Category: Investing Analysis

While stocks markets around the world plunged over the last month, Zoom Video Communications‘s (NASDAQ: ZM) share price has defied gravity, zooming up by close to 30%.

Investors are anticipating great things for the company this year as the COVID-19 epidemic accelerates the adoption of video conferencing tools around the globe.

With the hype surrounding Zoom, I thought it would be an opportune time to share some of my thoughts on the fast-growing company and whether it is still worth investing at today’s price.

Fast growth

Zoom is one of the fastest-growing listed software-as-a-service firms in the world today. That says a lot.

In fiscal 2020 (ended 31 January), Zoom recorded revenue of US$622.7 million, up a staggering 88% from a year ago.

New customers and a net dollar expansion rate of more than 130% contributed to the sharp rise in sales. Over the course of 2019, Zoom had 641 customers contributing more than US$100,000 in trailing-12-months revenue, an increase of 86% from a year ago. 

Consistently strong performance

Last year’s growth was by no account a one-off. Zoom has been growing rapidly for the three years prior to its IPO in 2019. Annual revenue increased by 149% and 118% in fiscal 2018 and fiscal 2019, respectively.

The company’s net dollar expansion rate has also been north of 130% for seven consecutive quarters, a testament to the strength of the business platform.

COVID-19, a catalyst for greater use of Zoom’s tools

On top of the long-term tailwinds for video conferencing, the COVID-19 pandemic has accelerated the adoption of Zoom’s video conferencing tools. Many people – from university students to work-at-home employees – have begun using Zoom’s software as they take shelter at home.

My sister who has returned home from Australia during this COVID-19 outbreak is using Zoom’s software for “long-distance” tutorials. Fortune magazine reported that teachers are even conducting piano lessons through Zoom.

Huge addressable market

Video is increasingly becoming the way that individuals communicate with each other at work and in their daily lives. And Zoom is the market leader in the space.

Zoom addresses the Hosted/Cloud Voice and Unified Communications, Collaboration Application, and IP Telephony Lines segments within the communication and collaboration market. Market researcher International Data Corporation estimates that these segments would be worth US$43.1 billion by 2022.

Remember that Zoom’s trailing-12-months revenue is just US$622.7 million. That’s a mere 1.4% of the addressable market, so there’s plenty of room for Zoom to grow into.

A cash-generating business

Unlike some of the other fast-growing SaaS (software-as-a-service) companies, Zoom is already cash-flow positive. In fiscal 2020, Zoom generated US$151.9 million and US$113.8 million in operating cash flow and free cash flow, respectively. That translates to a healthy free cash flow margin of 18.3%, with room for further margin expansion as usage of Zoom’s services grows.

In addition, even after accounting for stock-based compensation, Zoom is still profitable, with GAAP (generally-accepted accounting principles) net income of US$21.7 million in fiscal 2020, or US$0.09 per share.

Zoom’s high gross margin of more than 80% enables it to spend a large chunk of its revenue to acquire customers and grow the business while still sustaining a decent free cash flow margin and squeeze out some GAAP profit.

A robust balance sheet

A time when many businesses are being momentarily put on hold due to the COVID-19 spread highlights the importance of a company with a strong balance sheet. Companies that have enough cash to pay off their fixed costs during pauses in sales are more resilient to economic hardships.

Although Zoom is thriving in the current COVID-19 situation, there could be other incidents that may cause temporary disruptions to its business. It is hence heartening to note that Zoom has a robust balance sheet.

As of 31 January 2020, the video conferencing software company had US$283 million in cash and no debt. In fact, Zoom has been so adept at generating cash flow that it said that much of the primary capital it had raised prior to its IPO was still on its balance sheet.

Competition threat

Competition is perhaps the biggest threat to Zoom. The video conferencing company faces competition from mega tech firms such as Google, which has the free Google Hangout video conferencing service. Facebook and Amazon have also spent heavily on video communication tools.

However, Zoom’s video-first focus has propelled it to become the market leader in the video conferencing space. Unlike other companies that added video tools to their legacy communication software, Zoom built a video-conferencing tool with video at the front and centre of its architecture. This focus gives Zoom users a better video conferencing experience.

For now, Zoom remains the forefront in this space with most users preferring its software over competitors but it must consistently add features and update its software to keep users on its platform.

But is it too expensive?

There is no doubt that Zoom has all the makings of a great company. The software-as-a-service firm is growing rapidly and already boasts free cash flow margins in the mid-teens range.

I foresee Zoom’s free cash flow growing much faster than revenue in the future as margins expand due to economies of scale. Moreover, the COVID-19 pandemic is accelerating the adoption of video conferencing software, which is great news for Zoom, being the market leader in this space.

Having said all that, Zoom’s stock has skyrocketed well above what I believe is reasonable. Zoom, which is still run by founder Eric Yuan, has a market cap of around US$38 billion currently.

That’s an astonishing 62 times fiscal 2020 revenue. Even if Zoom’s profit margin was 40% today (a level I think it can achieve in the future), its current market cap would still translate to 176 times earnings.

My conclusion

Based on its share price, the market is anticipating big things for Zoom in the coming quarters as more companies are forced to adopt video conferencing software. On top of that, Zoom, even before the COVID-19 outbreak, was already successfully riding on the coattails of a rapidly growing industry.

As an investor, I would love to participate in Zoom’s growth. However, I think Zoom’s stock is priced for perfection at the moment. Even if Zoom can deliver on all fronts over a multi-year time frame, investors who buy in at this price may still only achieve mediocre returns due to its high valuation.

As such, even though I wish I could be a shareholder of Zoom, I’ll happily wait at the sidelines until a more reasonable entry point arises.

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.

Alteryx (NYSE: AYX) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Alteryx shares for the portfolio in September 2019 at a price of US$118 and I’ve not sold any of the shares I’ve bought.

The purchase has not worked out well for my family’s portfolio thus far, with Alteryx’s share price being around US$98 now. But we’ve not even owned the company’s shares for a year, and it is always important to think about how the company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Alteryx shares.

Company description

Alteryx provides a self-service subscription-based software platform that allows organisations to easily scrub and blend data from multiple sources and perform sophisticated analysis to obtain actionable insights.

The company’s platform can interact with nearly all data sources. These include traditional databases offered by the likes of IBM, Oracle, and SAP, as well as newer offerings such as those from MongoDB, Amazon Web Services, Google Analytics, and even social media.

Once data from different sources are fed into Alteryx’s platform, it cleans and blends the data. Users can easily build configurable and sophisticated analytical workflows on the platform through drag-and-drop tools. The workflows can be easily automated and shared within the users’ organisation, and the results can be displayed through Alteryx’s integrations with data-visualisation software from companies such as Tableau Software and Qlik. Here’s a chart showing the various use cases for Alteryx’s data analytics platform:

At the end of 2019, Alteryx had around 6,100 customers, of all sizes, in more than 90 countries. These customers come from a wide variety of industries and include more than 700 of the Global 2000 companies. The Global 2000 is compiled by Forbes and it’s a list of the top 2,000 public-listed companies in the world ranked according to a combination of their revenue, profits, assets, and market value. With thousands of customers, it’s no surprise that Alteryx does not have any customer concentration – no single customer accounted for more than 10% of the company’s revenue in the three years through 2019. The graphic below illustrates the diversity of Alteryx’s customer base:

Despite having customers in over 90 countries, Alteryx is currently still a US-centric company. In 2019, 71% of its revenue came from the US. The UK is the only other country that accounted for more than 10% of Alteryx’s revenue in 2019 (10.7%).

Investment thesis

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

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

Alteryx earned US$417.9 million in revenue in 2019. This is significantly lower than the US$73 billion addressable market that the company is currently seeing. It comprises two parts:

1. US$49 billion in the global big data and analytics software market (according to a July 2017 IDC report) which includes the US$28 billion global analytics and business intelligence market (according to a January 2019 Gartner report) 
2. A US$24 billion slice, based on Alteryx’s estimate of the spend associated with 47 million spreadsheet users worldwide who worked on advanced data preparation and analytics in 2018 (according to an April 2019 IDC report)

I believe that better days are ahead for Alteryx for a few reasons:

• I mentioned earlier that the company’s data analytics platform can interact with nearly all data sources. This interactivity is important. A 2015 Harvard Business Review study sponsored by Alteryx found that 64% of organizations use five or more sources of data for analytics.
• Market researcher IDC predicted in late 2018 that the quantity of data in the world (generated, captured, and replicated) would compound at an astounding rate of 61% per year, from 33 zettabytes then to 175 zettabytes in 2025. That’s staggering. 1 zettabyte equals to 10¹² gigabytes.
• A 2013 survey on more than 400 companies by business consultancy group Bain found that only 4% of them had the appropriate human and technological assets to derive meaningful insights from their data. In fact, Alteryx’s primary competitors are manual processes performed on spreadsheets, or custom-built approaches. These traditional methods for data analysis involve multiple steps, require the support of technical teams, and are slow (see chart below).
• Crucially, Alteryx’s self-service data analytics platform is scalable, efficient, and can be mastered and used by analysts with no coding skill or experience. I think this leads to a few good things for Alteryx. First, it democratises access to sophisticated data analytics for companies, and hence opens up Alteryx’s market opportunity. Second, it places Alteryx’s platform in a sweet spot of riding on a growing trend (the explosion in data generated) as well as addressing a pain-point for many organisations (the lack of resources to analyse data, and the laborious way that data analysis is traditionally done).

(Traditional way to perform data analysis)

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

As of 31 December 2019, Alteryx held US$974.9 million in cash, short-term investments, and long-term investments. This is comfortably higher than the company’s total debt of US$698.5 million (all of which are convertible notes).

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

On integrity

Alteryx was listed in March 2017, so there’s only a short history to study when it comes to management. But I do like what I see.

The company was founded in 1997. One of its co-founders, Dean Stoecker, 63, has held the roles of CEO and chairman since its establishment. Another of Alteryx’s co-founders is 57-year-old Olivia Duane Adams, the company’s current chief customer officer. The third co-founder, Ned Harding, 52, was a key technology leader in the company and left in July 2018; he remains an advisor to Alteryx’s software engineering teams. The company’s chief technology officer role is currently filled by Derek Knudsen, 46. He stepped into the position in August 2018  after Harding’s departure. Knudsen had accumulated over 20 years of experience working with technology in companies in senior leadership positions before joining Alteryx.

Stoecker and Duane Adams collectively controlled nearly 10 million Alteryx shares as of 31 March 2019. These shares are worth around US$980 million at the company’s current share price of US$98. That’s a large stake and it likely aligns the interests of Stoecker and Duane Adams’ with Alteryx’s other shareholders.

Alteryx has two share classes: (1) The publicly-traded Class A shares with 1 voting right per share; and (2) the non-traded Class B shares with 10 voting rights each. Stoecker and Duane Adams’ Alteryx shares were mostly of the Class B variety. So, they controlled 47.9% of the voting power in the company despite holding only 16% of the total shares. Collectively, Alteryx’s key leaders controlled 54.1% of the company’s voting rights as of 31 March 2019.

Having clear control over Alteryx means that management can easily implement compensation plans that fatten themselves at the expense of shareholders. The good thing is that the compensation structure for Alteryx’s management looks sensible to me.

In 2018, 70% to 79.7% of the compensation of Alteryx’s management team came from long-term incentives. These incentives include restricted stock units (RSUs) and stock options that vest over multi-year periods. There is room for some misalignment to creep in though – as far as I can tell, there is no clear description given by Alteryx on the performance metrics that management must meet in order to earn their compensation. But I don’t see this as a dealbreaker. Because of the multi-year vesting period for the RSUs and stock options, Alteryx’s management will do well over time only if the share price does well – and the share price will do well only if the business does well. From this perspective, the interests of management and shareholders are still well-aligned.

On capability and innovation

Alteryx’s business has changed dramatically over time since its founding. In its early days, the company was selling software for analysing demographics. Alteryx’s current core data analytics software platform was launched only in 2010, and a subscription model was introduced relatively recently in 2013. I see Alteryx’s long and winding journey to success as a sign of the founders’ ability to adapt and innovate.

I also credit Alteryx’s management with the success that the company has found in the land-and-expand strategy. The strategy starts with the company landing a customer with an initial use case, and then expanding its relationship with the customer through other use cases. The success can be illustrated through Alteryx’s impressive dollar-based net expansion rates (DBNERs). The metric is a very important gauge for the health of a SaaS (software-as-a-service) company’s business. It measures the change in revenue from all the company’s customers a year ago compared to today; it includes positive effects from upsells as well as negative effects from customers who leave or downgrade. Anything more than 100% indicates that the company’s customers, as a group, are spending more.

Alteryx’s DBNER has been more than 120% in each of the last 20 quarters – that’s five years! The chart below illustrates Alteryx’s DBNER going back to 2017’s first quarter.

Alteryx’s management has also led impressive customer-growth at the company. The company’s customer count has more than quadrupled from 1,398 at the end of 2015 to 6,087 at the end of 2019.

But there is a key area where Alteryx’s management falls short: The company’s culture. Alteryx has a 3.5-star rating on Glassdoor, and only 65% of reviewers will recommend Alteryx to friends. Stoecker only has an 85% approval rating as CEO. SAP, a competitor of Alteryx, has 4.5 stars on Glassdoor, and recommendation and CEO-approval ratings of 93% and 97%, respectively. Alteryx has managed to post impressive business-results despite its relatively poor culture, but I’m keeping an eye on things here.

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

Alteryx’s business is built nearly entirely on subscriptions, which generate recurring revenue for the company. The company sells access to its data analytics platform through subscriptions, which typically range from one to three years. In 2019, 2018, 2017, and 2016, more than 95% of Alteryx’s revenue in each year came from subscriptions to its platform; the rest of the revenue came from training and consulting services, among others. 

5. A proven ability to grow

There isn’t much historical financial data to study for Alteryx, since the company was listed only in March 2017. But I do like what I see.

A few key points to note:

• Alteryx has compounded its revenue at an impressive annual rate of 61.6% from 2014 to 2019. The astounding revenue growth of 92.7% in 2018 was partly the result of Alteryx adopting new accounting rules in the year. Alteryx’s revenue for 2018 would have been US$204.3 million after adjusting for the impact of the accounting rule, representing slower-but-still-impressive top-line growth of 55.2% for the year. 2019 saw the company maintain breakneck growth, with its revenue up by 64.8%.
• Alteryx started making a profit in 2018, and also generated positive operating cash flow and free cash flow in 2017, 2018, and 2019.
• Annual growth in operating cash flow and free cash flow from 2017 to 2019 was strong at 33.8% and 21.4%, respectively.
• The company’s balance sheet remained robust throughout the timeframe under study, with significantly more cash and investments than debt.
• At first glance, Alteryx’s diluted share count appeared to increase sharply by 22.1% from 2017 to 2018. But the number I’m using is the weighted average diluted share count. Right after Alteryx got listed in March 2017, it had a share count of around 57 million. This means that the increase in 2018 was milder (in the mid-teens range) though still higher than I would like it to be. The good news is that the diluted share count inched up by only 6% in 2019, which is acceptable, given the company’s rapid growth. I will be keeping an eye on Alteryx’s dilution.

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

Alteryx has already started to generate free cash flow. Right now, the company has a poor trailing free cash flow margin (free cash flow as a percentage of revenue) of just 5.4%.

But over the long run, Alteryx expects to generate a strong free cash flow margin of 30% to 35%. I think this is a realistic and achievable target. There are other larger SaaS companies such as Adobe, salesforce.com, and Veeva Systems (my family’s portfolio owns shares in all three companies too) with a free cash flow margin around that range or higher.

Valuation

You should get some tissue ready… because Alteryx’s shares have a nosebleed valuation. At a share price of US$98, Alteryx carries a trailing price-to-sales (P/S) ratio of 16.1. This P/S ratio is in the middle-range of where it has been since Alteryx’s IPO in March 2017 (see chart below). But the P/S ratio of 16.1 is still considered high. For perspective, if I assume that Alteryx has a 30% free cash flow margin today, then the company would have a price-to-free cash flow ratio of 54 based on the current P/S ratio (16.1 divided by 30%). 

But Alteryx also has a few strong positives going for it. The company has: (1) a huge addressable market in relation to its revenue; (2) a large and rapidly expanding customer base; and (3) very sticky customers who have been willing to significantly increase their spending with the company over time. I believe that with these traits, there’s a high chance that Alteryx will continue posting excellent revenue growth – and in turn, excellent free cash flow growth – in the years ahead.

The current high valuation for Alteryx does mean that its share price is likely going to be more volatile than the stock market as a whole (I’m also keeping in mind that stocks have been very volatile of late because of COVID-19 fears). But the potential volatility is something I’m very comfortable with.

The risks involved

I see a few key risks in Alteryx, with the high valuation being one. Besides introducing volatility (which I don’t see as a risk), Alteryx’s high valuation means that the market has high expectations for the company’s future growth. If Alteryx stumbles along the way, its share price will be punished. With COVID-19 causing widespread slowdowns in business activity across the world, there may be a global recession in the works. Should it happen, Alteryx may find it tough to grow its business.

Competition is another important risk. I mentioned earlier that Alteryx’s primary competitors are spreadsheets, or custom-built approaches. But the company’s data analytics platform is also competing against services from other technology heavyweights with much stronger financial resources, such as International Business Machines, Microsoft, Oracle, and SAP. Providers of data visualisation software, such as Tableau, could also decide to move upstream and budge into Alteryx’s space. To date, Alteryx has dealt with competition admirably – its quarterly DBNERs and growth in customer numbers are impressive. I’m watching these two metrics to observe how the company is faring against competitors.

Two other key risks deal with hacking and downtime in Alteryx’s services. The company’s platform is important for users, since it is used to crunch data to derive actionable insights; it is also likely that Alteryx’s platform is constantly fed with sensitive information of its users. Should there be a data breach on the platform, and/or if the platform stops working for extended periods of time, Alteryx could lose the confidence of its customers.

Then there’s also succession risk with Alteryx. Dean Stoecker, the company’s co-founder and CEO, is already 63. Should he step down in the future, I will keep an eye on the leadership transition.

Lastly, the following are all yellow-to-red flags for me regarding Alteryx: (1) The company’s DBNER comes in at less than 100% for an extended period of time; (2) it fails to increase its number of customers; and (3) it’s unable to convert revenue into free cash flow at a healthy clip in the future.

The Good Investors’ conclusion

Summing up Alteryx, it has:

1. A valuable self-service data analytics platform that addresses customers’ pain-points and is superior to legacy methods for data analysis;
2. high levels of recurring revenue;
3. outstanding revenue growth rates;
4. positive profit and free cash flow, with the potential for much higher free cash flow margins in the future;
5. a large and mostly untapped addressable market;
6. an impressive track record of winning customers and increasing their spending; and
7. capable leaders who are in the same boat as the company’s other shareholders

The company does have a premium valuation, so I’m taking on valuation risk. There are also other risks to note, such as tough competition and succession. But after analysing all the data on Alteryx’s pros and cons, I’m happy for my family’s portfolio to continue owning 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.

Patients can be their own worst enemy. This is especially true for people who suffer from chronic conditions such as diabetes. Suboptimal lifestyle choices and poor medication compliance often lead to avoidable complications. 

A company called Livongo Health (NASDAQ: LVGO) is trying to change all that. The software-as-a-service (SaaS) company provides diabetic patients with an app that can prompt them to take their medications as well as provide feedback and coaching. Livongo also provides patients with an internet-connected blood glucose meter and unlimited test strips.

The end-result is that Livongo users are more compliant with glucose monitoring and have fewer complications. They also save on healthcare expenses over the long run. Besides diabetes, Livongo also has services for hypertension, weight management, pre-diabetes, and behavioural health.

With preventive medicine gaining greater prominence today, I thought it would be worth taking a deeper look into Livongo to see if the healthtech company makes a worthwhile investment.

As usual, I will analyse Livongo using my blogging partner Ser Jing’s, six-point investment framework.

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

Livongo’s member count increased by 96% in 2019 to 223,000. More impressively, its revenue for 2019 jumped 149% to US$170 million from 2018.

Despite the spike in member and revenue, Livongo still has a huge market to grow into. There are 31.4 million people in the US living with diabetes and 39.6 million people with hypertension.

Based on Livongo’s fees of US$900 per patient per year for diabetics and US$468 for patients with hypertension, its total opportunity adds up to US$46.7 billion.

As preventive health gains greater prominence, Livongo can win a greater chunk of its total addressable market. Currently, Livongo’s penetration rate is only 0.3%. Meanwhile, Livongo has ambitions to increase its software’s use case to patients with other chronic diseases and to expand internationally. 

These two initiatives could further increase its already-large addressable market substantially.

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

Livongo is still burning cash. In 2019, it used US$59 million in cash flow from operations, an acceleration from the US$33 million spent in 2018. That’s a hefty amount and certainly something to keep a close eye on.

On the bright side, Livongo has more than enough cash on its balance sheet to continue its growth plans for several years. As of December 2019, the Healthtech firm had no debt and US$390 million in cash, cash equivalents, and short-term investments.

It’s also heartening to note that Livongo’s management is mindful of the way the company is spending cash. In the 2019 fourth-quarter earnings conference call, Livongo’s chief financial officer, Lee Shapiro, highlighted that the company is aiming to produce positive adjusted-EBITDA by 2021 and expects the company’s adjusted-EBITDA margin to improve in 2020.

Shapiro said:

“Adjusted EBITDA loss for 2020 will be in the range of negative $22 million to negative $20 million.

This implies adjusted EBITDA margins of negative 8% to negative 7% or an improvement of between 3.5 to 4.5 points over 2019. We plan to continue to invest in the business in 2020 while simultaneously marching toward our goal of sustained adjusted EBITDA profitability in 2021.” 

Adjusted EBITDA is roughly equal to net income after deducting interest, tax, depreciation, amortisation, and stock-based compensation and is closely related to cash flow from operations. If Livongo can hit its 2021 goal to be adjusted EBITDA positive, cash flow should not be an issue going forward.

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

In my view, management is the single most important aspect of a company. In Livongo’s case, I think management has done a good job in executing its growth plans.

Current CEO, Zane Burke has only been in his post for slightly over a year but has a strong resume. He was the president of Cerner Corporation, an American healthtech company for the seven years prior. It was under Burke’s tenure that Livongo was listed and his first year in charge saw Livongo’s revenue grow at a triple-digit rate.

He is backed by Ex-CEO Glen Tullman who is now the chairman of the board. Glenn Tullman has a long track record of managing healthcare companies and was the key man before stepping down to let Burke take over. Tullman continues to have an influence on how the company is run.

The management team has also done a great job in growing Livongo’s business so far. The acquisition of Retrofit Inc and myStrength in April 2018 seems like a good decision as it opened the door for Livongo to provide prediabetes, weight management, and behavioural health services. With its ready base of clients, Livongo can easily cross-sell these newly acquired products.

However, Livongo is still a relatively new company. It was only listed in July 2019, so it has a very short public track record.

As such, it is worth keeping an eye on how well the management team executes its growth plans and whether it makes good capital allocation decisions going forward. 

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

Recurring income provides visibility in the years ahead, something that I want all my investments to possess.

Livongo ticks this box.

The digital health company has a unique business model that provides very predictable recurring income. Livongo bills its clients based on a per-participant, per-month subscription model. Clients include self-insured employers, health plans, government entities, and labour unions who then offer Livongo’s service to their employees, insurees, or members. 

There are a few things to like about Livongo’s model: 

Product intensity

First, the average revenue per existing client increases as more members eligible to use Livongo’s software per client increases. This is what Livongo describes as product intensity.

At the end of 12 months, the average enrollment rate for Livongo for Diabetes clients who launched enrollment in 2018 was 34%. The average enrollment rate after 12 months for fully-optimized clients who began enrollment in 2018 is over 47%.

Livongo also believes product intensity can increase further as more members warm up to the idea of using cloud-based tools to track and manage their medical conditions.

Product density

Livongo has also been successful in cross-selling its products to existing clients. High product intensity and density contributed to Livongo’s dollar-based net expansion rate of 113.8% in 2018. 

Anything above 100% means that all of Livongo’s customers from a year ago are collectively spending more today.

Very low churn rate

In its IPO prospectus, Livongo said that its retention rate for clients who had been with them since 31 December 2017, was 95.9%. That’s high, even for a SaaS company.

Another important thing to note is that the member churn rate in 2018 was also very low at just 2%. Most of the dropouts were also due to the members becoming ineligible for the service, likely because they changed employers.

5. Does Livongo have a proven ability to grow?

Livongo is a newly listed company but it has a solid track record of growth as a private firm. The chart below shows the rate of growth in the number of clients and members.

Livongo grew from just 5 clients and 614 members in 2014 to 679 clients and 164,000 members in the first quarter of 2019. At the end of 2019, Livongo had 223,000 members.

There is also a strong pipeline for 2020 as Livongo had signed agreements with multiple new clients in 2019. Based on an estimated take-up rate of 25%, the estimated value of the agreements Livongo signed in 2019 is around US$285 million, up from US$155 million in 2018.

Management expects revenue growth of 65% to 71% in 2020. Due to the contracts signed in 2019, management has clear visibility on where that growth will come from.

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

Ultimately, a company’s worth is determined by how much free cash flow it can generate in the future. Livongo is not yet free cash flow positive but I think the healthtech firm’s business model would allow it to generate strong free cash flow in the future.

Due to the high lifetime value of its clients, Livongo can afford to spend more on customer acquisition now and be rewarded later. The chart below illustrates this point.

From the chart, we can see that the revenue (blue bar) earned from the 2016 cohort steadily increased from 2016 to 2018. As mentioned earlier, this is due to the higher product intensity and density.

Consequently, the contribution margin from the cohort steadily increased to 60% with room to grow in the years ahead.

Currently, Livongo is spending heavily on marketing and R&D which is the main reason for its hefty losses. In 2019, sales and marketing was 45% of revenue, while R&D made up 29%. 

I think the sales and marketing spend is validated due to the large lifetime value of Livongo’s clients. However, both marketing and R&D spend will slowly become a smaller percentage of revenue as revenue growth outpaces them.

Management’s target of adjusted EBITDA profitability by 2020 is also reassuring for shareholders.

Risks

Livongo is a fairly new company with a very new business model. I think there is a clear path to profitability but the healthtech firm needs to execute its growth strategy. Its profitability is dependent on scaling as there are some fixed costs like R&D expenses that are unlikely to drop.

As such, execution risk is something that could derail the company’s growth and profitability.

As mentioned earlier, Livongo is also burning cash at a pretty fast rate. That cannot go on forever. The tech-powered health firm needs to watch its cash position and cash burn rate. Although its balance sheet is still strong now, if the rate of cash burn continues or accelerates, Livongo could see itself in a precarious position and may need a new round of funding that could hurt existing shareholders.

Healthtech is a highly dynamic field with new technologies consistently disrupting incumbents. Livongo could face competition in the future that could erode its margins and hinder growth.

Another thing to note is that while Livongo has more than 600 clients, a large amount of its revenue still comes from a limited number of channel partners and resellers. In 2018, its top five channel partners represented 50% of revenue. 

Stock-based compensation is another risk factor. In 2019, the company issued US$32 million worth of new stock as employee compensation. That translates to 18% of revenue, a large amount even for a fast-growing tech company. Ideally, I want to see stock-based compensation grow at a much slower pace than revenue going forward.

Valuation

Using traditional valuation techniques, Livongo seems richly valued. Even after the recent broad market sell-off, Livongo still has a market cap of around US$2.4 billion, or 14 times trailing revenue. The company is not even free cash flow positive or profitable, so the price-to-earnings and price-to-free-cash-flow metrics are not even appropriate.

However, if you take into account Livongo’s pace of growth and total addressable market, its current valuation does not seem too expensive.

Livongo’s addressable market is US$46.7 billion in the US. If we assume that the healthtech firm can grow into just 10% of that market, it will have a revenue run rate of US$4.6 billion, more than two times its current market cap.

The Good Investors’ take

Livongo has the makings of a solid investment to. It is growing fast, has a huge addressable market and has a clear path to profitability and free cash flow generation. There are likely going to bumps along the road but if the health SaaS company can deliver just a fraction of its potential, I think the company could be worth much more in the future.

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.

Most of us don’t go a day without using Facebook or Instagram. But despite its prominence, social media is still a relatively new concept.

The rise of Facebook and social media as an industry has been so swift that regulatory bodies have not been able to properly regulate it.

However, things are starting to change. 

Last year, Facebook (NASDAQ: FB) incurred a US$5 billion fine from the Federal Trade Commission (FTC) due to a privacy breach. The company also recently agreed to pay a US$550 million settlement for collecting users’ facial recognition data.

There have also been a few threats from European regulatory bodies and Facebook may even face retrospective fines in the future.

That brings me to my next question: Should Facebook shareholders be worried about regulations?

What are the possible regulatory measures that Facebook faces?

Although fines are painful, they are one-off expenses. The biggest risk is therefore not fines, but regulators forcing Facebook to change the way it operates.

Regulations that could hurt Facebook include prohibiting the kind of advertisements it can offer, or controlling Facebook’s content. Regulators could also force Facebook to spin-off or sell some of its assets. Currently, Facebook owns Instagram, Messenger, and Whatsapp.

Facebook reported in its 2019 fourth-quarter earnings conference call that there are now 2.9 billion people who use Facebook (the social media site), Instagram, Messenger, or Whastapp each month. A recent article from Verge showed that Whatsapp currently has 2 billion users while Instagram has 1 billion (as of June 2018).

The likelihood of extreme regulation

Although regulation is likely to hit Facebook, I think the odds of such extreme regulation are low.

After facing criticism in 2019, Facebook started taking privacy and regulation very seriously.

Facebook’s co-founder and CEO, Mark Zuckerberg, is outspoken about the need for regulation on social media companies. In a 30 March 2019 blog post, Zuckerberg wrote:

“I believe we need a more active role for governments and regulators. By updating the rules for the internet, we can preserve what’s best about it — the freedom for people to express themselves and for entrepreneurs to build new things — while also protecting society from broader harms.”

His willingness to cooperate with regulators should put Facebook in a better position to negotiate.

Moreover, despite all the negativity surrounding Facebook, it’s my opinion that Facebook has done more good than harm to society. Facebook not only provides humans with the ability to connect – it’s also a platform to express ourselves to a wide audience at relatively low cost.

Completely controlling the way Facebook is run will, therefore, have a net negative impact.

As such, I think the risk of extreme regulation is very low.

But what will happen if Facebook is forced to break up

Perhaps the biggest risk is competition law. Facebook is by far the biggest social media company in the world. To promote greater competition in the social media space, regulators could force Facebook to spin-off Whatsapp, Messenger, and Instagram into separate entities. 

Such a move will likely erode margins as the separate entities compete for advertising dollars. However, I think the impact of this will not be that bad for shareholders due to the huge and growing addressable market for social media advertising. Zenith estimated in late 2019 that global social media ad spending was US$84 billion for the year, and is expected to increase by 17% in 2020 and 13% in 2021.

A break-up could even be a good thing. It will force Whatsapp and Messenger to find ways to monetise their huge user bases. Currently, Whatsapp is a free platform and does not have any advertisements. If Whatsapp is spun off, investors will want to see it generate some form of revenue either through payments or advertising.

In addition, the separate entities could even command a higher valuation multiple and might even be a net gain for Facebook shareholders prior to the spin-off.

The Good Investors’ conclusion

As social media grows, scrutiny and regulation will inevitably follow. It happens in all industries.

But as a Facebook shareholder, I am not that concerned over regulations. For one, given Facebook’s own stance on regulation, its net positive impact as a platform and its willingness to cooperate with regulators, the odds of extremely unfavourable regulation is very low.

Facebook has also spent big on privacy protection and removing harmful content from its platform. These initiatives should put it in a much better position to negotiate with regulators.

On top of that, anti-competition laws that may force Facebook to break up could even be a good thing for shareholders.

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 try not to let short-term factors affect my long-term investing decisions. The COVID-19 outbreak is one such short-term factor. It is most definitely going to impact economic growth and corporate earnings this year for many countries. But it will likely have no economic impact five years from now.

So despite the huge drop in the S&P 500 and Dow Jones Industrial Average in the US stock market last week, I am still resolutely holding on to all my stocks. I believe that the economic impact will be short-lived and companies with strong balance sheets, recurring income, and steady free cash flow will be able to weather this storm.

At the same time, I am not hopping on the bandwagon of overly-hyped companies that could benefit from the coronavirus situation over the short-term, such as mask and glove producers. These manufacturers may see a sharp spike in revenue over the next few quarters, but the jump in sales will likely only be a one-off event.

All that being said, I think this latest global virus outbreak could still potentially throw up some unique long-term opportunities. One company I see benefiting long term from the outbreak is Teladoc Health Inc (NYSE: TDOC).

Why COVID-19 could benefit Teladoc

Teladoc is the leading telemedicine company in the US. It provides video consultations for primary care, dermatology, and behavioural health. The company’s app makes getting professional healthcare advice so much easier. Patients simply need to open the app and start a video consulting session with a doctor. Best of all, this can be done in the comfort of your own home, which is all the more important when you are suffering from an illness and don’t want the hassle of travelling to your local clinic.

The COVID-19 outbreak in the US could be the catalyst that Teladoc needs for faster adoption of its technology. Video consultations will reduce the spread of infections, enable patients to get real-time advice, and increase the consultation-efficiency for doctors. All of these advantages are important at a time when the virus is rampant and patients need access to quick and effective advice.

CEO Jason Gorevic also said in the company’s latest earnings conference call, “We also see that once members use our services for the first time, they are much more likely to use us again.” As such, if COVID-19 does increase adoption of Teladoc during this time, the likely impact will be that patients who use the technology for the first time will continue using it in the future.

Strong growth even before the outbreak

Although the COVID-19 epidemic will likely increase the rate of adoption of video consultations around the world, Teladoc has already seen rapid growth even without this catalyst.

Teladoc reported a 32% increase in revenue in 2019. The total number of visits increased by 57% to 4.1 million, exceeding the company’s own projections.

And the leading telehealth company is expecting more growth in 2020. Even before factoring the spread of COVID-19 in the US, Teladoc reported in its latest earnings update that 2020 revenue will increase by 25% at the low-end. Over the longer term, Teladoc expects to grow between 20% to 30% a year.

Huge addressable market

Back in 2015, Teladoc said in its IPO prospectus that the Centers for Disease Control and Prevention in the US estimated that there were 1.25 billion ambulatory care visits in the United States per year. Of which, 417 million could be treated by telehealth. And that figure should be much larger today. 

Teladoc, therefore, has plenty of room to grow into. In 2019, despite the 57% spike in the number of visits, total visits were still only 4.1 million. That is less than 1% of its addressable market in the US alone.

The international market provides another avenue of growth. Online consultations could be an even greater value-add in countries with lower doctor-to-patient ratios and where access to doctors is even more prohibitive. Right now, international markets only contribute less than 20% of Teladoc’s revenue. 

Recurring revenue model

Another thing I like about Teladoc is its revenue model. The telemedicine company has recurring subscription revenue that it derives from employers, health plans, health systems, and other entities. These clients purchase access to Teladoc services for their members or employees. 

The revenue from these clients is on a contractually recurring, per-member-per-month, subscription access fee basis, hence providing Teladoc with visible recurring revenue streams.

Importantly, the subscription revenue is not based on the number of visits and hence should have a huge gross profit margin for the company.

Teladoc ended 2019 with 36.7 million US paid members, a 61% increase from 2018. In 2019, this subscription access revenue increased 32% from a year ago and represented 84% of Teladoc’s total revenue.

Other significant catalysts

Besides the COVID-19 outbreak, there are possible catalysts that could drive greater adoption of Teladoc services in the near future.

• Mental health services driving B2B adoption: As mental health continues to become an increasingly important health issue, Teladoc’s mental health product has been a significant contributor to its B2B adoption.
• Expanding its product offering: Teladoc launched Teladoc Nutrition in the fourth quarter of 2019, offering personalised nutrition counselling. Nutrition is becoming an increasingly important aspect of preventive medicine and the new service could add significant value to existing and new clients.
• Regulatory shifts in the US: In April 2019, the Centers for Medicare & Medicaid Services finalised policies that could potentially benefit Teladoc. Its new policies increase plan choices and benefits and allow Medicare Advantage plans to include additional telehealth benefits. Jason Gorevic, Teladoc’s CEO, commented on this: “We view this as further evidence of CMS encouraging the adoption of virtual care in the Medicare population, and we continue to see a significant avenue for growth within the Medicare program.”
• Acquisition of InTouch Health: Besides organic growth drivers, Teladoc is expected to complete the acquisition of InTouch Health in the near futue. InTouch Health is a leading provider of enterprise telehealth solutions for hospitals and health systems. 

The Good Investors’ Take

The COVID-19 situation is likely going to hinder the growth of many companies in the near term at least. However, Teladoc looks like one that will buck the trend and will instead benefit in both the short and long run from the epidemic.

Besides the COVID-19 catalyst, the long-term tailwinds surrounding the truly disruptive service and Teladoc’s first-mover advantage in this space gives it an enormous opportunity to grow into.

There are, however, risks to note. Competition, execution risk, and the company’s inability to generate consistent free cash flow are all potential risks. Moreover, the telehealth provider’s stock trades at more than 16 times trailing revenue, a large premium to pay. Any hiccups in its growth could cause significant volatility to its share price.

Nevertheless, I think the reasons to believe it can grow in the long-term are compelling. Its addressable market is also big enough for multiple players to split the pie. If Teladoc can even service just 20% of its total addressable market, it will likely be worth many times more by then.

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.

2019 was a mixed year for IPOs. While big names such as Uber and Lyft failed to live up to the hype, others such as BeyondMeat and Zoom were roaring successes. 

One company that was hot straight off the bat was Bill.com (NYSE: BILL), whose share price surged 65% on its first trading day. The cloud-based software provider helps small and medium-sized businesses manage customer payments and cash flow.

After releasing a good set of results for its first quarter as a listed company, Bill.com’s share price jumped again and are now trading an eye-popping 143% above its IPO price. 

With the surge in price, I decided to take a deeper look into the company and whether its shares at today’s price is a good investment opportunity. I will analyse Bill.com using my blogging partner Ser Jing’s six-point investment framework.

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

Bill.com’s main clientele are small and medium businesses (SMB). According to the US Census Bureau, there were 6 million SMBs in the US in 2018. Data from SME Finance Forum pointed to 20 million SMEs globally in 2019. These numbers translate to a market opportunity of US$30 billion globally and US$9 billion domestically for Bill.com, based on an average revenue of US$1,500 per customer.

Comparatively, Bill.com, as of the end of 2019, served just 86,000 customers and had a US$156 million revenue run rate. That means it is serving just 2.6% of its total US addressable market, giving it a huge opportunity to grow into.

We’ve not even touched the international market opportunity yet. Bill.com currently operates only in the US and if and when it opens its doors internationally, we could see another big wave of growth.

The 61% year-on-year jump in core revenue in the quarter ended 31 December 2019 also demonstrates that the company is on the right track to fulfilling its vast potential.

CEO and founder, Rene Lacerte, outlined five key drivers of growth during the latest earnings conference call that will help Bill.com capitalise on its market opportunity:

1. Invest in sales and marketing activities to acquire new customers
2. Seek increased adoption by existing customers by increasing the number of its customers’ employees who become regular users (Bill.com charges each company a fixed amount per user)
3. Grow the number of network members (network members are suppliers and clients that customers can interact with through the platform) 
4. Enhance platform capabilities through R&D
5. Expand internationally

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

As is the case for most fast-growing start-ups, Bill.com is still loss-making and burning cash. The company had negative free cash flow of around US$10 million and US$8 million in fiscal 2018 and 2019 (the company’s fiscal year ends on 30 June). 

Thankfully, Bill.com is flushed with cash after its IPO. At end-2019, the company had no debt, and US$382 million in cash and short term investments. This puts Bill.com in a commanding position financially and it also means that the company should have the financial power to continue investing for growth.

It is also positive to note that the company’s sharp rise in share price could also open the door for it to raise more money through issuing shares (in a reasonable manner!) to boost its balance sheet in the future.

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

Rene Lacerte has an impressive resume. He is a serial entrepreneur who sold his last startup, PayCycle, to Intuit for US$170 million. It was at PayCycle when he realised how difficult it was to run the back-office operations of a company. Hence, he started Bill.com to streamline the back-office processes of SMBs. 

His track record as an entrepreneur is a testament to his ability to innovate and lead a team. Bill.com has a 13-year track record of growth and has consistently improved its service and grown its network of partners.

These initiatives have helped build Bill.com into a platform that customers trust and stick with.

I think Lacerte has a clear vision for the company and he has put in place a good framework to achieve that. In addition, his decision to take the company public last year is also smart, given the high valuation that he managed to raise new capital at.

When looking at a company’s management team, I also like to assess whether the compensation structure is incentivised to boost long-term shareholder value. 

I think Bill.com has a fair incentive structure. Rene Lacerte is paid a base salary of US$350,000 and also given option awards. As the option awards vest over a multi-year period, it incentivises him to grow long-term shareholder value. 

4. Are Bill.com’s revenue streams recurring in nature?

Bill.com has a predictable and recurring stream of revenue. The cash management software company derives its revenue through (1) monthly subscriptions, (2) transaction fees, and (3) interest income from funds held on behalf of customers while payment transactions are clearing.

Monthly subscriptions are recurring as Bill.com’s customers tend to auto-renew their subscriptions. Transaction fees are not strictly recurring in nature, but approximately 80% of total payment volume and the number of transactions on Bill.com’s platform in every month of fiscal 2019 represented payments to suppliers or from clients that had also been paid or received from those same customers in the preceding quarter.

In other words, Bill.com’s customers tend to make recurring payments or collect recurring fees over the platform. This, in turn, generates recurring transaction fees for Bill.com.

In the quarter ended December 2019, subscription and transaction revenue made up US$33 million of the total revenue of US$39.1 million.

Bill.com also has a decent customer retention rate of 82% as of June 2019. The net dollar-based retention rate is an indicator of how much more customers are spending on the platform, net of upsells, contraction, and attrition. Ideally, the number should be more than 100%. Bill.com’s net dollar-based retention rate was 110% for fiscal 2019 and 106% for 2018. Put another way, Bill.com’s customers as a group, paid 10% and 6% more in 2019 and 2018, respectively.

The increase in net spend by existing customers is a good indicator that Bill.com has a business model that promotes recurring and growing revenue from its existing clients.

5. Does Bill.com have a proven ability to grow?

Bill.com has barely gotten its feet wet as a listed company so it has yet to prove itself to the investing public. However, as a private company, Bill.com has grown by leaps and bounds.

The chart below shows the annual payment growth and milestones that it has achieved since 2007.

Bill.com grew to 1,000 customers in three years after launching its demo in 2007. In 2014, it hit 10,000 customers and today serves more than 86,000 customers.

As the company’s revenue is closely linked to the number of customers it serves and the payment volume handled through its platform, Bill.com’s revenue has also likely compounded at an equally rapid pace over the years.

Most recently, Bill.com reported a strong set of results in its first quarter as a listed company with core revenue up 61% in the quarter ended December 2019.

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

As mentioned earlier, Bill.com is still not free cash flow positive. However, I believe the company has a clear path to profitability and free cash flow generation.

For one, its existing customers provide a long and steady stream of cash over a multi-year time period. As such, the company can afford to spend a higher amount to acquire customers.

In its S-3 filing, Bill.com showed a chart that illustrated the value of its existing customer base.

The chart is a little blur so let me quickly break it down for you. The orange bars illustrate the revenue earned from the customers who started using Bill.com’s software in the fiscal year 2017. The revenue earned from the cohort increased from US$6.7 million in FY17 to US$14.2 million and US$17.3 million in FY18 and FY19, respectively.

The dark blue chart shows customer acquisition costs related to getting the 2017 cohort onto its platform. Once the customers are using the platform, they tend to stay on and there is no need to spend more on marketing. Hence, there is no dark blue bar in FY18 and FY19.

The dotted black line is the contribution margin from the cohort. Contribution margin rose from -108% (due to the high customer acquisition cost that year) in FY17 to 73% and 76% in FY18 and FY19, respectively.

In short, the chart demonstrates the multi-year value of Bill.com’s customers and the high potential margins once the customers are on its platform. These two factors will likely drive profitability in the future for the company.

Risks

Execution-risk is an important risk to take note of for Bill.com. The relatively young SaaS firm is just finding its feet as a public company and will need to execute on its growth plans to fulfill its potential and deliver shareholder returns.

With barely three months of a public track record to go on, investors will need to take a leap of faith on management to see if they can actually deliver.

There is also key-man risk. Lacerte is the main reason for the company’s success so far. His departure, for whatever reason, could be a big blow to the company.

In addition, the market for financial back-office solutions is fragmented and competitive. Some of Bill.com’s competitors may eat into its market share or develop better products.

That said, Bill.com has built up an important network of partners and businesses that are already supported on its platform. This network effect creates value for its current customers and I think it is difficult for competitors to replicate.

Valuation

Now we come to the tricky part- valuation. Valuation is always difficult, especially so for a company that has yet to generate free cash flow and with an uncertain future. I will, therefore, have to make an educated guess on where I see the company in the future.

According to its own estimate, Bill.com has a market opportunity of US$39 billion worldwide. To be a bit more conservative, let’s cut this opportunity by half and then assume it can achieve a 20% market share at maturity in five to 10 years’ time.

If that comes to fruition, Bill.com can have annual revenue of US$3.9 billion. Given its high 75% gross profit margin, I will also assume that it can achieve a net profit margin of 25%. Mathematically, that translates to an annual profit of US$975 million.

If the market is willing to value the company at 25 times earnings by then, Bill.com could be worth close to US$24.4 billion.

Today, even after the spike in Bill.com’s share price, it has a market cap of just around US$3.8 billion. In other words, the stock could potentially rise by more than 600% over the next five to 10 years if it lives up to the above projections.

The Good Investors’ conclusion

Bill.com has had a good start to life as a listed company, with shares soaring above its IPO price.

It also ticks many of the boxes that Ser Jing and I look for in our investments. It has a huge addressable market, a proven track record of growth, and a clear path to profitability. The injection of cash from the IPO also gives it a war chest to invest in international expansion.

On top of that, its market cap is still a fraction of its total addressable market and potential future market value. There are risks but if Bill.com can live up to even a fraction of its potential, I believe its stock could rise much higher.

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.

Mastercard (NYSE: MA) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Mastercard shares for the portfolio in December 2014 at a price of US$89 and subsequently made three more purchases (in February 2015 at US$85, in March 2017 at US$111, and in June 2019 at US$267). I’ve not sold any of the shares I’ve bought.

The purchases have worked out very well for my family’s portfolio, with Mastercard’s share price being around US$303 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Mastercard shares.

Company description

The US-headquartered Mastercard should be a familiar company to many of you who are reading this. Chances are, you have a Mastercard credit card in your wallet. But what’s interesting is that Mastercard is not in the business of issuing credit cards – it’s also not in the business of providing credit to us as consumers.

What Mastercard does is to provide the network on which payment transactions can happen. Here’s a graphical representation of Mastercard’s business:

Let’s imagine you have a Mastercard credit card and you’re buying an item in a NTUC supermarket. The transaction will involve five parties: Mastercard; the cardholder (you); the merchant (NTUC); an issuer (your bank that issued you the credit card); and an acquirer (NTUC’s bank). The transaction process will then take place in six steps:

1. Paying with your Mastercard credit card: You (cardholder) purchase your item from NTUC (the merchant) with your credit card.
2. Payment authentication: NTUC’s point-of-sale system captures your account information and sends it to NTUC’s bank (the acquirer) in a secure manner.
3. Submission of transaction: NTUC’s bank gets Mastercard to request an authorisation from your bank (the issuer).
4. Authorisation request: Mastercard sends information of your transaction to your bank for authorisation.
5. Authorisation response: Your bank authorises your transaction and pings the go-ahead to NTUC.
6. Payment to merchant: Your bank sends the payment for your transaction to NTUC’s bank, which then deposits the money into NTUC’s bank account.

Mastercard’s revenue comes from the fees it earns when it connects acquirers and issuers. In 2019, Mastercard earned US$16.9 billion in net revenue, which can be grouped into five segments:

• Domestic assessments (US$6.8 billion): Fees charged to issuers and acquirers, based on dollar volume of activity, when the issuer and the merchant are in the same country.
• Cross-border volume fees (US$5.6 billion): Charged to issuers and acquirers, based on dollar volume activity, when the issuer and merchant are in different countries.
• Transaction processing (US$8.5 billion): Revenue that is earned for processing domestic and cross-border transactions and it is based on the number of transactions that take place.
• Other services (US$4.1 billion): Includes services such as data analytics; consulting; fraud prevention, detection, and response; loyalty and rewards solutions; and more.
• Rebates and incentives (-US$8.1 billion): These are payments that Mastercard pays to its customers. Revenues from domestic assessments, cross-border volume fees, transaction processing, and other services collectively make up Mastercard’s gross revenue. We arrive at Mastercard’s net revenue when we subtract rebates and incentives from gross revenue.

With the ability to handle transactions in more than 150 currencies in over 210 countries, it should not surprise you to find that Mastercard has a strong international presence. In 2019, the US accounted for just 32% of the company’s total revenue; no other individual country took up a revenue-share of more than 10%.

Investment thesis

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

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

On the surface, Mastercard’s business already looks huge. The company processed 87.3 billion switched transactions in 2019, with a gross dollar volume of US$6.5 trillion; these helped to bring in US$16.9 billion in net revenue.

But the total market opportunity for Mastercard is immense. According to a September 2019 investor presentation by the company, the size of the payments market is US$235 trillion. From this perspective, Mastercard has barely scratched the surface.

It’s worth noting too that around 80% of transactions in the world today are still settled with cash. So there are still plenty of cash-based transactions available for Mastercard to divert to its network.

Mastercard formed a JV with NetsUnion Clearing Corporation last year to conduct business in China. Earlier this month, the JV received in-principle approval from China’s central bank to operate in the country. Prior to this, Mastercard had no operations in China, so the regulatory approval could pave the way for a huge new geographical market for the company. NetsUnion Clearing Corporation’s stakeholders include China’s central bank, the People’s Bank of China. The JV will be able to apply for formal approval within a year.    

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

At the end of 2019, Mastercard had US$7.7 billion in cash and investments on its balance sheet, against US$8.5 billion in debt. This gives rise to US$0.8 billion in net debt.

I generally prefer a balance sheet that has more cash than debt. But I’m not troubled at all in the case of Mastercard. That’s because the company has an excellent track record in generating free cash flow. The average annual free cash flow generated by Mastercard in 2017, 2018, and 2019 was US$5.0 billion, which compares well with the amount of net-debt the company has.

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

On integrity

Ajay Banga, 60, is Mastercard’s President and CEO. He has been CEO since July 2010, and I appreciate his long tenure. In 2018, Banga’s total compensation was a princely sum of US$20.4 million. But that is reasonable when compared with the scale of Mastercard’s business – the company’s profit and free cash flow in the same year were US$8.1 billion and US$5.5 billion, respectively. More importantly, his compensation structure looks sensible to me as a shareholder of the company. Here are the important points:

• In 2018, 66% of Banga’s total compensation was from stock awards and stock options that vest over multi-year periods (three years and four years, respectively).
• The stock awards are based on Mastercard’s revenue and earnings per share growth over a three-year period. I emphasised “per share” because Mastercard shareholders can only benefit from the company’s growth if there is per-share growth. 
• The value of the stock awards and stock options are nearly the same.

The lion’s share of the compensation of most of Mastercard’s other key leaders in 2018 also came from stock awards and stock options. This is illustrated in the table below.

It’s worth noting too that Mastercard’s management each have many years of experience with the company. Current CFO Sachin Mehra replaced Martina Hund-Mejean when the latter retired in April 2019; Mehra first joined Mastercard in 2010. The fact that Mastercard promotes from within is also a positive sign for me on the company’s culture.

There’s also a point I want to make on the alignment of interests between Banga and Mastercard’s shareholders: As of 26 April 2019, he controlled 1.859 million Mastercard shares which have a value of around US$563 million at the current share price. That’s a sizeable stake which likely places him in the same boat as other shareholders of the company.  

On capability and innovation

Mastercard is a digital payment services provider. Some of the key business metrics that showcase the health of its network are: (1) Gross dollar volume, or GDV, of payments that flow through the network; (2) cross-border volume growth; (3) the number of processed transactions; and (4) the number of the company’s cards that are in circulation. The table below shows how the four metrics have grown in each year since 2007. I picked 2007 as the start so that we can understand how Mastercard’s business fared during the 2008-09 Great Financial Crisis.

It turns out that Mastercard’s management has done a great job in growing the key business metrics over time. 2009 was a relatively rough year for the company, but growth picked up again quickly afterwards. As mentioned earlier, current CEO Ajay Banga had been leading the company since 2010, so the increases in the business metrics from 2007 to 2019 had happened mostly under his watch.

As another positive sign on Mastercard’s culture (I talked about the promotion from within earlier), we can look at Glassdoor, a website that allows a company’s employees to rate it anonymously. 96% of Mastercard’s employees who have submitted a review approve of Banga’s leadership, while 81% will recommend a job in the company to a friend. I credit Mastercard’s management, and Banga in particular, for building a strong culture.

Coming to innovation, Mastercard’s management has, for many years, been improving the payments-related solutions that it provides to consumers and organisations. This is aptly illustrated by the graphic below, which shows the changes in Mastercard’s business from 2012 to 2018:

Here are some interesting recent developments by Mastercard:

• Launched Mastercard Track in 2019; Mastercard Track is a B2B (business-to-business) payment ecosystem which helps to automate payments between suppliers and buyers.
• Drove blockchain initiatives in 2019, in the areas of cross-border B2B payments and improving provenance-knowledge in companies’ supply chains.
• Implemented AI-powered solutions to prevent fraudulent transactions and improve fraud detection. 

In particular, the B2B opportunity is huge and worth tackling, because companies do encounter many pain-points that are related to payment issues. This is shown in the graphic below.

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

I think Mastercard is a great example of a company with recurring revenue from customer-behaviour. Each time we make a purchase and we pay with our Mastercard credit card, the company takes a small cut of the payment.

I showed earlier that the company handled trillions in dollars worth of payments in 2019, and processed billions in transactions. These numbers, together with the fact that no individual customer accounted for more than 10% of Mastercard’s revenues in 2019, 2018, and 2017, lend further weight to my view that the company’s revenue streams are largely recurring in nature.     

5. A proven ability to grow

The table below shows Mastercard’s important financials from 2007 to 2019:

A few key points about Mastercard’s financials:

• Net revenue compounded decently at 12.6% per year from 2007 to 2019; over the last five years from 2014 to 2019, the company’s annual topline growth was similar at 12.3%. 
• The company also managed to produce net revenue growth in 2008 (22.7%) and 2009 (2.1%); those were the years when the global economy was rocked by the Great Financial Crisis.
• Net profit surged by 18.2% per year from 2007 to 2019. Mastercard’s net profit growth from 2014 to 2019 was similarly healthy at 17.5%. Net profit was negative in 2008 because of large legal settlement expenses of US$2.5 billion incurred during the year, but it is not a cause for grave concern for me. 
• Operating cash flow grew in most years for the entire time frame I studied; increased markedly with annual growth of 21.8%; and had been consistently positive. The growth rate from 2014 to 2019 was still impressive at 19.2% per year.
• Free cash flow, net of acquisitions, was consistently positive too and had stepped up from 2007 to 2019 at a rapid clip of 20.1% per year. The annual growth in free cash flow from 2014 to 2019 was 16.8% – not too shabby. It’s worth noting that Mastercard’s capital expenditure of US$2.6 billion in 2019 is significantly higher compared to the past primarily because of large acquisitions totalling US$1.4 billion. Without the acquisitions, Mastercard’s free cash flow in 2019 would be much higher at US$7.0 billion.  
• The net-cash position on Mastercard’s balance sheet was positive from 2007 to 2018 and had dipped into negative territory only in 2019. I mentioned earlier that I’m not troubled by Mastercard currently having more debt than cash, since the company has been adept at producing free cash flow and the amount of net-debt is manageable. 
• Mastercard’s diluted share count declined by 24% in total from 2007 to 2019, and also fell in nearly every year over the same period. This is positive for the company’s shareholders, since it boosts the company’s per-share earnings and free cash flow. For perspective, Mastercard’s free cash flow per share compounded at 20.0% per year from 2014 to 2019, which is higher than the annual growth rate of 16.8% over the same period for just free cash flow. Mastercard’s share price has also increased by a stunning amount of nearly 3,000% in total since the start of 2007. This means that the share buybacks conducted over the years by Mastercard’s management to reduce the share count have been excellent uses of capital. 

In Mastercard’s 2019 fourth-quarter earnings conference call, management guided towards net revenue growth in the low-teens range for 2020. Growth in the first quarter of 2020 was expected to be around two percentage points lower than the whole year. But in late February, Mastercard updated its forecast for net revenue growth. The ongoing outbreak of COVID-19 has negatively impacted cross-border travel and cross-border e-commerce growth. As a result, Mastercard now expects its 2020 first-quarter net revenue growth to be “approximately 2-3 percentage points lower than discussed [during the earnings conference call].” Mastercard added:

“There are many unknowns as to the duration and severity of the situation and we are closely monitoring it. If the impact is limited to the first quarter only, we expect that our 2020 annual year-over-year net revenue growth rate would be at the low end of the low-teens range, on a currency-neutral basis, excluding acquisitions. We anticipate giving further updates on our first-quarter earnings call.”

No one knows what kind of impact COVID-19 will eventually have on the global economy. But I’m not worried about the long-term health of Mastercard’s business even though COVID-19 has already made its mark. My stance towards COVID-19 is that this too, shall pass.

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

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

First, the company has a long track record of producing strong free cash flow from its business. Moreover, its average free cash flow margin (free cash flow as a percentage of revenue) in the past five years from 2014 to 2019 was strong at 33.5%. In 2019, the free cash flow margin was 32.9%.

Two, there’s still tremendous room to grow for Mastercard in the entire payments space. The company has a strong network (the number of currencies it can handle; the number of countries it operates in; the sheer payment and transaction volumes it is processing; the billions in its self-branded credit cards that are circulating) as well as a capable and innovative management team that has integrity. These traits should lead to higher revenue for Mastercard over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Mastercard in the future.

Valuation

I like to keep things simple in the valuation process. In Mastercard’s case, I think the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value. That’s because the company has been adept at producing positive and growing profit as well as free cash flow for a long period of time.

Right now, Mastercard carries trailing P/E and P/FCF ratios of around 38 and 56 at the current share price of US$303. These ratios look expensive, and are also clearly on the high-end (see chart below) when compared to their own histories over the past five years.

(Note: The chart above is from Ycharts and the P/FCF ratio excludes the impact of acquisitions. Using my own numbers for Mastercard, the company’s P/FCF ratio falls to 44 if I remove acquisition-related effects. My P/FCF ratio and that from YCharts are not the same, but they are similar enough. Moreover, I’m only relying on the P/FCF chart for general guidance.)

But I’m happy to pay up, since Mastercard excels under my investment framework. I also want to point out that Mastercard not only has a large market opportunity – the chance that it can win in its market is also very high, in my view. Put another way, Mastercard scores well in both the magnitude of growth and the probability of growth. For companies like this, I’m more than willing to accept a premium valuation. But the current high P/E and P/FCF ratios do mean that Mastercard’s share price could be volatile going forward. This is something I have to be – and I am – comfortable with.

The risks involved

There are a few key risks that I see in Mastercard.

First is a leadership transition. Mastercard announced earlier this month that long-time CEO Ajay Banga will become Executive Chairman on 1 January 2021. Current Chief Product Officer, Michael Miebach, will succeed Banga as CEO on the same date. Given the timeline involved, the transition seems planned. Miebach, who’s relatively young at 52 this year, joined Mastercard in June 2010. Again, this promotion from within is a positive thing in my view. Banga has high-praise for Miebach, commenting in the announcement:

“As the company moves into this next phase of growth, we have a deep leadership bench–with Michael at the helm–to take us to the next level. He has a proven track record of building products and running businesses globally.

Over his career, Michael has held leadership positions in Europe, the Middle East and Africa and in the U.S. across payments, data, banking services and technology. During the course of Michael’s 10 years at Mastercard, he has been a key architect of our multi-rail strategy–including leading the acquisition of Vocalink and the pending transaction with Nets–to address a broader set of payment flows. He’s also a visionary who kickstarted much of the work behind our financial inclusion journey.

I am excited to continue working closely with Michael and supporting Mastercard’s success when I become Executive Chairman.”

Miebach looks like a safe pair of hands and Banga will still continue to have a heavy say on Mastercard’s future given his upcoming role as Executive Chairman. But I will be keeping an eye on this leadership transition.

Competition is the second risk I’m watching. I mentioned in my investment thesis for PayPal (a digital payments services provider) that the payments space is highly competitive. There are larger payment networks such as that operated by Mastercard’s competitor, Visa (which processed US$11.6 trillion on its platforms in the 12 months ended 30 September 2019). In my PayPal thesis, I also said:

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

Just like PayPal, there are no guarantees that Mastercard will continue winning. But I do think the odds are in Mastercard’s favour.

Regulations are the third risk I’m watching. Payments is a highly regulated market, and Mastercard could fall prey to heavy-handed regulation. Lawmakers could impose hefty fines or tough limits on Mastercard’s business activities. In general, I expect Mastercard to be able to manage any new legal/regulatory cases if and when they come. But I’m watching for any changes to the regulatory landscape that could impair the health of Mastercard’s business permanently or for a prolonged period of time.

Lastly, there is the risk of recessions. Mastercard did grow its net revenue in 2009, but the growth rate was low. I don’t know when a recession in the US or around the world will hit. But when it does, payment activity on Mastercard’s network could be lowered. As I mentioned earlier, COVID-19 has already caused a softening in Mastercard’s business activity. 

The Good Investors’ conclusion

To wrap up, Mastercard excels under my investment framework:

1. The payments market is worth a staggering US$235 trillion and Mastercard has barely scratched the surface.
2. The company currently has more debt than cash, but the net-debt level is manageable and the company has a strong history of producing free cash flow.
3. Mastercard’s management team has proved itself to be innovative and capable, but that’s not all – the company’s leaders also have sensible compensation structures that align their interests with shareholders.
4. Mastercard’s revenue streams are highly likely to be recurring in nature (each time we make a payment with a Mastercard service or product, the company gets a cut of the transaction).
5. The company has a long history of growing its net revenue, profit, and free cash flow, while keeping its balance sheet strong and reducing its share count.
6. There is a high likelihood that Mastercard will continue to be a free cash flow machine.

The company does have a high valuation – both in absolute terms and in relation to history. But I have no qualms with accepting a premium valuation for a high-quality business.

I’m also aware of the risks with Mastercard. I’m watching the leadership transition and also keeping an eye on risks that are related to competition, the regulatory landscape, and recessions.

But after weighing the pros and cons, I’m happy to allow Mastercard to continue to be in my family’s investment portfolio.

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

Tesla has been the talk of the town so far in 2020. The tech-driven company’s stock price has more than doubled since the start of the year thanks to a strong end to 2019 for its business.

With the recent hype around Tesla, here’s a look at some of the reasons why Tesla’s stock may have surged and whether it is still worth investing in.

Free cash flow generation

Previously, one of the concerns investors had with Tesla was its cash burn rate. The company’s high cash burn (see chart below) had resulted in Tesla raising money through secondary offerings that diluted existing shareholders. 

However, 2019 could be a turning point for Elon Musk’s brainchild. The electric vehicle company was GAAP-profitable in the second half of 2019 and had generated US$1.4 billion in free cash flow for the same period. Its 2020 outlook was also extremely positive. Tesla said:

“We expect positive quarterly free cash flow going forward, with possible temporary exceptions, particularly around the launch and ramp of new products. We continue to believe our business has grown to the point of being self-funding.”

And although Tesla announced another secondary offering last week, I think this time it was not because of cash flow issues but rather to take advantage of the run-up in its share price.

The chart below illustrates improvements in its trailing twelve months (TTM) of free cash flow over the last 12 quarters.

Ramping up production capacity 

Another major plus for the company was the announcement that it was going to ramp up production capacity. In its outlook statement, Tesla said:

“For full-year 2020, vehicle deliveries should comfortably exceed 500,000 units. Due to ramp of Model 3 in Shanghai and Model Y in Fremont, production will likely outpace deliveries this year.”

Tesla’s 2020 projection translates to at least a 36% jump in deliveries from 2019. 

Perhaps the most impressive part of its 2019 fourth-quarter earnings announcement was that it was able to start Model 3 production in its Gigafactory in Shanghai in less than 10 months from breaking ground- a sign that the company is becoming more efficient in ramping up production.

The China factory will boost production capacity by around 150,000. Besides the factory in China, Tesla has moved forward with its preparations to build a factory near Berlin, which is expected to be open by 2021.

Irresistible demand for products to meet its production ramp-up

The production ramp-up is only possible due to the strong demand for Tesla’s products. In his earnings call with analysts, Musk gushed:

“Our deliveries reached over 112,000 vehicles in a single quarter. It’s hard to think of a similar product with such strong demand that it can generate more than US$20 billion in revenue with zero advertising spend.”

Musk was even more optimistic about Tesla’s new Cybertruck vehicle. He said:

“I have never seen actually such a level of demand at this — we’ve never seen anything like it basically. I think we will make as about as many as we can sell for many years. So — as many — we’ll sell as many as we can make, it’s going to be pretty nuts.”

As Tesla plans to start production of its Cybertruck only in 2021, investors will need to wait at least a year before the initial sales figures are released but the early signs are certainly encouraging.

Better gross margins 

In addition, gross margins for Tesla should improve.

Improved efficiency in product cost and higher gross margins for its newest car (Model Y) will be the driving force behind Tesla’s better gross margins.

The company will deliver its first Model Y in this quarter and expects to ramp up sales of its latest model over the year. As the product-mix shifts towards Model Y, I think investors can expect a slight improvement in gross Tesla’s margin.

On top of improvements in gross margin, Tesla also said that it is likely going to be more efficient in terms of capital expenditure per production capacity. The improvements to capital efficiency should enable the company to scale its capacity faster and produce its vehicles at a cheaper rate on a per unit basis.

Other factors

Besides selling electric vehicles, there are a few other potential drivers of growth:

• Tesla is at the forefront of the fully autonomous vehicles trend. The technology-driven company logged 500 million autonomous miles in 2018. Tesla is, literally, miles ahead of its rivals, Waymo and GM’s Cruise, which logged 1.3 million and 447,000 miles respectively.
  Currently, Tesla sells cars that are fitted with the hardware needed for full self-driving (FSD), with an optional upgrade for FSD software features. As FSD technology matures, we can expect Tesla to roll out updates to the software. In addition, Tesla can also retain a fleet of FSD vehicles for rental and driverless transportation- in a way becoming the Uber of driverless vehicles. Ark Invest estimates that autonomous ride-hailing platforms in aggregate could have a value of a whopping US$9 trillion by 2029.
• Tesla also sells vehicle software such as its Premium Vehicle Connectivity feature which enables users to stream music on their cars. Owners of Tesla vehicles can also buy other software updates such as acceleration boost, basic Autopilot, and additional premium features. As Tesla grows its suite of software products, this revenue stream is expected to become another important driver of growth for the company.
• The company’s energy storage and solar roof installations businesses have also increased year-on-year. Tesla expects both storage and solar roofing to grow by 50% in 2020.

But is Tesla’s stock too expensive?

2019 is a year which Tesla proved many of its doubters wrong. But has the market gotten ahead of itself?

After the surge in its share price, Tesla’s valuation currently tops US$160 billion. That translates to nearly seven times trailing sales. For a company that has a gross profit margin for its automotive business of 22% (which is high for vehicle sales but low compared to other industries), its current share price certainly seems rich- even for a company growing as fast as Tesla is.

Even if Tesla can quadruple its sales figures to a US$80 billion run rate and earn a 10% net profit margin, today’s share price still represents 20 times that possible earnings. And Tesla will need to keep its foot to the floor of the accelerator to generate that kind of numbers.

In addition, the automotive industry has traditionally been in a tough operating environment. Even though demand for Tesla’s vehicle models seem irresistible at the moment, things could change in the future and a drop in popularity could hurt sales.

The Good Investors’ conclusion

Tesla’s products are in hot demand now and the company has plans to ramp-up its production capacity. And if Tesla can deliver on all fronts (including full-self-driving), I could still stand to make a very decent profit if I buy shares today.

However, its stock does seem a little bit expensive. Any misstep in Tesla’s growth could send the stock price tumbling. As such, despite the tailwinds and huge market opportunity, I prefer to take a wait-and-see approach for now.

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

Cancer is a devastating disease and a growing cause of death in the developed world. Worldwide, the disease struck more than 17 million people in 2018 and that figure is expected to mushroom in the future. The numbers are scary but the silver lining is that the world is making great strides in combating the disease.

One company that is doing its part to help is Guardant Health (NASDAQ: GH).

The medical diagnostics company sells liquid biopsies to help identify tumours that can be treated with targeted therapy.

Liquid biopsies are a much less invasive method of obtaining information about cancer cells in a person’s body than traditional tissue biopsies. Put another way, liquid biopsies are a fancy term for a simple blood test that can replace painful tissue biopsies.

On top of that, Guardant Health’s first commercialised liquid biopsy, called Guardant360, produces faster results that are as effective as traditional biopsies.

But Guardant Health is not just creating a positive impact on humanity. Its stock price has already nearly tripled since its IPO in 2018, but I think it still has legs to run and could even potentially be a 10-bagger in the making. 

Here’s why.

FDA approval

The leader in liquid biopsy has applied for Food and Drug Administration (FDA) approval for Guardant 360. So far, Guardant 360 is being sold without FDA approval and falls into the category of a laboratory-developed test. An approval by the FDA will give the test more credibility and should help it achieve greater commercial adoption.

Gaining FDA approval will also support improvements in coverage by commercial payers and reimbursements. Higher coverage by commercial payers will likely increase the take rate among patients and also enable Guardant Health to increase the selling price of Guardant 360.

Helmy Eltoukhy, Guardant’s co-founder and CEO, said the following in the company’s 2019 third-quarter earnings conference call:

“We believe FDA approval will be an important catalyst for helping to establish a blood-first paradigm that will lead to continued clinical adoption of Guardant360.”

Pipeline products

Besides Guardant360, Guardant has three other products that are either in the pipeline or marked for research use. They are GuardantOMNI, LUNAR-1, and LUNAR-2. 

GuardantOMNI is similar to Guardant360 but can identify a broader panel of genes (500 vs 73) from circulating tumour DNA. It was designed for biopharmaceutical companies to accelerate clinical development programs for both immuno-oncology and targeted therapy treatments. GuardantOMNI is being sold for research-use only.

LUNAR-1 is a test that is aimed at detecting cancer recurrence in patients that are in remission. LUNAR-2 is a test to detect cancer in asymptomatic but high-risk populations. Essentially, LUNAR-2 can become a more accessible screening tool to detect cancer early. LUNAR-1 and LUNAR-2 have yet to be commercialised but are in late-stage clinical trials. 

Together, these four tests provide immense potential for the company. The chart below provides a nice summary of Guardant Health’s pipeline.

Huge addressable market

Liquid biopsies have a huge addressable market since it could replace traditional tissue biopsy and cancer screening tests such as colonoscopies.

According to Guardant Health’s IPO prospectus, Guardant360 and GuardantOMNI have a potential addressable market of US$6 billion. 

But the biggest potential lies with LUNAR-1 and LUNAR-2, which have addressable markets of US$15 billion and US$18 billion, respectively.

Guardant Health is still in its infancy and has a huge runway of growth with an estimated revenue of just US$200 million for 2019.

International opportunity

Moreover, the addressable markets stated above are only for the US. Guardant Health has a joint venture with Softbank to take its products internationally. The strategic partnership with the Japanese firm should give Guardant Health a first look into the Japanese market and open doors for international expansion.

FDA approval will also enable greater adoption internationally and should be a catalyst for international commercialisation in the future.

Guardant Health is making good progress

The biotech firm has shown signs of progress on multiple fronts. On top of the submission for FDA-approval for Guardant360, Guardant Health’s management also mentioned in the earnings conference call for the third quarter of 2019 that it was likely that Guardant360 could gain Medicare Pan-Cancer local coverage determination, giving more patients access to Guardant360 through the medicare plan.

Guardant Health is also advancing its LUNAR tests and in its earnings announcement for 2019’s third quarter, said that it had enrolled its first patient in its ECLIPSE study, a “prospective multi-site registrational study designed to support the introduction of our LUNAR-2 assay for using guidelines-recommend colorectal cancer screening in average-risk adults.”

These initiatives are encouraging signs for the commercialisation and adoption of the two LUNAR tests.

Financially, the numbers look great

Although Guardant Health’s business is still very much in its infancy, the numbers look promising. 

In the third quarter of 2019, revenue was up 181% to US$60.8 million from just US$21.7 million. The number of clinical precision oncology tests increased by 89% to 13,259, while tests for research purposes increased by 111% to 5,280. These figures suggest that oncologists and biopharmaceutical firms are warming up to the idea of Guardant Health’s less invasive cancer testing products.

The gross margin for Guardant Health is also high at 70% and could widen if Guardant 360 earns FDA approval.

Guardant Health is still experiencing losses but this is expected for a company that is spending heavily on marketing, research, and applications for regulatory approvals. The company’s management expects 2019 revenue in the range of US$202 million to US$207 million, representing growth of 123% to 128% from 2018.

Its balance sheet is also healthy with no debt and slightly over US$500 million in cash and short-term marketable securities. Its solid financial footing gives the company the flexibility to continue investing in research and to push for the commercialisation of its two LUNAR tests.

The stock is cheap compared to its addressable market

Guardant Health’s stock trades at around 40 times the projected revenue for 2019. On the surface, that looks expensive but investors should consider the company’s total addressable market and the milestones that the company has achieved towards greater market penetration.

The liquid biopsy firm has a market cap of around US$8 billion, which is tiny when compared to its total addressable market of US$40 billion in just the US alone. 

The Good Investors’ conclusion

Having said all that, I acknowledge the possibility that Guardant Health will not live up to its potential. Competition, regulatory restrictions, and missteps in clinical trials are just some of the risks that could derail its growth.

But despite the risks, the signs look promising. The take-up rate for Guardant360 and GuardantOMNI are increasing year-on-year and the possibility of FDA-approval could be a near-term catalyst. Moreover, progress has been made with the two LUNAR tests which can provide the next avenue of growth.

If Guardant Health lives up to even a fraction of its potential, I think the stock will rise much higher.

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.

Booking Holdings (NASDAQ: BKNG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Booking shares for the portfolio in May 2013 at a price of US$765 and subsequently made three more purchases (in December 2014 at US$1,141, in February 2016 at US$1,277, and March 2017 at US$1,771). I’ve not sold any of the shares I’ve bought.

The first three purchases have worked out pretty well for my family’s portfolio, with Booking’s share price being around US$1,990 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Booking shares.

Company description

Booking, formerly known as Priceline, was listed in March 1999, right in the middle of the dotcom bubble. When the bubble met its sudsy end, Booking’s share price collapsed by over 99% from peak-to-trough. But like a phoenix rising from the ashes, Booking’s share price then embarked on an incredible climb of more than 30,000% from the bottom (reached in October 2002) to where it is today.

At the beginning of its life as a public listed company, Booking was in the online travel business. Today it is still in the online travel business. The difference between now and then is that Booking was an unproven business with significant losses in the days of yore. Now, it is the world’s largest online travel company, and very profitable. Some of you may have booked hotels online with Agoda or Booking.com – that’s Booking, the company, in action!

In the first nine months of 2019, Booking pulled in US$11.7 billion in revenue. These came primarily from the following brands the company has:

• Booking.com – one of the world’s largest, if not the largest, online service for booking accommodation reservations
• KAYAK – an online service for users to search and compare prices for air tickets, accommodations, and car rentals from hundreds of travel websites
• priceline – an online travel agent in North America for reservations of hotels, rental cars, air tickets, and vacation packages
• Agoda – a website for accommodation reservations, with a focus on consumers in the Asia-Pacific region
• Rentalcars.com – an online worldwide rental car reservation service
• OpenTable – allows consumers to make restaurant reservations online, and provides restaurant reservation management and customer acquisition services to restaurant operators.

Booking.com, which is based in the Netherlands, is Booking’s largest brand – it accounted for 77% of the company’s total revenue in the first nine month of 2019. Because of the location of Booking.com’s headquarters, Booking counts the Netherlands as its largest geographical market (a 77% share of the pie). The US is Booking’s next largest country, with a 10% share of total revenue.

Each time you make a hotel reservation, Booking earns either the entire room rate as revenue, or earns a referral fee. This is because the company runs two different business models:

• There is the merchant model, where Booking earns the entire room rate when rooms are booked through its platforms. It is a more complex model as the company has to negotiate room prices and allocations with the operator of the property. Ensuring parity between the company’s room-rate and the operator’s room-rate is likely also a tricky problem.
• Then there is the agency model, which is a lot simpler. It allows hoteliers to set their own price and room allocations. Under this model, Booking is the agent that passes customer reservations to hotels and it collects a commission fee for each reservation made. Guests also pay only on checkout, compared to the merchant model where guests have to pay when the reservation is made (so now you know why certain travel websites require you to pay upfront, while some don’t!). 

In the first nine months of 2019, 68% of Booking’s total revenue of US$11.7 billion came from its agency business, while 25% was from the merchant model. Advertising and other types of services accounted for the rest. Nearly all of Booking’s agency revenue came from Booking.com.    

Investment thesis

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

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

I’m confident that online travel is a huge and growing market because of a few data points.

First, according to statistics from travel research firm PhocusWright that were cited by travel review site TripAdvisor, the global travel market was estimated to be US$1.3 trillion in 2016, with online travel spend accounting for US$492 billion (38%). The latest data from PhocusWright that was cited by TripAdvisor in the latter’s November 2019 investor presentation showed that the global travel market had expanded to around US$1.7 trillion for 2019.

Second, Allied Market Research released a report in mid-2019 that contained a forecast for the online travel market to grow by 11.1% annually from 2016 to 2022 to reach US$1.1 trillion.

Third, aircraft manufacturer Airbus expects air travel traffic to grow by 4.3% annually from 8.7 trillion RPK in 2018 to 20.3 trillion RPK in 2038, driven by a rising middle class population across the globe (from 3.95 billion individuals in 2018 to 5.94 billion in 2038). Air travel traffic has been remarkably resilient in the past, and had grown by around 5.5% annually in the 30 years from 1988 to 2018. The chart just below shows the growth of global air travel traffic, in terms of RPK (RPK stands for revenue passenger-kilometres, which is the number of fare-paying passengers multiplied by the distance travelled), since 1978.

The following chart shows the sources for the expected global air travel traffic growth of 4.3% per year from 2019 to 2038:

For context, Booking’s revenue is only US$14.9 billion over the last 12 months, suggesting a long runway for growth for the company. 

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

Booking has a strong balance sheet right now, with slightly more cash and investments than debt as of 30 September 2019 (US$8.8 billion in cash and investments against US$8.5 billion in debt).

Note: Booking’s cash and investments of US$8.8 billion excludes US$2.9 billion in strategic investments that the company has in Trip.com (a China-focused travel agent), Meituan Dianping (a China-based e-commerce platform for services), Didi Chuxing (China’s leading ride hailing platform), and other private companies, such as Grab, the Singapore-based version of Didi Chuxing.

The company also has an excellent track record in generating free cash flow. I’ll discuss this later.  

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

On integrity

Glenn Fogel, 57, is currently Booking’s CEO. He joined the company in February 2000 and was promoted to his current role in January 2017. Prior to being CEO, Fogel was already a key leader in Booking since 2009. I appreciate his long tenure with the company. Seeing Booking promote from within is also a positive sign on its culture.

Fogel’s total compensation was US$20.5 million for 2018, which is a tidy sum of money. But it is a reasonable amount when we consider that Booking’s profit and free cash flow in 2018 were US$4.0 billion and US$4.6 billion, respectively.

68% of Fogel’s total compensation for 2018 came from long-term stock awards that depend on the performance of Booking’s stock price and adjusted EBITDA (earnings before interest, taxes, depreciation, and amortisation) over a three year period. I’m not the biggest fan of EBITDA and would much prefer the use of earnings per share or free cash flow per share. I also typically frown upon compensation plans that are linked to a company’s stock price. But there are strong redeeming factors in Booking’s overall compensation structure:

• The adjusted EBITDA excludes any positive impacts from acquisitions as well as the sale of loss-making subsidiaries; so, the performance of the adjusted EBITDA will have to depend on the growth of Booking’s core businesses.
• The changes to adjusted EBITDA and the stock price are measured over three years, which is a sufficiently long time period (although I wouldn’t mind an even longer time frame!).
• Fogel’s base salary and cash bonus is designed to be below the market rate, to incentivise him to lead Booking towards strong long-term business performance in order to earn his attractive stock awards.

In all, I think that Booking’s compensation structure for Fogel aligns his interests with mine as a shareholder of the company. I want to point out too that Booking’s other key leaders, including CFO David Goulden (59 years old) and General Counsel Peter Millones Jr. (49 years old), also have similar compensation structures as Fogel’s. In addition, Booking’s compensation plan for its leaders has been substantially similar for many years – that’s another plus-point for me on the integrity of the company’s management team.

I also want to mention Jeffrey Boyd, 62. He has been the Chairman of Booking’s board of directors since January 2013, and was CEO of the company from November 2002 to December 2013. He also became interim CEO from April 2016 to December 2016 (more on this in the Risk section of this article). As Chairman of the board, Boyd’s compensation was just US$491,399 in 2018. It is an extremely low sum compared to the scale of Booking’s business, and I think it’s another testament to the integrity that Booking’s leaders have. 

On capability and innovation

Earlier, I mentioned that Booking’s key brand is Booking.com. In 2005, Booking acquired the Netherlands-based Booking.com for merely US$133 million. In just the first nine months of 2019, Booking.com produced around US$9 billion in revenue, representing 77% or so of Booking’s overall top-line. These stunning figures make the acquisition price-tag of US$133 million look like one of the greatest business deals of all time. Jeffrey Boyd, the company’s current Chairman of the Board, was Booking’s CEO at the time of the acquisition.

As a platform for online travel reservations, I believe Booking’s business exhibits a classic network effect, where having more accomodation properties on its platform leads to more visitors, which in turn leads to more accommodation properties. Booking’s management has done a fantastic job in growing its accommodations network over the years. The table below shows this, along with the growth in the number of room nights booked by travellers, demonstrating the power of Booking’s network effect.

The company’s growth in unique accommodations is noteworthy. Online travel is a massive and growing market, so I think there is room for multiple winners. But I still see AirBnB, with more than 6 million listings in early 2019, as one of the main threats to Booking’s business. (Note: The definition of listings by AirBnB is different from Booking’s property-count in the table above, but the key point is that AirBnB also has a wide network.) I’m sure most of you reading this have used, or at least heard of, AirBnB’s online platform that provides travellers with alternative accommodation options to hotels. Booking has amassed a sizable inventory of unique accommodations of its own, to management’s credit – and this part of the business is growing faster than Booking’s main hotel business.

There’s an aspect of Booking’s accommodations network that I think is underappreciated by investors: The supplier- and customer-support that is provided by the company. Booking is able to provide 24/7 support in nearly 50 languages – small, independent hotels and owners of alternative accommodations are unable to provide that for travellers. This is why Booking believes its services enable this group of accommodation-providers to reach a wider audience than they otherwise could by themselves. To be clear, Booking believes that its services are valuable to large hotel chains too. It is worth noting that independent hotels make up around 40% to 50% of the total hotel supply in Asia Pacific, Middle East, Africa, Europe, and Latin America; in the US, it is 72%. 

Bookiing’s leaders have also proven to be quick to adapt, in my view. I want to bring up two points on the matter.

First, the company had produced significant growth in agency revenue from 2007 to 2017, with merchant revenue being relatively flat (especially from 2011 to 2017). But when the agency business started facing growth headwinds in 2018 and the first nine months of 2019, the merchant business helped to pick up the slack with significant growth. These are shown in the table just below.

Second, the company had traditionally been big spenders on performance marketing, which are marketing expenses on online search engines (primarily Google) and other travel-related websites to drive traffic to Booking’s own websites. But after experiencing a decline in the return on investment in performance marketing, Booking started to place heavier emphasis on brand marketing in the past few years.

I believe that brand advertising will be a net benefit to the long-term health of Booking’s business – if the brand advertising efforts are a success, travellers will flock to Booking’s websites without the need for the company to advertise online. The changes in the growth of Booking’s performance marketing spend and brand marketing spend over the past few years is shown in the table below. The early signs are mixed. On one hand, Booking’s direct channel (where customers head to the company’s websites directly) is growing faster than its paid channel (where customers visit the company’s websites because of performance-marketing adverts). On the other hand, management had expected its brand advertising results to be better. I have confidence that Booking’s management will work things out in the end. 

Booking’s culture can be described as decentralized, empowered, and innovative. According to a 2014 interview of Booking’s former CEO, Darren Huston, the company operates in small teams that are no larger than eight people, and runs more than 1,000 concurrent experiments on its products every day. Booking’s current CEO, Glen Fogel, was interviewed in 2018 by Skift and revealed that constant testing is still very much in the company’s DNA.

Perhaps the greatest feather in the cap of Booking’s management is the fact that the company has handily outpaced its rival Expedia over the long run. In 2007, Expedia’s revenue was almost twice of Booking’s. But Booking’s revenue over the last 12 months was significantly higher than Expedia’s.

Being a travel-related technology company, it’s no surprise to learn that Booking also has an innovative streak. The company is working with machine learning and artificial intelligence to improve people’s overall travel experience. In particular, Booking’s highly interested in the connected trip, where a traveller’s entire travel experience (from flights to hotels to ground-transport to attraction-reservations, and more) can be integrated on one platform. Another nascent growth area for Booking is payments, which the company started investing in only in recent years. Here’s CFO David Goulden describing the purpose of the company’s payments platform during Booking’s 2018 third-quarter earnings conference call:

“[The payments platform] does a number of great things for us, for our customers and our partners. For our customers, it gives them many more choices to how they may want to pay for their transactions in advance or closer to the stay, it gives them more opportunities to pay with the payments product of their choice, it may not necessarily be a credit card, it could be something like an Ally pay for example.

For us, it lets us basically provide our customers with a more consistent service, because we’re in charge of exactly how that payment flow works.

And then for our partners, again, we offer them more ability to access different payment forms from different customers in different parts of the world, because we can basically pay them the partner in the form of whatever they like to take even though we may have taken the payment in on the front end, there are different payment mechanisms.”

I also think management’s investments in a number of Asia-focused tech start-ups are smart moves. As I mentioned earlier, Booking has stakes in Meituan Dianping, Didi Chuxing, and Grab. These investments aren’t just passive. Booking is actively collaborating with some of them. Here’s Booking’s CEO Glenn Fogel in the aforementioned interview with Skift describing how the company is working with Didi Chuxing to improve the experience of travellers in China:

“Now until recently by the way, DiDi only had a Chinese app. Kind of hard for most of the people who go to China to use it. Recently now, they have an English language one. But still, we have a lot of customers, English isn’t their language, right? So what we’ve done is this deal is so wonderful.

One, our customers, they go onto the Booking.com or they go to the app and you’ll be able to get that ground transportation from Didi app in the language that they were doing the work with Booking or Agoda. Really good. Nice, seamless, frictionless thing. Second thing is, we’re going to work with them so we can help make sure all those Didi customers know about Booking.com and Agoda. You need a place to stay, that’s where you can go and get a great deal, a great service in Chinese.”            

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

I believe that Booking’s revenue streams are highly recurrent because of customer-behaviour. Each time you travel, you’ll need to reserve accommodations and arrange for transport options. Moreover, I think it’s highly likely that Booking does not have any customer-concentration – I showed earlier that 654 million room-nights were reserved through Booking’s platforms in the first nine months of 2019. 

5. A proven ability to grow

The table below shows Booking’s important financials from 2007 to 2018:

A few key points about Booking’s financials:

• Revenue has compounded impressively at 23.6% per year from 2007 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower but still strong at 16.4%. 
• The company also managed to produce strong revenue growth of 33.8% in 2008 and 24.0% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Net profit has surged by 35.7% per year from 2007 to 2018. Like revenue-growth, Booking’s net profit growth from 2013 to 2018 is slower, but still healthy at 16.1%.
• Operating cash flow has not only grown in each year from 2007 to 2018. It has also increased markedly with annual growth of 37.9%, and been consistently positive. The growth rate from 2013 to 2018 was considerably slower at 18.3% per year, but that is still a good performance.
• Free cash flow, net of acquisitions, has consistently been positive too and has also stepped up from 2007 to 2018 at a rapid clip of 38.9% per year. The annual growth in free cash flow from 2013 to 2018 was 19.7% – not too shabby. Booking’s free cash flow fell dramatically in 2014 because it acquired OpenTable for US$2.4 billion during the year.  
• The net-cash position on Booking’s balance sheet was mostly positive. I include Booking’s investments in bonds and debt as part of its cash, but I exclude the company’s strategic investments. 
• Dilution has also been negligible for Booking’s shareholders from 2007 to 2018 with the diluted share count barely rising in that period. 

2019 has so far been a relatively tough year for Booking. Revenue was up by just 3.7% to US$11.7 billion in the first nine months of the year. Adverse currency movements and a decline in the average room-rate had dented Booking’s top-line growth. Profit inched up by just 0.9% year-on-year to US$3.28 billion after stripping away non-core profits. Booking has strategic investments in other companies and some of them are listed; accounting rules state that Booking has to recognise changes in the stock prices of these companies in its income statement. A 9.4% reduction in the company’s diluted share count to 43.9 million resulted in adjusted earnings per share for the first nine months of 2019 climbing by 11.4% to US$74.52 from a year ago. Operating cash flow declined by 11.0%, but was still healthy at US$3.8 billion. Free cash flow was down 6.9% to US$3.5 billion. The balance sheet, as mentioned earlier, remains robust with cash and investments (excluding the strategic investments), slightly outweighing debt.

Booking has an impressive long-term track record of growth, so I’m not concerned with the slowdown in 2019 thus far. The market opportunity is still immense, and Booking has a very strong competitive position with its huge network of accommodations spanning large hotel chains to unique places to stay.

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

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

Firstly, the company has done very well in producing free cash flow from its business for a long time. In the past five years from 2013 to 2018, its average free cash flow margin (free cash flow as a percentage of revenue) was strong at 26.5%. Booking’s free cash flow margin was 29.8% in the first nine months of 2019.

Secondly, there’s still tremendous room to grow for Booking. This should lead to higher revenue for the company over time. If the free cash flow margin stays fat – and I don’t see any reason why it shouldn’t – that will mean even more free cash flow for Booking in the future.

Valuation

I like to keep things simple in the valuation process. In Booking’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value for two reasons: (1) The online travel company has a strong history of producing positive and growing free cash flow; and (2) the company’s net profit is muddied by the inclusion of changes in the stock prices of its strategic investments. 

Booking carries a trailing P/FCF ratio of around 20 at a share price of US$1,990. This ratio strikes me as highly reasonable when we look at the company’s excellent track record of growth, strong network of accommodation options across its websites, and opportunities for future expansion in its business. Moreover, this P/FCF ratio is low when compared to history. The chart below shows Booking’s P/FCF ratio over the past five years.

The risks involved

Every company has risks, and Booking is no exception. There are a few key ones that I see.

The first is management turmoil. I have confidence in the quality of Booking’s current leaders. But the company has seen some management shake-ups in recent years.

Earlier, I mentioned that current Chairman Jeffrey Boyd had to become interim CEO in April 2016 (till December 2016). That’s because the then-CEO of both Booking and Booking.com (Booking.com is the main brand of Booking the company), Darren Huston, stepped down from his roles in the same month after he was caught in a relationship with an employee. He was promoted to CEO of Booking only in January 2014. Gillian Tans, a long-time Booking employee, assumed the position of CEO for Booking.com right after Huston’s departure. But she was replaced by Glenn Fogel after just over three years (Fogel is now the CEO of both Booking.com and Booking the company). Booking’s current CFO, David Goulden, stepped into his current role only in January 2018 after long-time CFO Daniel Finnegan announced his retirement in 2017. The good thing is that Booking can still benefit from Boyd’s experience, and Fogel has a long tenure with the company. I will be keeping an eye on leadership transitions at Booking.

The second risk involves downturns in travel spending. Travellers could tighten their purse strings in the face of a global recession or slowdown in economic growth, for instance, since travel can be considered a discretionary activity. The good thing here is that Booking managed to post significant growth during the Great Financial Crisis. But the company’s much larger today, so it may not be able to outrun a future recession as it has in the past.

Another potential important reason for consumers to travel less will be outbreaks of contagious diseases. The world – particularly China – is currently battling COVID-19. If the situation worsens, Booking’s business could be hurt. The good thing with such cases is that the idea of “This too, shall pass” applies. Natural disasters could also dent travel spending. In 2010, the Icelandic volcano Eyjafjallajökull erupted. Many flights that involved Europe were disrupted for a period of time, and the episode was a speed bump for Booking. The clouds eventually cleared for the company, but there could be similar instances in the future.

The last important risk I see with Booking relates to competition. In 2018, Google launched Google Hotels, its search product that focuses on – you guessed it – hotels. As a result, travel websites such as Expedia and TripAdvisor started feeling the heat from Google. This is what Skift reported in a November 2019 article:

“The fact that Google is leveraging its dominance as a search engine into taking market share away from travel competitors is no longer even debatable. Expedia and TripAdvisor officials seem almost depressed about the whole thing and resigned to its impact…

… Both Okerstrom [Expedia CEO] and Kaufer [TripAdvisor CEO] complained that their organic, or free, links are ending up further down the page in Google search results as Google prioritizes its own travel businesses.”

This is where Booking’s huge spending on performance marketing and pivot toward brand marketing comes into play. Booking has been spending billions of dollars on performance marketing, most of it likely on Google Search – this stands in contrast to Expedia and TripAdvisor, which have relied more heavily on free search results from Google. So I believe that Google and Booking currently have a frenemy type of relationship – both rely on each other for business but are also somewhat competitors. But if Booking is successful in building its brand and mindshare among travellers through its brand marketing initiatives, there will be a lot less reliance on Google, thereby lessening the threat of the online search giant.

AirBnB, with its focus on alternatives to hotels, could also be a formidable threat for Booking. Moreover, AirBnB has been making inroads into the hotel-reservations business, such as its acquisition of HotelTonight in March 2019. But like I mentioned earlier, Booking has its own huge and growing supply of hotel-alternatives for travellers to choose from. Ultimately though, I believe that online travel is such a huge pie that multiple winners can exist – and Booking is likely to be one of those.

Meanwhile, in Booking’s latest quarterly earnings report, it also listed other internet giants besides Google – the list includes Apple, AliBaba, Tencent, Amazon, and Facebook – as potential competitors with significant resources to mount a serious assault on the company’s business. So far, Booking has held its own. But it is always possible that another company might build a better mousetrap in the future.

A smaller risk that I perceive relates to Booking’s multi-billion stakes in the Chinese companies, Meituan Dianping, Trip.com, and Didi Chuxing. Booking’s investments in them are based on a variable interest entity (VIE) structure, which is considered to be common with Chinese internet companies. But there’s a risk that China’s government may someday view the VIE structure as a violation of China’s laws.                  

The Good Investors’ conclusion

I think the online travel market holds immense opportunities for companies, especially for an organisation with a wide network of hotels and alternative accommodations, such as Booking, for instance.

Furthermore, Booking has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. Booking’s P/FCF ratio is also low in relation to its own history.

Every company has risks, and I’m aware of the important ones with Booking. They include recent management turmoil, competition from Google and other tech players, and a few factors that could dampen travel spending. But after weighing the risks and rewards, I’m more than happy for my family’s investment portfolio to continue flying high with Booking.

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.