Category: Investing Analysis

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.

Shopify is one of the hottest stocks in the market right now. The e-commerce platform has seen its stock rise 18-fold since it went public in 2015, with much of that gain coming in the past 13 months.

But the past is the past. What investors need to know is whether the stock has the legs to keep up its market-beating performance. With that said, here’s an analysis of Shopify, using my blogging partner Ser Jing’s six-point investment framework.

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

Canada-based Shopify is a cloud software company that empowers entrepreneurs and even large enterprises to develop online storefronts to sell their goods. 

It earns a recurring monthly subscription from retailers that use its platform. In addition, Shopify collects other fees for merchant solutions such as payment processing fees, Shopify Shipping, Shopify Capital, referral fees, and points-of-sale hardware. 

All of Shopify’s services essentially make the entire e-commerce experience more seamless for the retailer. From the building of a website site to the collection of payments and the shipping of the product to the user, everything can be settled with a few clicks of a button.

Based on the way Shopify charges its customers, there are two factors that are needed to drive growth: (1) Increasing the number of users for the company’s platform and (2) higher gross merchandise value (GMV) being sold by Shopify’s retailers.

In 2019, Shopify generated US$1.578 billion in revenue. Of which, US$642 million was from its subscription service and US$935.9 million was from merchant solutions. Shopify also breached the 1 million user milestone in 2019.

On the surface, these figures may seem big but it’s still small compared to Shopify’s total addressable market size.

The global online retail market is expected to grow from around US$3.5 trillion in 2019 to US$6.5 trillion in 2023. Comparatively, Shopify’s gross merchandise value for 2019 was only US$61.1 billion, which translates to just 1.7% of the total e-commerce market.

Shopify is well-positioned to grow along with the wider industry and also has the potential to gain market share.

This growth is likely to be fueled through the company’s international expansion. Shopify only increased the number of native languages on its platform in 2018 as it begun to target the international market.

The number of merchants outside its core geographies of the US and Canada are also growing much faster and will soon become a much more important part of Shopify’s business. 

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

Shopify is part of a rare breed of high growth companies that have no cash problems. As of December 2019, the software company had US$2.5 billion in cash and marketable securities and no debt.

It is also generating a decent amount of cash from operations. Net cash from operations was US$70 million in 2019, despite it reporting a GAAP loss. Shopify also turned free cash flow positive in the year.  

A large part of the diversion between cash flow and the GAAP-loss is that a large portion of Shopify’s expenses are in the form of stock-based compensation, which is a non-cash expense.

In September 2019, Shopify also raised around US$600 million in cash in a secondary offering of shares at US$317.50 apiece. The cash was immediately put to use to pay 60% of its acquisition of 6 River Systems, which makes robotic carts for order fulfillment centres. The acquisition will automate part of Shopify’s nascent but growing fulfillment network, enabling it to compete with the one-day shipping that Amazon is offering.

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

Tobi Lutke, Shopify’s CEO and founder, has proven to be a capable leader. 

Shopify was born after Lutke himself tried to start an online shop selling snowboards. He realised that there were many challenges involved with selling a product online and that a solution to make the whole process easier was needed. 

So far, Lutke’s focus on the customer experience has increased Shopify’s market share even though it operates in a highly competitive environment, which includes Amazon and Adobe’s Magento.

I think Lutke has taken the right steps to make Shopify a force to be reckoned with. His decision to focus on the core English-speaking geographies at the start proved sensible as Shopify increased its presence in those markets first before pursuing international growth.

Shopify has also made sensible capital allocation decisions in the past. I think 6 River Systems looks to be an astute acquisition – it should improve Shopify’s competitiveness in terms of the speed and cost of fulfilling orders.

In addition, Shopify’s compensation structure for executives is tilted towards long-term objectives. Lutke received US$586,000 in base salary in 2018 and US$8 million in shares and options-based awards that vest over a three-year period.

It is also worth noting that Shopify has consistently beaten its own forecasts. As an investor, I appreciate a management team that is able to over-deliver on its promises.

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

If you’ve read our blog before, you know that Ser Jing and I love companies that have recurring revenue. Recurring revenue provides a consistent platform for businesses to build on. A company that does not have to worry about retaining existing revenue can focus more of its efforts on growing its business.

Shopify ticks this box.

Its subscription service is a monthly auto-renewal contract that is recurring in nature. As of December 2019, monthly recurring revenue for its subscription service was US$53.9 million. That translates to a run rate of around US$650 million, which is around 35% of its projected 2020 revenue.

Shopify’s merchant solutions are less consistent and more dependent on the gross merchant value (GMV) sold by merchants using its platform.

That said, the GMV sold by merchants on the company’s platform has risen considerably in the past and looks poised to continue doing so.

In 2019, merchants selling on the Shopify platform for 12 months or more grew their GMV year-on-year by an average rate of 21%. The more successful its partner-merchants are, the more Shopify can earn from its merchant solutions.

5. Does Shopify have a proven ability to grow?

Shopify certainly does well here too. The chart below illustrates the company’s immense track record of revenue-growth since 2012.

In 2019 (not pictured in the graph), Shopify’s revenue increased by 47% to US$1.578 billion, and revenue is expected to top US$2 billion in 2020.

Although growth has decelerated of late, Shopify is still expected to grow by double digits for the foreseeable future.

Not only are the number of merchants using the platform increasing, but existing clients are also seeing more sales. The chart below illustrates the revenue earned by annual cohort:

Shopify’s existing clients have increasingly paid more fees to Shopify. Shopify describes the trend saying:

“The consistent revenue growth coming from each cohort illustrates the strength of our business model: the increase in revenue from remaining merchants growing within a cohort offsets the decline in revenue from merchants leaving the platform.”

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

Shopify already turned free cash flow positive in 2019. That’s a good achievement for a company growing as fast as Shopify is.

It’s also important that there seems to be a clear path toward profitability. Shopify’s subscription revenue and merchant solutions have a gross margin of 80% and 38%, respectively. 

The high gross margins will enable the company to profit when it reins in its marketing expenses. In 2019, sales and marketing made up about 30% of revenue. However, that has been trending down in recent years. For instance, in 2018, sales and marketing expenses were 35% of revenue.

Although Shopify is still spending heavily on international expansion, based on its 2019 results, I think that it will start to see more consistent profit and free cash flow generation in the future.

It is also heartening to note that management seems sensible in its approach to growth. In a recent interview with the Motley Fool, CEO Lutke said:

“Shopify had an ambition to be a profitable company for its first four years, and then it accomplished this in years five and six. Only afterwards (when) the venture capital and then into an investment mode which we’re still in.

So I know what it feels like to run a profitable company. I loved it. I really want to get back there at some point. Not a lot of things are much better in life than the company you’re running happens to be profitable. But I think it would have been also a grave mistake to not change gears back then, because clearly the opportunity was the right one. We needed this investment money. We needed to invest.”

Risks

Competition

One of the biggest risks I see with Shopify is competition. The e-commerce enabler is fighting with some of the biggest tech companies on the planet. Amazon has its own market place that enables third-party merchants to sell products. Amazon’s fulfilment network also provides merchants with the ability to ship its products within a day.

But unlike Amazon, Shopify enables entrepreneurs to build their very own virtual storefront. Amazon sellers, on the other hand, have to sell their products on a common market place and are also competing with Amazon’s own products. This is why Shopify has been able to attract a growing number of retailers to its platform each year.

Other players such as Magento (owned by Adobe), Woo Commerce, and Wix also provide startups with the necessary tools to build their very own online store.

I believe Shopify currently has an edge over its competitors due to its integration with numerous apps and other services it provides such as payment, fulfillment, and referrals etc. But the competitive landscape could change and Shopify needs to continue innovating to stay ahead.

Key-man risk

Another big risk is key-man risk. Tobi Lutke has led the company from a young start-up to one that is generating more than a billion in revenue each year in a relatively short amount of time. That’s an amazing feat and his leadership has been key to Shopify’s success.

Although I don’t see him stepping down anytime soon, a change in leadership – if it happens – may be detrimental to Shopify’s vision and progress.

Stock-based compensation

Anothing thing I am keeping my eye on with Shopify is its stock-based compensation. Although stock-based compensation could align the interests of the company’s employees and leaders with shareholders’, Shopify’s stock-based compensation has been very high relative to its revenue. 

In 2019, stock-based compensation was US$158 million compared to revenue of US$1.57 billion. That means that almost 10% of all revenue generated is being paid back to management in the form of stocks, diluting existing shareholders in the process. Ideally, I want to see revenue grow much faster than stock-based compensation in the future. Stock-based compensation was up by 65.5% in 2019.

Valuation

This is where I think Shopify fails. The e-commerce enabler has a market cap of US$60 billion. That’s a whopping 30 times next years’ sales-estimate. Even for a company that is growing as fast as Shopify is, that number is hard to justify.

Shopify’s valuation today looks pricey even if we assume that (1) it doubles its market share, (2) total GMV grows to US$6.5 trillion, (3) merchants on Shopify’s platform doubles by 2022, and (4) the company generates a 10% profit margin.

If all the above assumptions come into fruition, Shopify’s current shares still trade at a lofty 12 times projected revenue and 120 times earnings.

The Good Investors’ conclusion

There are so many things I admire about Shopify. It is led by a visionary leader who has grown Shopify into a dominant e-commerce player. Besides Shopify’s impressive top-line growth, it is also one of the rare fast-growing SaaS (software-as-a-service) companies that are already free cash flow positive. Moreover, its untapped addressable market is immense.

However, while I would love to participate in Shopify’s growth, the company’s stock seems too expensive at the moment. 

I think the market has gotten ahead of itself and the long-term returns on the stock do not look enticing due to its frothy valuations. As such, I prefer waiting for a slightly lower entry point before dipping my toes in this fast-growing SaaS firm.

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.

As one of the best performing stock of the 2010s, it is no surprise that Netflix is also one of the most talked-about stocks on the internet. But despite the seemingly endless discussions online, I still think there are some aspects of the company that some investors may be overlooking.

I want to discuss these aspects in this article.

#1 There is a clear path to positive free cash flow generation

Netflix had a negative free cash flow of US$3.5 billion in 2019, extending a streak of eight years of increasing cash burn. This burn rate certainly cannot go on forever and it is what’s putting many investors off. The negative free cash flow is even more alarming when you add the fact that the company is in a net debt position of around US$9 .7billion.

However, Netflix’s high cash burn rate may soon be a thing of the past. Netflix’s CEO, Reed Hastings, believes a turnaround is on the cards. In its most recent 2019 fourth-quarter shareholder letter, Netflix said:

“For the full year, FCF was -$3.3 billion which we believe is the peak in our annual FCF deficit. Our plan is to continually improve FCF each year and to move slowly toward FCF positive. For 2020, we currently forecast FCF of approximately -$2.5 billion… With our FCF profile improving, this means that over time we’ll be less reliant on public markets and will be able to fund more of our investment needs organically through our growing operating profits.”

I think management’s confidence is entirely warranted. Let’s break it down. The majority of the cash Netflix is spending is for the licensing and production of content. In 2019, Netflix spent US$14.6 billion on streaming content, meaning around 75% of its US$20 billion in revenue was spent on content alone.

To improve its free cash flow metric, Netflix needs to spend much less as a percentage of its revenue. And I think its entirely possible that this scenario will play out sooner rather than later. 

The math is simple. 

There is a fixed cost to producing content but the value of the content scales as the user count grows. 

For instance, the content that Netflix is producing today can reach its 167 million global subscribers. But as the number of subscribers grows, the content it is producing will reach a larger subscriber base. Put another way, the fixed amount spent on each movie or series will be spread out across a much larger revenue base as user count grows.

Over time, the amount of cash spent on content will take up a much lower percentage of revenue and, in turn, free cash flow should eventually be positive.

#2 Content retains value over a long time frame

Another point to note is that the company is actually already profitable and has been for a few quarters. Then why is the company free cash flow negative?

For one, the company is spending money upfront for content that it is only releasing in the future. As such, it does not recognise this into its income statements. Think of it as capital expenditure for the future.

The second reason is that the content is amortised over a multi-year time frame. I think investors underappreciate the fact that much of the original content that Netflix is producing will be in its content library forever. Good content, while most valuable when it’s first released, retains some of its value to viewers for years. Case in point include hits such as Friends and Seinfield, which fans love to rewatch. 

I think investors often overlook these two facts: (1) that Netflix’s current cash burn includes its spending for the future, and (2) good content retains its value over a multi-year period.

#3 Competition is not hurting Netflix as much as feared

When Disney and Apple announced that they would be entering the online streaming market, I’m sure many Netflix watchers (shareholders included) must have feared the worse. Disney has a vast library of intellectual property and Apple is flush with cash. Surely, Netflix would be in trouble.

However, competition has not hurt Netflix as much as some may have feared. In the fourth quarter of 2019, Netflix’s paid memberships in the United States increased by 400,000. While this fell short of analyst estimates, the growth in paid subscribers at a time when Disney Plus was released shows how sticky Netflix’s user base is. More impressively, the gain in member-count in the US in 2019 coincided with an increase in the membership price by US$2. 

Internationally, growth continues at a breakneck pace. Paid memberships outside of the US increased from 80.8 million in 2018 to 106 million in 2019, a 25% increase. 

There are a few things to glean from these trends. 

First, Netflix’s subscriber base is sticky. The lure of original content that customers love and the fact that Netflix’s price point is still considerably lower than cable TV means customers are willing to stick around despite price hikes.

Second, Disney Plus, Apple TV, Amazon Prime, and Netflix can co-exist. 

A recent survey of Netflix subscribers showed that they are willing to subscribe to multiple streaming video subscriptions. The trend is fueled by consumers reducing their spending on traditional TV offerings by turning to streaming services.

On top of that, subscribers who want to watch Netflix Originals have no alternative besides subscribing to Netflix.

In its most recent shareholder letter, Netflix explained:

“We have a big headstart in streaming and will work to build on that by focusing on the same thing we have focused on for the past 22 years – pleasing members.”

With Netflix’s content budget dwarfing all its competitors (US$15 billion in 2019 vs US$6 billion for Amazon Prime, the second-largest spender of content), the chances that subscribers switch to another online streaming platform looks much slimmer than what investors may have initially feared.

The Good Investors’ conclusion

Netflix is one of the more divisive stocks in the market today. There seems to be an endless discussion between bears and bulls online.

In my view, I think there are a few crucial aspects of Netflix that some investors may be overlooking:

• Netflix has a clear path towards free cash flow generation 
• It is spending wisely on well-loved content that retains value over a multi-year period
• The threat of competition is not as bad as it looks

Moreover, management has a knack of spotting trends well before they develop. As such, shareholders should be confident that management will be able to adapt and thrive even as operating environments change.

Given all this, I think Netflix looks poised to prove its doubters wrong.

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 woke up last Thursday to a rude surprise. My shares of Facebook had fallen 6% in a single trading session, following the company’s 2019 fourth-quarter earnings results. A big jump in expenses during the quarter was the culprit. 

However, after reassessing Facebook’s position, I think the decline was unwarranted. In fact, I feel more optimistic than ever for the social network’s long term prospects and am more than happy to hold onto my shares. 

Why investors have been put off

Before discussing the reasons why I am bullish about Facebook, let me first say that I acknowledge that there are very real reasons why the broader market is sceptical of Facebook. 

The first possible reason is that Facebook carries a degree of regulatory risk. We can’t sugarcoat that.

In recent months, Facebook incurred a US$5 billion fine from the Federal Trade Commission due to a privacy breach and had to pay a US$550 million settlement for collecting users’ facial recognition data. In addition, there have also been a few threats from European regulatory bodies.

These regulatory concerns are, in turn, the reason why Facebook’s expenses have skyrocketed. The company has spent big hiring thousands of employees to update its platform and make it safer for users. 

The second reason is Facebook’s decelerating growth. Facebook enjoyed 36% annualised top-line growth over the last 3 years. However, that growth has since decelerated. Shareholders who have been accustomed to the 30%-plus growth rate may have been disappointed by the latest figures.

Despite these two factors, I think Zuckerberg’s brainchild is still a great investment. Here’s why. 

The numbers are still really good

Despite a slight deceleration in growth in recent times, Facebook is still posting solid numbers.

In the fourth quarter of 2019, Facebook saw revenue jump 25% and income from operations grow 13%. Looking ahead, management said that it expects revenue-growth in 2020’s first quarter to decelerate by a low to a mid-single-digit percentage point compared to 2019’s fourth quarter.

Although a deceleration looks bad, that still translates to a healthy 20% increase in revenue.

The social media giant is also now sitting on US$55 billion in cash and marketable securities, and zero debt. On top of that, its cash flow from operations in 2019 was 24% higher than in 2018.

Other metrics are healthy too

Besides its financials, the company’s all-important user engagement metrics are also very healthy. Daily active users, monthly active users, and family daily active people were up 9%, 8% and 11% respectively at end-2019 compared to a year ago.

The worldwide average revenue per user also ticked up 15.6% from 2018’s fourth quarter, demonstrating that Facebook is doing an excellent job improving the monetisation of its gargantuan user base.

Facebook is addressing the regulatory concerns

Zuckerberg and his team have also taken privacy concerns very seriously. Zuckerberg emphasised in his recent conference call with analysts:

“This is also going to be a big year for our greater focus on privacy as well. As part of our FTC settlement, we committed to building privacy controls and auditing that will set a new standard for our industry going beyond anything that’s required by law today. We currently have more than 1,000 engineers working on privacy-related projects and helping to build out this program.”

Facebook is also rolling out a privacy checkup tool to close to 2 billion of its users to remind them to set their user privacy control to the level they wish for.

I think with Facebook’s size, the task of managing privacy is going to be a multi-year process but Facebook’s commitment to addressing the issue is certainly heartening for investors. 

Becoming a Super App

While advertising is Facebook’s bread and butter, the social media giant has the potential for so much more.

It now has online dating features, e-commerce, gaming, Watch and other features. Although not all of these features will cater to everyone, they each appeal to a certain segment of people. This will grow user engagement and increase ad impressions per user.

This is similar to WeChat in China. The Super app of the East has built-in functions such as payments, e-commerce, bookings, and much more. Facebook, with its billions of users, has the potential to become the Super app of the world.

New functions also give Facebook a different source of revenue. One example is through implementing a take rate for payments made on its platform. This could be a new revenue growth driver as Facebook plans to roll out WhatsApp payment and payment services to facilitate Facebook Marketplace.

History of great capital allocation decisions

Although there is a lot to like about Facebook’s business going forward, I think the most exciting thing is how Facebook will use its massive cash pile, which is growing by the day.

As mentioned earlier, Facebook is sitting on US$55 billion in cash (US$50 billion after it pays off the aforementioned US$5 billion fine). That’s an incredible amount of financial resources and the possibilities are endless.

Most importantly, Facebook has a brilliant track record of spending its cash wisely. In the past, it bought Instagram for just a billion dollars in 2012, solidifying its position as the leading social media player in the world. On top of that, the outlay for the Instagram investment should have already been more than covered by the ad revenue that Facebook has generated from it.

More recently, Facebook has been aggressively buying back shares. In its latest announcement, it said it has earmarked another US$10 billion for share repurchases, which I think is a great use of capital given its stock’s ridiculously cheap valuation (more on that later). This again shows that the decision-makers in Facebook are doing the right things with its ever-growing cash hoard.

Valuation too cheap to ignore

It is no secret that Facebook is not the most loved stock on Wall Street. Despite growing its top line by 26% in 2019 and the numerous tailwinds at its back, the stock still trades at just 23.5 times normalised earnings (after removing the one-off fines and settlement charges).

That’s the lowest multiple among the FAAMG stocks. For perspective, Alphabet, Apple, Microsoft and Amazon trade at price-to-earnings multiple of 31, 25, 29, and 87 respectively.

I simply don’t see how Facebook can suffer a further earnings multiple compression unless there’s a market-wide collapse.

Even after factoring the deceleration in growth, Facebook is still expected to grow revenue and profits by close to 20% in 2020 and beyond. Moreover, Facebook has so much cash on hand, its growth could even be boosted if Facebook decides to make an acquisition down the road.

The Good Investors’ Take

With so many opportunities for growth and the heavy fines behind it, Facebook is likely to see double-digit growth to its bottom line for years to come. Its enduring competitive moat looks unlikely to be eroded any time soon and the capital allocation decisions have been extremely sound.

Just as importantly, the stock trades at unreasonably beaten down valuations. Given everything, I’ve seen, I like my position in Facebook.

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.

Twilio (NYSE: TWLO) isn’t a household name, but many of us unknowingly use it every day. The software company provides developers with an in-app communication solution. By integrating phone numbers and messaging communications, Twilio offers communication channels including voice, SMS, Messenger, WhatsApp, and even video. 

When your Uber arrives and you receive a text, that’s Twilio. Airbnb uses Twilio to automate messages to hosts to alert them of a booking. eBay, Twitter, Netflix, Wix, Mecardo Libre each use Twilio in some form or other. 

With in-app communications set to boom and Twilio the top dog in this space, is Twilio worth investing in? To answer this, I will use my blogging partner’s six-point investment framework to dissect Twilio’s growth potential.

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

Twilio recently surpassed US$1 billion in annualised revenue run rate in the third quarter of 2019. That’s tiny compared to its market opportunity. The CPaas (communications platform as a service) segment is forecast to grow from US$3.3 billion in 2018 to US$17.2 billion in 2023- a 39% annualised growth rate.

International Data Corporation said in a report that CPaaS companies are driving this growth by “integrating new segments, churning out new use cases, and piquing the interest of enterprise developers with innovative digital solutions for customer engagement.”

With the acquisition of SendGrid last year, through an all-shares purchase, Twilio added email communication into its array of products. SendGrid also brought with it 84,000 customers, giving Twilio a new base of developers to cross-sell existing products to.

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

Twilio is financially sound. As of 30 September 2019, it had US$1.9 billion in cash and marketable securities and around US$450 million in debt (in the form of convertible senior notes). That translates to a net cash position of around US$1.5 billion.

That said, Twilio’s cash flow from operations has been lumpy over the past few years as it chased growth over profitability or cash flow.

While its relatively large cash position should provide it with a buffer to last a few years, investors should continue to monitor how Twilio is using its capital.

Twilio already ended up having to issue new shares in a secondary offering in 2019 to raise money. This diluted existing shareholders, and current shareholders of Twilio should not rule out further dilution in the future.

The table below shows Twilio’s cash flow over the past four years.

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

Twilio’s founder Jeff Lawson has overseen the company from the start (the company was founded in 2008). As mentioned earlier, Twilio has a US$1 billion revenue run rate. That’s an impressive achievement, and a testament to Lawson and the rest of the management team’s ability to scale the company.

I also believe Twilio’s executive compensation structure promotes long-term growth in the company.

Lawson’s base salary in 2018 was only 2% of his target pay mix. 51% was in restricted stock units and the other 47% was in stock options. As the stock options vest over a few years, it encourages planning towards increasing shareholder value over the long term.

Lawson’s base salary of just US$133,700 in 2018 is also low in comparison to what other CEOs are getting.

So far, Twilio’s management has also been able to strategically acquire companies to expand its product offering and customer base. Its purchase of SendGrid brought with it email communication capabilities and more than doubled Twilio’s existing active users.

Twilio’s management has also taken the opportunity to raise more capital as its shares trade at relatively high multiples. This, to me, seems like a prudent move, considering that Twilio needs some cash buffer as it looks to grow its business.

Twilio is also proving to be led by innovative leaders as the company has consistently introduced new products. In 2018, Twilio introduced Twilio Flex, a programmable contact centre that integrates multiple tasks into a single user interface. Twilio Flex opened a new door of opportunity to tap into.

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

Twilio’s enjoys a sticky customer base. Its existing customers have a history of becoming increasingly dependent on Twilio’s services over the years.

The communication software company’s net dollar base expansion rate, a metric measuring net spend by existing customers, was 132% in the quarter ended 30 September 2019. What that means is that existing customers spent 32% more on Twilio’s services in the last 12 months compared to a year prior. 

More importantly, Twilio’s net dollar expansion rate has been consistently north of 100% for years. Its net dollar expansion rate was 140%, 128%, 161%, and 155% for 2018, 2017, 2016 and 2015.

The beauty of Twilio’s business model is that there are no built-in contracts. Customers simply pay as they use the company’s software. The more messages they send using Twilio’s API, the more Twilio charges them.

As customers such as Uber, Lyft, Airbnb grow their own customer base, the need for in-app messaging increases, and Twilio grows along with its clients. The model also allows small enterprises to start using Twilio at the get-go due to the pay-as-you-go model.

It is also heartening to see that there is little concentration risk as the top 10 accounts contributed around 13% of Twilio’s total revenue in the most recent quarter.

5. Does Twilio have a proven ability to grow?

With a steady base or recurring revenue, Twilio has been able to focus its efforts on expanding its services and winning over new customers. Its customer account has risen more than six-fold from 2013 to 2018.

The growth in customer accounts is also reflected in its financial statements. Revenue increased from below US$100 million in 2013 to more than US$600 million in 2018.

That growth still has legs to run with base revenue (excluding the impact of its acquisition of SendGrid) in the first three quarters of 2019 increasing by 47% year-on-year.

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

While Twilio’s topline has shown impressive growth, it has neither been able to generate consistent profit nor free cash flow.

Twilio has been spending heavily on research and development and marketing. In fact, the company has consistently spent around a quarter of its revenue of research and development.

However, I believe that there is a clear path towards profitability and free cash flow generation, as Twilio can eventually cut back its R&D and marketing expenses.

That being said, the company is still laser-focused on top-line growth at the moment and consistent profitability and free cash flow generation may take years.

Risks

One of the big risks I see in Twilio is succession risk. Lawson is the biggest reason for Twilio’s success so far. He is the founder and has led Twilio every step of the way. 

That said, Lawson is only 42 this year and is likely to continue at the helm for the foreseeable future.

I also believe that the high cash burn rate is still a concern. Investors should keep a close watch on Twilio’s free cash flow levels and hopefully, we can see it turn positive in the coming years.

Twilio also faces competition that could eat into its market share. Its competitors such as Nexmo, MessageBird, and PLivo are also growing quickly. Twilio will need to consistently upgrade its APIs to ensure that it defends its competitive edge. For now, Twilio’s competitive moat includes the high switching cost to a competitor.

Twilio also enjoys a network effect. In its 2018 annual report, Twilio said:

“With every new message and call, our Super Network becomes more robust, intelligent and efficient…Our Super Network’s sophistication becomes increasingly difficult for others to replicate over time as it is continually learning, improving and scaling.”

Valuation

Valuing a company is always tricky- especially so for a company that has no profits or consistent free cash flow.

As such, we will need to estimate what is the company’s long term growth potential and mature-state profit margins.

While some best-in-class SaaS companies enjoy profit and free cash flow margins of around 30%, that does not seem feasible for Twilio.

Twilio’s gross profit margin is only around 54%, much lower than other software companies such as Adobe which has a gross margin north of 80%. As such, I think that Twilio’s steady-state profit margin could potentially be closer to 10%.

Given the total addressable market of US$17 billion, and assuming Twilio can achieve a market share of around 50%, revenue can increase to around US$8 billion. Using my 10% net profit assumption, net profit will be around US$800 million. If growth can sustain at current rates of around 35%, Twilio will take around seven years to hit this size.

We also have to estimate a reasonable multiple to attach to its earnings. Adobe has a price-to-earnings (P/E) ratio of 58 but it is still growing. Let’s assume a discount to that multiple and assume Twilio can command a P/E ratio of 40. That translates to a US$32 billion market. Given all these assumptions, Twilio will have a market cap that is twice its current market cap in seven years, which translates to a decent 10% annualised return for existing shareholders.

The Good Investors’ conclusion

There are certainly compelling reasons to like Twilio as a company. Its 40%-plus top-line growth, huge market opportunity, dominant position in the CPaaS industry, and capable management team, are just some of the reasons why I think Twilio has a bright future ahead.

However, its stock is richly priced, trading at more than 16 times revenue. It has yet to record a profit and has been burning cash. There is a lot of optimism baked into the stock already and the company needs to live up to the high expectations if investors are to make a decent annualised profit from the stock.

While my valuation assumptions predict a decent return, there are certainly risks involved. Any stumble in those growth projections or an earnings multiple compression will result in mediocre returns to investors. I suggest that investors who want to take a nibble off of Twilio’s growth should size their position to reflect the risk involved.

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.

Ulta Beauty (NASDAQ: ULTA) is a retailer defying the odds. While many retailers have struggled since the introduction of e-commerce, Ulta’s sales have risen sharply over the last decade. Its share price has mirrored its business performance, rising nearly 1300% over that time frame, making it one of the top-ten performing US stocks of the decade. But Ulta’s stock lost some of its shine towards the end of last year- with the share price falling 25%-  after the company cut its full-year outlook for 2019.

Investors were also spooked by an industry-wide slow-down in cosmetic sales. But with Ulta Beauty shares trading at only 23 times earnings now, I believe it is way too cheap to ignore.

What caused the sell-down?

The first thing to note is Ulta still remains a fine business. Ulta has consistently won market share from other beauty retailers in the country and that has not changed. The only problem now is Ulta could suffer some near-term earnings volatility due to the downcycle of cosmetic sales in the US.

In the latest 2019 third-quarter earnings conference call, CEO Mary Dillion explained:

“Like other consumer categories, makeup has experienced a number of up and down cycles. The most recent growth cycle began in 2014, driven by new application techniques and looks like contouring, highlighting and brow styling, and new products such as pallets, minis, and travel sizes. The rise of social media influencers, video tutorials and selfies also contributed to strong growth in the category.

After several years of robust growth, the category began to decelerate in 2017 and turn negative in late 2018, resulting from a lack of engaging newness and incremental innovation. This negative trend has continued through 2019 with further deceleration in the most recent quarter.”

But there are reasons to be positive…

Despite the near-term challenges, there are still good reasons to be bullish about Ulta. 

The numbers are still really good

First, even though Ulta had a poor third quarter by its high standards, the company still delivered decent results. Total sales increased by 12% and comparable store sales increased by 6.2%. Diluted earnings per share, excluding last year’s tax benefit, increased by 11.5%.

Despite the decline in cosmetics sales in the broader US market, Ulta still posted low single-digit growth in that category. That just goes to show that Ulta continues to drive meaningful market share growth across the cosmetics category.

According to data for February through July, Ulta captured 24.5% of the prestige beauty market (as tracked by NPD Group, an American Market research company). That’s 2.1 percentage points better than last year.

Cosmetic sales will rebound

Cosmetics remains Ulta’s largest revenue contributor at around 50%, so a market-wide sales decline will no doubt impact Ulta’s business. But the downcycle will eventually come to an end.

Dillion, who has been extremely candid and frank with shareholders, believes that innovation and new products will help aid the turnaround. She said in the latest earnings conference call:

“We continue to believe that the headwinds facing the makeup category are largely cyclical, resulting from a lack of incremental innovation and compelling newness. We remain confident that makeup category will return to growth, but recognize that it will take time.”

Other categories picking up the mettle

Yes, cosmetics is an important part of Ulta’s business but Ulta is not just about cosmetics. In fact, its other segments in total make up about 50% of sales. One of the strongest growth categories in recent years is skincare. Suncare, prestige, and mass-market skincare products each delivered double-digit growth in Ulta’s most recent reporting quarter. 

Gen Z spending habits are also shifting towards skincare as young women increasingly decide to go for a more natural look. The Gen Z demographic is more engaged in skin care products than other cohorts were at the same age.

Haircare and fragrance are also both expanding. The performance of these other categories should help to reduce the impact of the slowdown in cosmetic sales.

Ulta is growing its membership base

At the end of the 2019 third quarter, Ulta had 33.9 million active members in its Ultamate Rewards program. That’s 11% higher than it was last year. The growing member base shows that Ulta is still attracting new customers to its shops.

On top of that, once customers sign up, they receive points, which can then be redeemed for gifts, giving them extra incentives to shop at Ulta.

The beauty segment is not as impacted by e-commerce

While Ulta’s online sales increased by around 20% per year in the latest quarter, brick and mortar sales still make up the bulk of the company’s business.

Fortunately for Ulta, according to a survey by Piper Jaffray, 91% of female teens still prefer in-store shopping for beauty products versus online. Consumers still prefer the in-person experience of testing colours, fragrances, and textures when it comes to beauty products.

As such, until augmented reality (AR) can truly replace the in-person experience, I don’t foresee Ulta losing significant market share to online sales channels.

Rewarding shareholders

Ulta has also been rewarding shareholders by using the cash generated from its business to buyback shares. The total number of outstanding shares dropped by close to 4% in the quarter ended 2 November 2019 from a year ago. With shares trading at a low valuation (I will touch on this later), I think it makes perfect sense for the company to continue using its spare cash to buy back shares.

Ulta is sitting on slightly over US$200 million in cash and has no debt (if we exclude its operating lease liabilities), giving it the financial muscle to continue to pursue share buybacks in the future.

More importantly, its business remains a cash cow. The beauty retail giant generated operating cash flow of US$634 million, US$779 million, and US$956 million in fiscal 2016, 2017, and 2018, respectively. And in the first 39 weeks of fiscal 2019, Ulta’s operating cash flow was up 2.8% from the year before to US$558 million.

The reliable stream of cash flow will enable the beauty retailer to continue reducing its outstanding share count further.

Valuation

As you can see, despite Wallstreet’s skepticism about Ulta, I think there are still numerous reasons to believe its long-term growth is intact.

On top of that, shares of Ulta are trading at what I would consider extremely low valuations. The company expects to earn diluted earnings per share of at least US$11.93 in fiscal 2019. Ulta currently trades at US$273, which translates to around 23 times that earnings projection.

An earnings multiple of 23 is much lower than LVMH (which owns Sephora), Loreal, and Estee Lauder – they trade at 33, 38 and 42 times earnings respectively. 

As such, barring a market-wide collapse, it is hard to see how Ulta can suffer a further compression in its earnings multiple.

More importantly, Ulta’s problems are likely short-term in nature. Cosmetics sales will rebound in the future and in the meantime, other beauty segments are picking up the slack.

On top of that Ulta looks likely to continue to win market share as it targets to open more stores in the coming years.

Over the longer term, Ulta has built lasting brand appeal and partnerships with some of the most loved beauty brands in the world. Despite being a dominant retailer in the US beauty industry, Ulta’s market share in the beauty products market was just 7% in 2018. This small share means the company should have room to grow much bigger.

With all that said, while I think it is reasonable for investors to be cautious about near-term sales volatility, I think Ulta’s valuation and long-term prospects are just too good to ignore.

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