Author: Jeremy Chia

Most of you reading this would be familiar with Uniqlo.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Risks

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

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

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

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

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

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

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

Valuation

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

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

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

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

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

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

Company description

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

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

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

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

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

I think Lululemon can do both.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. Are its revenue streams recurring in nature?

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

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

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

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

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

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

5. Does Lululemon have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Risks

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

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

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

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

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

Valuation

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5. Does Uber have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Other risks

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

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

Software-as-a-service (SaaS) is fast-becoming the go-to business model for software companies. The SaaS model gives the service provider a predictable and recurring revenue stream, while clients enjoy hassle-free software updates, cloud storage, and the ability to access the software seamlessly on multiple devices.

One company that has quietly transitioned to the SaaS model is Autodesk (NASDAQ: ADSK). The 3D design and engineering software company is reaping the returns of this shift as recurring revenue streams have steadily increased. 

The market has also appreciated the company’s shift toward the SaaS model. Autodesk’s stock climbed 44% in 2019, compared to a 29% gain for the S&P 500.

With all that said, I decided to do a quick review of Autodesk using my blogging partner Ser Jing’s six-point 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?

I think the answer to this is yes. Autodesk raked in US$715 million in revenue in the third quarter ended 31 October alone, and US$2.5 billion in its fiscal year 2019, which ended on 31 January.

On the surface that seems huge, but Autodesk’s revenue is still tiny compared to its total addressable market. Management expects that its market opportunity today is about US$48 billion. It sees that figure rising to US$59 billion by 2023.

To get a better grasp of Autodesk’s market opportunity, we need to understand what Autodesk really does. In short, the company provides a suite of different software-as-a-service, including computer-assisted design, construction management, and animation among others. It is the go-to software provider for the architecture and construction world. 

Its Revit design software is one of the most commonly used among architects, which in turn leads to engineers and construction professionals using Autodesk services to collaborate with each other. Travis Hoium explained in an article for the Motley Fool:

“Once architects are hooked, then the waterfall of other available products begins. Engineering firms are more likely to use Navisworks (another one of Autodesk’s software) for model reviews of engineering and construction documents if an architect works in Revit. Building information modeling software like BIM360 also becomes more efficient in optimizing the construction process.”

The switch to a subscription model has also started paying off. Recurring revenue streams are growing, while the company’s painful transition years in 2016 and 2017 are already behind it. In the first three quarters of fiscal 2020, Autodesk generated a 57% increase in recurring subscription revenue and a 29% jump in total revenue. 

More importantly, there is a group of customers who are still on the licensing model who could potentially transition to the subscription model in the future. As of July this year, Autodesk converted about 4.3 million customers to its SaaS model. But there are around 18 million active users of its software, which means that 14 million more users could potentially switch to the subscription model in the future. Autodesk’s very own user base represents a huge untapped addressable market.

The other big market opportunity is the move towards augmented reality and 3D models. While the technologies have not yet caught on, they could potentially be another avenue of growth. 

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

The next criterion in the framework is balance sheet strength. I typically want to invest in companies that have minimal or reasonable amounts of debt so that it can continue to sustain its operations should bad times arise.

Unfortunately, Autodesk fails in this regard. The software giant has been investing heavily in acquisitions and has suffered losses over the last few years. That has hurt its financials.

As of 31 October 2019, Autodesk had around US$1 billion in cash and marketable securities. However, it also sat on around US$1.75 billion of debt. On top of that, it was in the unenviable position of having negative shareholder equity. The company had US$5 billion in assets and US$5.2 billion in liabilities. That’s certainly a black mark in my books.

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

I think Autodesk’s management team has proven itself to be innovative and capable in a few ways. Current CEO Andrew Anagnost has only had a short history as CEO, but he has already managed to transition the company to a subscription-based model fairly seamlessly.

For the three months ended 31 October, around 83% of the company’s total revenue was from recurring subscriptions. In fiscal 2019, Autodesk also managed to top its revenue generated in 2016, the year it started to make the transition to subscription.

Autodesk has also invested heavily in R&D. I believe its investments in expanding its product services, specifically into augmented reality, will pay off substantially when the market is eventually ready for it.

I also believe that the compensation structure for Anagnost and other executives is tied to that of Autodesk’s long-term shareholders. The performance metrics for the CEO and other senior executives included total annual recurring revenue, free cash flow per share, and total shareholder return over 1,2, and 3 years. While I prefer to see a larger focus on shareholder return over a longer time frame, I think that the performance indicators seem reasonable.

4. Are its revenue streams recurring in nature?

Recurring revenue is an underappreciated but beautiful thing for a company to have. Not only does it mean reliable revenue streams year after year, but the company can also spend less time and money on past sales and focus on other aspects of its business.

Autodesk ticks this box easily. Its transition to a subscription-based model means that its revenue is likely going to be recurring year after year.

Its net revenue retention range is also consistent between management’s target of 110% to 120%, which means existing customers are increasing their net spend on its products by 10% to 20% each year.

Autodesk provides free software training in a bid to grow its user base and to let students as young as grade school get familiar with its software. But the high lifetime value of each customer makes these customer acquisition efforts extremely worthwhile over the long-term.

On top of that, the fact it has about 4 million subscriptions to its services means there is very little customer concentration risk.

5. Does Autodesk have a proven ability to grow?

Autodesk is one of the early movers in software. It was founded nearly 40 years ago by John Walker who co-authored the first versions of AutoCAD. The software company has grown from focusing solely on computer-assisted design to one that has a whole suite of services. 

Its revenue has also soared to around US$3 billion. In more recent years, the company’s top line has fluctuated due to the move towards subscriptions. But with the transition more or less complete, it is likely to have a smoother growth ride ahead. Analysts are also anticipating twenty-plus percent annual revenue growth for 2020.

6. Does Autodesk 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 not based on its profits but on its cash that it can generate in the future. That is why the sixth criterion of Ser Jing’s investment framework is so essential. 

While Autodesk’s free cash flow generation has been lumpy for the last few years, the completion of the transition to subscriptions will likely mean better days ahead. This year, Autodesk showed signs that it has begun to reap the fruits of its work.

In the nine months ended 31 October 2019, the company generated US$677.7 million in free cash flow. 

The company’s gross profit margin stands north of 80%, which means that as the company scales down other expenses, we can expect it to generate a healthy net profit margin, and in turn a higher free cash flow margin.

Risks

A discussion of a company will not be complete without addressing the potential risks.

As mentioned earlier, the main risk I see in Autodesk is its weak balance sheet. The company has net negative shareholder equity and is sitting on a pile of debt. That said, it has started to generate a decent amount of free cash flow. This should enable it to pay off its interest expenses and to reduce some of its debt load.

The company also paid its executives nearly US$250 million in share-based compensation in the year ended 31 January 2019. While stock-based compensation does not factor into the company’s cash flow statement, it does have a meaningful impact. It reduces earnings per share and results in heavy dilution of shareholder interest. For a company that is generating around US$3 billion in revenue, stock-based compensation of US$250 billion does seem excessive. 

Competition is another major risk. Autodesk operates in a highly competitive environment that is subject to change. That said, Autodesk has been investing heavily in research and technology to update its software and provide new services. I also believe its customer base who have familiarised themselves with Autodesk will be unwilling to swap products so easily.

Valuation

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

Autodesk is anticipated to generate an annualised revenue of around US$3.2 billion in its current fiscal year. The company’s customer count can increase as more of its existing customers switch to subscription models. Revenue will also likely grow organically as existing customers pay more in revenue each year. This can happen by increasing the number of services they buy or through price hikes.

In 10 years’ time, I estimate that around a quarter of Autodesk’s 14 million existing clients who are currently not on subscription plans will eventually switch over. That will bring the total number of customers subscribing to Autodesk’s services to eight million (from four million now). In addition, if the net revenue retention rate continues at 110% per year for 10 years, revenue could eventually reach US$16 billion.

It is difficult to estimate Autodesk’s mature-state profit margin, but considering its 80%-plus percent gross margin, it could easily reach a 10% net profit margin. That translates to US$1.6 billion in net profit.

Attaching a 30 times multiple to the projected net profit, the software giant’s market cap could potentially scale to US$48 billion.

Based on my estimate and the current market cap of the stock of around US$40 billion, the future market cap translates to 20% upside. 

However, a 20% upside for a 10-year holding period is too low for my liking.

The Good Investors’ conclusion

There are certainly many things to like about Autodesk. Its transition into a subscription-based model gives it a more predictable recurring revenue stream. The addressable market opportunity for the company is also immense compared to its current revenue.

But having said all that, from a valuation standpoint, the company seems expensive. At its current market cap of US$40 billion, Autodesk sports a 12.5 price-to-sales (PS) ratio. It also only provides a 20% upside to my 10-year valuation projection.

Admittedly, my projection is very rough and conservative, but Autodesk’s high valuation leaves very little room for execution risk. In addition, if its relatively high stock-compensation scheme continues to rise, it might leave shareholders grasping at straws because of dilution, even if the company generates more free cash flow in the future.

As such, even though Autodesk seems like a solid growth company, it still remains only on my watchlist.

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.

Haidilao has been one of the top-performing stocks in Hong Kong this year. The premium hot pot restaurant brand’s share price has climbed 79.4% this year, compared to a 10.8% gain for the Hang Seng Index.

But historical share price performance is not necessarily an indicator of future success. With that said, I decided to do a quick analysis of Haidilao’s business. I will use Ser Jing’s six-criteria investment framework to determine if the company is indeed worth buying.

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

This criterion is important because Ser Jing and I want to invest in companies that have the ability to grow. The size of the company’s addressable market, and the speed of the market’s growth, are important determinants of the company’s growth potential.

I think Haidilao ticks this box easily. The hotpot king’s revenues are still tiny compared to its overall addressable market size. 

Haidilao, as of 30 June 2019, had a network of 593 restaurants around the world. On the surface that seems like plenty but if you dig deeper a different picture emerges.

First, Haidilao has room to grow in China. The company has 550 restaurants in mainland China. Given that China’s middle-class population (defined by the Chinese government as having an annual income of RMB 60,000 to RMB 500,000) numbers around 420 million people, that translates to just one restaurant for every 763,300 middle-income person in the country. 

Comparatively, the largest casual dining chains in the US restaurant industry serve around 200,000 to 500,000 people (including the low-income population) per restaurant.

If we assume Haidilao can penetrate the market at the low end of that range, it can increase its store count by more than 30% just based on the current middle-income population.

On top of that, the middle income population in China is growing – and fast. Mckinsey estimates that the upper-middle-class population (defined by McKinsey as having an annual income of RMB 106,000 RMB to RMB 229,000) will account for 54% of urban households by 2022, up from just 14% in 2012. That loosely translates to a population of 750 million people. The new generation of upper-middle-class is more sophisticated, has more picky taste, and is more loyal to brands.

All of which is good news for Haidilao, which already has an established reputation for good food and impeccable service.

The Mainland China market is not the company’s only avenue for growth. Haidilao has successfully broken into other International markets such as Taiwan, Singapore, Japan, South Korea, Malaysia, Australia, the United Kingdom, Canada, and Vietnam. And it has barely scratched the surface of the International market scene. It only operates 43 restaurants outside of China, leaving it plenty of room for growth. The average spending per guest outside of China is also much higher at RMB 185 per customer, compared to its overall average spend of RMB 104.4 per customer. 

The company’s recent financial results also point to its ability to grow. In the 12 months ending 30 June 2019, Haidilao increased its store count by 73.9%, or 252 stores. More importantly, the increase in store numbers had little impact on existing stores, signaling limited cannibalisation. Same-store sales increased by around 4.7% and the average same-store table turnover increased to 5.2 from 5.0.

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

Haidilao is in a great position financially. As of 30 June 2019, the group reported a positive net cash balance of around RMB 2.57 billion. It also had another RMB 1.7 billion in deposits placed with financial institutions. The company generated RMB 1.9 billion in cash from operations in the first six months of 2019; it was more than sufficient to fund capital expenditures for the opening of new restaurants which amounted to RMB 1.7 billion.

It is good to see that Haidilao is using internally-generated cash to expand rather than tapping into its reserves.

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

Haidilao has not had a long history as a listed company, but its management seems to be treating existing shareholders fairly for now.

Even though 38% of Haidilao’s suppliers are linked to CEO Zhang Yong and his family, the cost of goods has not increased unreasonably since Haidilao was listed. This is a sign that Zhang Yong is committed to treating Haidilao and its minority shareholders fairly. On top of that, Haidilao has also started to reward shareholders by paying a small dividend for 2018.

Zhang Yong has also proven himself to be a capable leader. Now Singapore’s richest man, Zhang Yong has maintained his commitment to improving the customer experience in his restaurants. He has also overseen the company’s adaptation numerous times, including its expansion into delivery, Haidilao-branded food products and the adoption of artificial intelligence in restaurant operations.

Haidilao is also one of the more innovative businesses in the traditional F&B industry: 

• The company was one of the first to provide unique manicure and free snack services for customers waiting for a seat.
• This year, it deployed intelligent robotic arms and intelligent soup base preparation machines in 3 restaurants. It also introduced AI robot waiters in 179 restaurants.
• It has expanded its offering and now offers milk tea under the Haidilao brand. In 2019 alone it introduced 187 new dishes.
• It encourages restaurant-level managers to maintain customer service by sending at least 15 mystery diners each year to each restaurant to rate their experience. Their feedback is a key performance indicator for managers.
• Restaurant managers are also compensated based on the profitability of the restaurants under their care.
• Restaurant managers are encouraged to train mentees and they are then compensated based on the profitability of the restaurants that their mentees manage. 

These unique initiatives have helped to create a culture of providing good service and have enabled the company to retain talent more effectively.

4. Are its revenue streams recurring in nature?

A recurring revenue stream is an underrated but beautiful thing to have. It means the company does not have to spend time and money to remake a past sale. This can be achieved through repetitive customer behaviour or long contracts with clients.

In Haidilao’s case, its strong brand and loyal customers make its revenue streams recurring and predictable. 

Needless to say, more brand-conscious consumers are loyal to brands that they trust. Haidilao has a strong brand and sticky following with consumers. The long queues in its Singapore outlets are a testament to that.

The number of customers Haidilao serves is also obviously large. In 2018, it served more than 160 million customers! That means it has no customer concentration risk at all.

5. Does Haidilao have a proven ability to grow?

Haidilao was listed only in 2018, and so far, it has shown the ability to grow based on its financials released in its initial public offering prospectus and subsequent earnings updates.

Revenue has compounded by 43% per year from 2015 to 2018 and the growth rate accelerated to 59% in the first half of 2019. Profit has grown at an even faster pace, at a compounded rate of 82% per year from 2015 to 2018. In the first half of 2019, profit increased by 41%.

6. Does Haidilao 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 not based on its profits but on all the cash that it can generate in the future. That is why the sixth criteria of the investment framework is so important.

Based on Haidilao’s recognisable brand, strong customer loyalty, and the management’s determination to keep customer-satisfaction high, I can see customers continuing to frequent the company’s restaurants well into the future.

Haidilao is not only well-positioned to grow its store count, but same-store sales are also growing at mid-single-digits.

Although capital expenditures remain high, likely due to the opening of stores, I foresee that Haidilao could start to generate copious amounts of free cash flow in the future.

Risks

A discussion of a company will not be complete without addressing the potential risks.

Keyman risk is an important concern I have with Haidilao. Zhang Yong is a visionary leader who reinvented the hotpot dining space, through innovative initiatives. He continues to adopt new technologies and has constantly implemented plans to improve his customers’ dining experience.

He is the key reason for the brand’s huge success so far. Zhang Yong is 45 now and I don’t foresee him stepping down anytime soon. Nevertheless, investors should watch this space.

Another risk is that Haidilao continues to source supplies from entities with related-party ownership. Even though these related-party suppliers have so far been fair to Haidilao, there remains a risk that things could change. 

Lastly, execution risk is another concern. The company’s growth is dependent on it expanding the number of stores without affecting its existing business. Store-location choice is an important determinant of whether new restaurants succeed.

On top of that, while size improves economies of scale, it can also become increasingly difficult to maintain food quality, food safety, and the quality of the customer experience. 

Valuation

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

The company recorded revenue of RMB 10.6 billion in China in the first half of 2019. Based on the addressable market size, I think the mainland Chinese market can easily absorb 1,500 Haidilao restaurants. That’s a three-fold increase.

The international market is a bit harder to estimate. But I do think Haidilao can easily increase its store count in geographies with large Chinese populations such as Taiwan, Singapore, Malaysia, Australia, United States, and Hong Kong. For simplicity’s sake, let’s assume it can increase its current international store count of 43 by three times to 129.

We will also leave out the growth in delivery sales for now. 

Based on these assumptions, Haidilao can achieve an annual profit (assuming net profit margin remains the same) to shareholders of around RMB5.5 billion.

If we attach a multiple of 30 times to that figure, we can estimate a reasonable future market capitalisation. Based on this rough estimation, the company’s future market capitalisation should be around RMB 164 billion.

I think that Haidilao, at the current rate it is expanding its network, can realistically hit that level of profit in eight to 10 years.

If I want to achieve an annualised return of 10%, the most I would pay for the company would be RMB 76.5 billion.

At its current share price, it has a market capitalisation of RMB 154.8 billion, which is around 74 times trailing earnings. The company’s current market cap is twice the amount I would be willing to pay based on my calculations.

Although the numbers I used for my estimation may be conservative, the current market cap seems inflated and leaves investors exposed to huge risk should the company fail to achieve the anticipated growth.

The Good Investors’ conclusion

Haidilao ticks all six criteria of Ser Jing’s investment framework and is certainly a good business with great prospects. I think my estimates of the potential addressable market are fairly conservative, and the company could easily grow faster and bigger than I predicted. The addressable market could also grow much more as the Haidilao brand could penetrate the International market more deeply.

But despite all that, from a valuation perspective, the company’s share price is a little too expensive for my liking. It leaves very little room for execution error. Should Haidilao fail to deliver my projected growth, its stock might also risk valuation-compression.

As such, even though Haidilao is a solid growth company, it is only on my watchlist.

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.