-date. Is it too late to get in on these COVID-19 vaccine frontrunners?

A few weeks ago, the world rejoiced to the news that two COVID-19 vaccine trials produced extremely encouraging results.

Pharmaceutical giant Pfizer Inc (NYSE: PFE) and BioNtech (NASDAQ: BNTX) announced that their trial COVID-19 vaccine was 95% effective. In its phase III trial, out of the 170 confirmed cases of COVID-19 among the trial participants, 162 were from the placebo group, while only 8 were in the vaccine group.

Hot on the heels of Pfizer and BioNtech’s announcement, Moderna (NASDAQ: MRNA), a young front-runner in the development of mRNA-based vaccines, announced that its own investigational COVID-19 vaccine had promising interim results. Out of 95 participants of the trial who got COVID-19, only 5 were from the vaccinated group, suggesting a 94.5% efficacy rate.

Stock markets have reacted sharply to the news. Moderna’s current share price is nearly 60% higher from the day before its vaccine announcement on 16 November 2020, while BioNtech’s share price is up by 24% since its joint announcement with Pfizer on 9 November.

Year-to-date, Moderna and BioNtech’s share prices are up by 621% and 237%, respectively.

US$200 billion opportunity

With the hype surrounding these two companies, I wanted to find out if it was too late to get in on their shares. To do so, I came up with a simple calculation to see how much the two companies could potentially earn from their vaccines.

We are currently being told that for best efficacy, two doses of the vaccines are required. There are 7 billion people in the world and to achieve herd immunity, 70% of the population (5 billion people) needs to be vaccinated.

Based on these figures, the world will need about 10 billion doses.

The US government has placed an initial order of 100 million doses for US$1.95 billion with Pfizer and BioNTech, with the option to purchase 500 million additional doses. That works out to US$20 per dose. Moderna has said that it will charge between US$25 and US$37 per dose.

Moderna’s market cap vs its potential profits

We can now answer the question of whether the rally in Moderna and BioNTech’s share prices are justified.

Let’s take a base case scenario that the two front runners will manage to corner 50% of the market opportunity.

If Moderna can supply 25% of the global need for COVID-19 vaccines, it will need to supply 2.5 billion doses. We can also assume that these vaccine doses will be sold over a few years. Moderna CEO Stephane Bancel said that they are on track to produce between 500 million to 1 billion doses in 2021.

For the sake of simplicity, let’s assume that Moderna will sell 500 million doses a year for five years. Based on US$25 per dose, that translates to US$12.5 billion in revenue each year.

Pharmaceutical companies can command extremely high margins, especially for a novel product that is first to the market. Given this, Moderna can possibly earn a gross margin as high as 60%, and a net margin of 40%. This will mean that Moderna could earn an annual net profit of US$5 billion based on my projected revenue figure.

Moderna currently sports a market cap of US$56 billion. Given these assumptions, it trades at around 11 times its potential annual earnings.

How About BioNTech?

BioNtech currently has a market cap of US$27.5 billion. Pfizer has agreed to pay BioNTech US$185 million in a mix of cash and Pfizer shares, and an additional US$563 million for future milestone payments.

In addition, BioNTech stands to earn 50% of the profit brought in from the sale of the vaccines.

Pfizer and BioNTech sold their first batch of vaccine doses to the US government at US$20 per dose. If they can sell a similar number of doses as Moderna and achieve similar margins, BioNTech’s share of the profit will be around US$2 billion.

Based on this scenario, BioNTech trades at 14 times this potential annual earnings.

If the above scenarios materialise, BioNTech and Moderna stand to gain a huge windfall. On top of that, their current valuations, at less than 15 times future earnings each, do not seem too demanding.

But…

… there are risks.

First of all, not every government may be willing to pay for the vaccines to immunise their country. Governments from first world countries such as the US, UK, Malaysia, and Singapore have shown a willingness to pay for the vaccines for their citizens but other countries may not be so willing or even have the means to do so. If fewer governments bite, my estimate of a market opportunity of 10 billion doses over five years may have been overstated.

Another thing to consider is the threat of new vaccines. Competition could erode margins and lead to a lower market share than I modelled for. Pharmaceutical giants AstraZeneca and Johnson and Johnson, have pledged not to make a profit from their vaccines as long as the world is still in a pandemic. This could force companies like Moderna to lower their prices if vaccines from these companies gain approval in the coming months.

We should also not overlook the fact that the vaccines may be effective enough that patients do not need a booster every few years. In this scenario, it could be possible that after the initial demand for vaccines, and once global herd immunity is achieved, subsequent demand for vaccines will subside and earnings will dry up.

This is a legitimate concern as both BioNTech and Moderna have no other product currently in the market.

Potential tailwinds

But there are some potential tailwinds on the cards. Both Moderna and BioNTech have a healthy pipeline of drugs in development besides their COVID-19 vaccines.

The success of their COVID-19 vaccines also validates the potential of mRNA technology in other use-cases. Experts claim that mRNA-based vaccines could potentially be targeted at numerous diseases that we previously had no vaccines for. Both companies specialise in mRNA technology and could stand to benefit from this breakthrough. Moderna, for example, is working on another mRNA vaccine for CMV, which is already in phase II clinical trial.

Besides vaccines, both companies are also researching drugs that use similar mRNA technologies to treat cancer. Moderna currently has a total pipeline of 20 other drugs while BioNTech boasts a pipeline of 28. If another blockbuster drug reaches the market, they could unlock a different source of profits.

So is it too late to buy now?

Investing in young Biotech companies is risky but can be rewarding. The successful commercialisation of a single drug, as in the case of both Moderna and BioNTech, can lead to a multi-year windfall for the company and, as shown, a large appreciation in its share price.

However, there are also risks to pre-product companies.

Many may start off with a promising novel technology only to stumble at the final hurdle.

In Moderna and BioNTech’s case, they seemed to have successfully navigated the final hurdle to commercialisation by posting excellent phase III results for their COVID-19 vaccines. The market opportunity for them is huge and they are set to bring in copious amounts of cash in the not so far future.

But are investors on the sidelines too late now? With the spike in both the share prices of Moderna and BioNTech, and considering the possibility of competition, it seems that the market has already priced in a substantial amount of the future earnings from both companies’ COVID-19 vaccine.

I believe investors who are still considering investing in these two companies should not focus on the COVID-19 vaccine as this has already been priced into the stock. Instead investors should explore the pipeline of drugs and how Moderna and BioNTech plan to invest their windfall. This will be a greater determinant of the long-term returns of the company’s shares.

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. We currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.

Is Zoom Video Communications Overvalued?

Zoom Video Communications is one of the hottest stocks this year and is up by 460% year-to-date. Does it still have legs to run?

Zoom Video Communications Inc (NASDAQ: ZM) has been on a roll this year. The video conferencing software provider has been one of the main benefactors of the COVID-19 pandemic.

In the quarter ended 30 April 2020, Zoom’s revenue increased by a mind-boggling 169% from the corresponding period a year ago. But that wasn’t all. In the very next quarter ended 31 July 2020, Zoom again blew past expectations, reporting a 355% increase in revenue.

Unsurprisingly, investors have reacted sharply to the news, sending Zoom’s stock price up 460% since the turn of the year. As of the time of writing, the company was valued at US$114.8 billion. To put that in perspective, the Singapore stock market’s largest company by market capitalisation, DBS Group Holdings, is only valued at S$61 billion. Zoom was born just nine years ago in 2011 while DBS took 52 years to get to where it is today.

The question now for investors is whether Zoom is overvalued.

Growth skeptic

In March this year, I preached conservatism when it came to Zoom. The company, then, had a market cap of around US$38 billion. It had just doubled in value and I was concerned that investors were getting too optimistic.

Looking back, I was way too conservative in my growth projections. Zoom went on to blow past consensus expectations in the two quarters after that, as I had described earlier, far exceeding what some of the biggest bulls had expected.

Zoom has become more than just a company, it has become a verb. Even my non-techy parents use “Zoom” as a synonym for video conferencing.

Since my article, Zoom has more than quintupled in value. After seeing the quick pace of adoption, my blogging partner, Ser Jing, and I decided that Zoom was worthy of a place in our investment fund’s portfolio.

We bought our first tranche of shares at US$254, which was then close to an all-time high and have added more since. Today, Zoom’s shares trade at around US$404.

Believing

I used to be one of the sceptics when it came to Zoom’s valuation but I am now firmly in the opposite camp. In fact, I think that even after the recent run-up in its share price, Zoom can still provide significant value for long-term investors.

Zoom exited the quarter ended 31 July 2020 with an annual revenue run rate of US$2.6 billion. Unlike many high-growth software companies, Zoom boasts not just GAAP profitability, but also a high free cash flow margin. In that quarter, it had a free cash flow margin of 56%. Boosted by record collections during the quarter, Zoom’s cash flow margin is best-in-class for software companies.

Even after accounting for any one-off jump in collections for the quarter, I think Zoom can settle at a free cash flow margin of close to 40% at its steady state.

Given this, and using Zoom’s annual revenue run rate, Zoom currently trades at a normalised price-to-annual free cash flow run rate multiple of 110. By most accounts that seems like a high multiple to pay. But let’s not forget that Zoom has immense business momentum in its favour. The company just grew by a staggering 355% in the last quarter and in its recent Zoomtopia customer and investor day event, the company let slip that usage is up since then.

Can Zoom continue to grow?

Zoom has undoubtedly been one of the benefactors of shelter-in-place measures enacted by governments around the world to combat COVID-19. But even after life returns to normal, I believe Zoom will still be a mainstay for most companies. Video conferencing has become a norm due to the ease and practicality of its use. In fact, many companies have announced that they will permanently adopt work-from-home or hybrid work settings, allowing employees to spend either all or part of their time working from home.

Although Zoom’s growth will understandably slow when the pandemic passes, I believe the company will still see decent growth well into the future as video conferencing becomes even more prevalent for businesses and individuals alike.

Zoom is also barely scratching the surface of its total addressable market. In its IPO prospectus released last year, Zoom stated that it is addressing a US$42 billion communications market, according to independent market researcher International Data Corporation. But I believe the US$42 billion figure understates the increasing number of use cases that video conferencing addresses. The pandemic has demonstrated that video conferencing software can be used for education, telemedicine, fitness classes, and many more purposes than previously imagined.

Given the momentum in video conferencing, I think it is not beyond Zoom to quadruple its annual revenue and free cash flow run rate in five years to north of US$10 billion and US$4 billion respectively.

Zoom’s current valuation is, hence, just 28 times that projected free cash flow in 2025. More importantly, I don’t see its growth stopping there. Zoom’s CEO, Eric Yuan, and his crew are highly innovative and have already recently released new products such as Zoom Phone and Zoom hardware to expand its addressable market.

Final words

From a trailing-12-months perspective, Zoom seems immensely overvalued. However, for a company that is growing as fast as Zoom is, the next 12 months will look very different from the last 12, so we certainly shouldn’t be looking backwards to come up with a valuation.

Looking beyond the next 12 months, Zoom’s growth will likely endure as it seeks to win its share of the more than US$42 billion market opportunity ahead of it. Competition remains a threat to Zoom, given that Zoom users can just as easily switch to an alternate software. But I believe that Zoom’s relentless pursuit of customer satisfaction and its superior product gives it a big leg up over its competitors. Zoom boasts a net promoter score of 62, the highest among video conferencing software that I’ve seen.

Zoom’s branding is also remarkably strong at the moment. Like Google, Zoom has become a verb, which is a fact that shouldn’t be underestimated.

Although there is invariably a chance that Zoom can lose its focus on satisfying customer, and competition can erode growth, the pie is large enough for multiple winners in this space. Given all this, and the momentum behind Zoom, I think that the odds of its success far outweigh the risks. For more on Zoom, you can head here to find an investment thesis for the company that Ser Jing and I have penned for our investment fund.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Zoom Video Communications. Holdings are subject to change at any time.