Category: Investing Analysis

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

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

Company description

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

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

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

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

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

Investment thesis

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

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

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

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

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

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

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

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

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

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

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

On integrity

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

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

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

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

On capability and innovation

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

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

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

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

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

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

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

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

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

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

5. A proven ability to grow

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

A few things to note:

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

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

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

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

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

Valuation

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

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

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

The risks involved

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

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

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

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

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

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

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

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

The Good Investors’ conclusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

5. Does Uber have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Other risks

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

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

Intuitive Surgical (NASDAQ: ISRG) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Intuitive Surgical shares for the portfolio in September 2016 at a price of US$237 and then again in April 2017 at US$255. I’ve not sold any of the shares I’ve bought.

The purchases have performed very well for my family’s portfolio, with Intuitive Surgical’s share price being around US$593 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 Intuitive Surgical shares. 

Company description

In recent years, there have been news articles on the da Vinci robotic surgical systems being used in some of Singapore’s major hospitals. The da Vinci systems are the handiwork of the US-based Intuitive Surgical.

Founded in 1995, Intuitive Surgical is a pioneer in robotic surgical systems. Today, the company primarily manufactures and sells its da Vinci family of robot systems and related instruments and accessories. The robots are used by surgeons around the world to perform minimally invasive surgical procedures across a variety of surgical disciplines, including general surgery, urology, gynecology, thoracic, and trans-oral surgery.

The da Vinci system, which costs between US$500,000 and US$2.5 million each depending on the model and geography, acts as an extension of a surgeon’s hands – surgeons operate the system through a console that is situated near a robot. But it is more than just an extension. The da Vinci system is tremor free, has a range of motion analogous to the human wrist, and has the ability to move at smaller length-scales with greater precision.

The US is currently Intuitive Surgical’s largest geographical market, accounting for 71% of the company’s US$3.2 billion in total revenue in the first nine months of 2019. 

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 Intuitive Surgical.

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

Intuitive Surgical is a great example of a company with revenue that is large in a fast-growing market. In 2018, the company’s revenue was US$3.7 billion, which accounted for a significant share of the global surgical robot market;  according to Mordor Intelligence, the market was US$4.1 billion then. Mordor Intelligence also expects the market to compound at nearly 22% per year between 2019 and 2024.

I believe the projection for high growth in the global robotic surgical market is sound for two key reasons.

Firstly, minimally invasive surgeries lead to better patient outcomes as compared to open surgery, such as lesser pain, faster post-surgery recovery, and lesser scarring. The da Vinci system is used to perform minimally invasive surgeries. Furthermore, the system “combines the benefits of minimally invasive surgery for patients with the ease of use, precision, and dexterity of open surgery.” I think these traits are likely to lead to long-term growth in demand for surgical robot systems from both patients and surgeon. As of 2018, there were over 18,000 peer-reviewed medical research papers published on Intuitive Surgical’s robotic surgery systems.

Secondly, just 2% of surgeries worldwide are conducted with robots today, according to medical device company Medtronic. Even in the US, which is Intuitive Surgical’s main market, only 10% of surgical procedures are performed with robots currently. These data suggest that robots have yet to make their way into the vast majority of surgical theatres across the globe.

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

Intuitive Surgical has a formidable balance sheet, with US$5.4 billion in cash, short-term investments, and long-term investments against zero debt (as of 30 September 2019).

Another big plus-point is that the company has been stellar at producing free cash flow over the years. I’ll discuss this soon.

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

On integrity

Intuitive Surgical is led by CEO Gary Guthart, Ph.D., who is currently 53. In 2018, his total compensation was US$6.4 million, which is less than 1% of the company’s profit of US$1.1 billion in the same year. There are two other big positives about the compensation structure for Guthart and the other key leaders of Intuitive Surgical.

Firstly, the majority – 75% – of Guthart’s total compensation in 2018 came from restricted stock units (RSUs) and stock options that vest over periods of 3.5 years to 4 years. It’s a similar story with other members of Intuitive Surgical’s senior management team – 78% of their total compensation in 2018 was directly tied to the long-term growth in the company’s share price through the use of RSUs and stock options that vest over multi-year periods. I typically frown upon compensation plans that are linked to a company’s stock price. But in the case of Intuitive Surgical, the compensation for its key leaders is tethered to multi-year changes in its stock price, which in turn is driven by the company’s business performance. So I think this aligns my interests as an Intuitive Surgical shareholder with the company’s leaders.

Staying on the topic of alignment of interests, I think it’s also worth pointing out that as of 31 December 2018, Guthart directly controlled nearly 339,000 Intuitive Surgical shares (not counting options that he could exercise shortly after end-2018) that are worth around US$200 million at the company’s current stock price. This is a large ownership stake that likely also puts Guthart in the same boat as other Intuitive Surgical shareholders.

Secondly, the chart below shows that the growth in Guthart’s total compensation from 2014 to 2018 has closely tracked the changes in Intuitive Surgical’s stock price over the same period.

On capability and innovation

Over the years, Intuitive Surgical’s management has done a tremendous job in growing the installed base of the da Vinci systems as well as the number of surgical procedures that have been conducted with the systems. These are two very important numbers for me when assessing the level of demand for Intuitive Surgical’s robots.

Management has also been innovative in expanding the range of surgical procedures that Intuitive Surgical’s systems can reach – see the chart below for how quickly the number of the company’s general surgery procedures around the world has expanded from 2012 to 2018 even as growth in gynecology and urology procedures have decelerated.

Staying with the theme of innovation, Intuitive Surgical has already commercialised four generations of its da Vinci family of surgical robots, so it has a strong history of improving its flagship product. There are also some interesting developments in the pipeline:

• Intuitive Surgical is in the first phase of the rollout of the da Vinci Sp system. The new system is already used in urology, gynecology, general, and head and neck surgical procedures in South Korea. But it was only cleared by US regulators in recent months for use in urologic and transoral surgical cases in the country. At the end of 2019’s third quarter, the total installed base of the da Vinci Sp was just 38. Intuitive Surgical’s management also said in the quarter’s earnings conference call that “customer response and early clinical results using Sp remain encouraging.”
• The Ion platform, Intuitive Surgical’s flexible robotics system for performing lung biopsies to detect and diagnose lung cancers, received 510(k) FDA (Food & Drug Administrattion) clearance in the US in 2019’s first quarter. “Hundreds” of procedures have been performed with the Ion platform as of 2019’s third quarter, and the initial rollout has met management’s expectations and received “strong” user feedback. Lung cancer is one of the most common forms of cancer in the world. If the Ion platform is successful, it could open a previously untapped market for Intuitive Surgical. 
• The company recently acquired an existing supplier of 3D robotic endoscopes, Schölly Fiberoptic. The acquisition boosts Intuitive Surgical’s capabilities in the areas of imaging manufacturing, design, and processing, which are important for surgeries of the future, according to the company’s management.
• Intuitive Surgical received 510(k) FDA clearance for its Iris product in 2019’s first quarter too. Iris is the company’s augmented reality software which allows 3D pre-operative images to be naturally displayed in a surgeon’s da Vinci console for use in real-time during an actual surgery.
• As recently as October 2019, Intuitive Surgical was looking to hire software engineers who have skills in artificial intelligence for its imaging and intelligence group. I see this as a sign that the company is working with AI to improve its product features. 

I think we should note that Guthart joined Intuitive Surgical in 1996 and became COO (Chief Operating Officer) in 2006. In 2010, he became CEO. In other words, much of Intuitive Surgical’s excellent track record in growing its installed base and procedure-count that I mentioned earlier had occurred under Guthart’s watch.

Many of Intuitive Surgical’s other key leaders have also been with the company for years and I appreciate their long tenures. Some last words from me on Intuitive Surgical’s management: It’s a positive sign for me on the company’s culture to see it promote from within, as has happened with many of the C-suite roles, including Guthart’s case.

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

You may be surprised to know that the one-time sale of robotic surgical systems accounts for only a small portion of Intuitive Surgical’s revenue despite their high price tag – just 29% of total revenue of US$3.2 billion in the first nine months of 2019 came from systems sales.

That’s because the robots bring with them recurring revenues through a classic razor-and-blades business model. Each surgery using the da Vinci robot results in US$700 to US$3,500 in sales of surgical instruments and accessories for Intuitive Surgical. Moreover, the robots also each generate between US$80,000 and US$190,000 in annual maintenance revenue for the company. The table below shows the breakdown of Intuitive Surgical’s revenue in the first nine months of 2019 according to recurring and non-recurring sources:

There is also an important and positive development at Intuitive Surgical in recent years: The proportion of the company’s robots that are sold on leases has been increasing. For 2019’s third quarter, 33.5% of new system placements by Intuitive Surgical were based on operating leases that include usage-based models, up from 25.1% a year ago. For more context, operating lease revenue at Intuitive Surgical has more than tripled from US$16.6 million in 2016 to US$51.4 million in 2018, and more than doubled from US$35.0 million in the first nine months of 2018 to US$72.9 million in the first nine months of 2019.

Intuitive Surgical’s management believes that providing leasing – an alternative to outright purchases of the da Vinci systems – accelerates market adoption of the company’s surgical robots by lowering the initial capital outlay for customers. I agree, and I think the introduction of leasing – which started in 2013 – is another sign of management’s capability.

Leasing also boosts recurring revenue for Intuitive Surgical, leading to more stable financial results. If leasing revenue was included, 73% of Intuitive Surgical’s total revenue in the first nine months of 2019 was recurring in nature.

5. A proven ability to grow

The aforementioned growth in the adoption of da Vinci robots by surgeons over time has led to a healthy financial picture for Intuitive Surgical. The table below the company’s important financial figures from 2006 to 2018:

A few key points about Intuitive Surgical’s financials:

• Revenue has compounded impressively at 21% per year from 2006 to 2018; over the last five years from 2013 to 2018, the company’s annual topline growth was slower, at just 10.5%. But growth has picked up in more recent years, coming in at 15.9% in 2017, 18.7% in 2018, and 19.5% in the first nine months of 2019.
• The company also managed to produce strong revenue growth of 45.6% in 2008 and 20.3% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Recurring revenue (excluding leasing) grew in each year from 2006 to 2018, and had climbed from 44.8% of total revenue in 2006 to 70% in 2018. As I mentioned earlier, recurring revenue (again excluding leasing revenue) was 71% in the first nine months of 2019.
• Net profit has jumped by nearly 26% per year from 2006 to 2018. Although growth has slowed to ‘merely’ 10.9% over the past five years (2013 to 2018), it has accelerated in the first nine months of 2019 with a 22% jump.
• Operating cash flow has increased markedly from 2006 to 2018, with annual growth of 22.8%. The growth rate from 2013 to 2018 was considerably slower at just 6%, but things appear to be picking up again: Operating cash flow was up by 25.7% in the first nine months of 2019. 
• Free cash flow, net of acquisitions, has consistently been positive and has also stepped up significantly from 2006 to 2018. The growth in free cash flow has grounded to a halt in recent years, but I’m not worried. The absolute amount of free cash flow is still robust, and in the first nine months of 2019, free cash flow was up 14.2% from a year ago to US$730.1 million. 
• The net-cash position on the balance sheet was positive in every year from 2006 to 2018, and has also increased significantly. In fact, Intuitive Surgical has consistently had zero debt. 
• Dilution has also been negligible for Intuitive Surgical’s shareholders from 2006 to 2018 with the diluted share count barely rising in that period. It’s the same story in the first nine months of 2019, with the diluted share count inching up by just 0.6% from a year ago.

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 Intuitive Surgical excels in this criterion.

Firstly, the company has done very well in producing free cash flow from its business for a long time. Its free cash flow margin (free cash flow as a percentage of revenue) was in a healthy range of 19.7% to 38.2% from 2006 to 2018, and it came in at 22.8% in the first nine months of 2019.

Secondly, there’s still tremendous room to grow for Intuitive Surgical. This should lead to a higher installed base of surgical robots for the company over time. It’s also reasonable to assume that the utilisation of the robots (procedures performed per installed robot) will climb steadily in the years ahead; it has increased in every year from 2007 to 2018, as shown earlier. These assumptions mean that Intuitive Surgical should see robust growth in its recurring revenues (instruments & accessories; services; and leasing) – and the company’s recurring revenue streams likely come with high margins.

Valuation

I like to keep things simple in the valuation process. Since Intuitive Surgical has a long history of producing solid and growing streams of profit and free cash flow, I think both the price-to-earnings (P/E) ratio and price-to-free cash flow (P/FCF) ratio are suitable gauges for the company’s value.

Intuitive Surgical’s valuation ratios at its current share price may give you sticker shock: The P/E ratio is around 54 while the P/FCF ratio is around 70. The chart below illustrates the two ratios (purple for the P/E ratio and orange for the P/FCF ratio) over the past five years, and they are clearly near five-year highs.

But Intuitive Surgical’s high levels of recurring revenue also lead to relatively predictable streams of earnings and cash flows, something which I think is very valuable. This, along with the company’s excellent track record and huge growth opportunities ahead, justifies its premium valuation, in my view.

I think it’s worth noting too that Intuitive Surgical has, in my eyes, built a strong competitive position because of its first-mover advantage in the surgical robot market. Hospitals and doctors need to invest time and resources in order to use the da Vinci robots. The more da Vinci systems that are installed in hospitals, the harder it is for competitors to unseat Intuitive Surgical – so it’s good to know that there are more than 5,000 da Vinci systems installed worldwide today.

The risks involved

There are two key risks with Intuitive Surgical that I’m watching.

The first is any future changes in healthcare regulations. Intuitive Surgical’s revenue-growth slowed dramatically in 2013 (up just 4%, compared to a 24% increase in 2012); revenue even declined in 2014. Back then, uncertainties related to the Affordable Care Act (ACA) – the US’s national health insurance scheme set up by then-US president Barack Obama – caused hospitals in the US to pull back spending.

Current US president, Donald Trump, made changes to the ACA as early as 2017. Trump’s meddling with the ACA has so far not dented Intuitive Surgical’s growth. But if healthcare regulations in the US and other countries Intuitive Surgical is active in (such as Germany, China, Japan, and South Korea) were to change in the future, the company’s business could be hurt.

The second key risk is competition. Intuitive Surgical name-dropped 16 competitors in its latest 2018 annual report, including corporate heavyweights with deep pockets such as Johnson & Johnson and Samsung Corporation. Although Intuitive Surgical is currently the runaway leader in the field of robotic surgery systems, there’s always a risk that someone else could come up with a more advanced and more cost-effective surgical robot.

Medtronic, one of the competitors named by Intuitive Surgical, will be launching its own suite of surgical robots in the near future – the company earned nearly US$31 billion in revenue over the last 12 months. Meanwhile, Johnson & Johnson has been busy in this space. It acquired Auris Healthcare (another of Intuitive Surgical’s named competitors) in 2019  for at least US$3.4 billion, and recently announced the full acquisition of Verb Surgical (yet another named competitor of Intuitive Surgical). Verb Surgical was previously a joint venture between Johnson & Johnson and Alphabet, the parent company of Google.

I mentioned earlier that Intuitive Surgical has already carved out a strong competitive position for itself, so I’m not worried about the competition heating up. Moreover, I think the real battle is not between Intuitive Surgical and other makers of robotic surgical systems. Instead, it is between robotic surgery and traditional forms of surgery. As I had already mentioned, only 2% of surgeries worldwide are conducted with robots today, so there’s likely plenty of room for more than one winner among makers of surgical robots. Nonetheless, I’ll still be keeping an eye on competitive forces in Intuitive Surgical’s market – I’ll be worried if I see a prolonged deceleration in growth or decline in the number of surgical procedures that the da Vinci robots are used in.

It’s worth noting too that Intuitive Surgical is not sitting still in the face of upcoming competition. At the end of 2018, the company had over 3,000 patents and 2,000 patent applications around the world, up from over 1,300 and 1,100, respectively, in 2012.

The Good Investors’ conclusion

Intuitive Surgical shines when seen through the lens of my investment framework: 

• It is a leader in the fast-growing surgical robot market.
• Its balance sheet is debt-free and has billions in cash and investments.
• The management team is sensibly incentivised. They also have excellent track records in innovation and growing the key business metrics of the company (such as the installed base of the da Vinci robots and the number of procedures conducted with the robots).
• The company has an attractive razor-and-blades business model that generates high levels of recurring revenues with strong profit margins.
• Intuitive Surgical has a robust long-term history of growth – its revenue, profit, and free cash flow even managed to soar during the Great Financial Crisis.
• It has historically been adept at generating free cash flow, and likely can continue doing so in the years ahead.

Intuitive Surgical carries pricey P/E and P/FCF ratios right now, but I think the high valuations currently could prove to be short-term expensive but long-term cheap. Firstly, the company’s recurring revenues provide a stability to the business that I think the market values. Secondly, there are significant growth opportunities for the company.

There are important risks to watch, as it is with any other investment. In Intuitive Surgical’s case, the key risks for me are future changes in healthcare regulations and an increasingly competitive business landscape.

In all, after weighing the risks and potential rewards, I’m happy to have Intuitive Surgical shares 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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. Are its revenue streams recurring in nature?

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

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

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

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

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

5. Does Autodesk have a proven ability to grow?

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

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

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

The true value of a company is not based on its profits but on its cash that it can generate in the future. That is why the sixth criterion of Ser Jing’s investment framework is so essential. 

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

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

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

Risks

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

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

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

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

Valuation

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

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

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

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

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

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

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

The Good Investors’ conclusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. Are its revenue streams recurring in nature?

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

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

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

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

5. Does Haidilao have a proven ability to grow?

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

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

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

The true value of a company is not based on its profits but on all the cash that it can generate in the future. That is why the sixth criteria of the investment framework is so important.

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

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

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

Risks

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

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

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

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

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

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

Valuation

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

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

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

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

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

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

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

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

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

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

The Good Investors’ conclusion

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

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

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

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

Amazon.com (NASDAQ: AMZN) is one of the 50-plus companies that’s in my family’s investment portfolio. I bought Amazon’s shares a total of four times. The first was in April 2014 at a price of US$313, then again in July 2014 at US$322, once more in December 2016 at US$767, and yet again in August 2017 at US$955. I’ve not sold any of the shares I’ve bought.

All the purchases of Amazon’s shares have performed well for my family’s portfolio, with Amazon’s share price being around US$1,785 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 Amazon’s shares.

Company description

Jeff Bezos founded Amazon in 1994. A year later, the company started business by selling just books online. Over time, Amazon expanded its online retail business that now provides an incredible variety of product-categories for consumers. In 2006, the company launched its cloud computing business, AWS (Amazon Web Services), which has since grown into the largest cloud computing service provider in the world.

Amazon currently has three business segments: North America, International, and AWS. The North America and International segments consists of Amazon’s online retail as well as other retail-related subscription businesses. The AWS segment houses well, AWS, which offers computing power, database storage, content delivery, and other services to various organisations.

The table immediately below shows the revenues and operating profits from Amazon’s three segments in the first nine months of 2019. Although Amazon’s retail operations make up the lion’s share of revenue, it is AWS that is currently generating more operating profit for the company.

For a geographical perspective, the US was the source of 69% of Amazon’s total revenue of US$232.9 billion in 2018. Germany, the UK, and Japan are the other countries that Amazon reports as individual revenue sources, but the US is the only market that accounted for more than 10% of the company’s revenue. 

Investment thesis

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

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, Amazon’s massive revenue (total of US$193 billion in the first nine months of 2019) makes it seem like the company has exhausted its room for growth. But if you dig deeper, a different picture emerges.

First, let us consider Amazon’s online retail business. The St Louis Federal Reserve’s data show that online retail sales in the US was just 11.2% of the country’s total retail sales in the third quarter of 2019. Moreover, total retail sales in the US in the first 11 months of 2019 (excluding food services) was over US$5 trillion. Amazon’s current revenue is merely a drop in the ocean. For more context, Walmart, a bricks-and-mortar retailer in the US, earned US$392 billion in revenue in the 12 months ended January 2019.

The chart below shows ecommerce sales as a percentage of total retail sales in the US for each quarter going back to 1999’s fourth-quarter. From then to today, the percentage has increased from just 0.6% to 11.2%. Ecommerce activity has clearly been growing in the US over a long period of time, and that’s a tailwind on Amazon’s back.

Next, let us look at the cloud computing landscape. AWS on its own, can be considered a huge business too with revenue of US$25 billion in the first nine months of 2019. But again, the runway for growth is long.

According to Gartner’s latest forecasts released in November 2019, the public cloud computing market is expected to grow by nearly 16% per year from US$197 billion in 2018 to US$355 billion in 2022.

Then, there’s Amazon’s digital advertising business which is reported within the North America and International business segments. In the first nine months of 2019, Amazon’s advertising business brought in revenue of around US$9 billion, up 38% from a year ago. The market opportunity is huge and fast-growing; global digital advertising spend was US$283 billion in 2018, and is expected to grow to US$518 billion in 2023, according to eMarketer.

The thing about Amazon is that we should not be surprised to see the company expand into new markets in the future. After all, Amazon “seeks to be Earth’s most customer-centric company.” This audacious statement also means that any industry is fair game for Amazon if it sees an opportunity to improve the customer experience. It helps that Amazon is highly innovative (more on this when I discuss Amazon’s management) and the company embodies a concept called optionality. Motley Fool co-founder David Gardner describes optionality as a company having multiple paths to grow.

Here are a few of Amazon’s irons-in-the-fire that I think hold high growth-potential:

• Amazon is making inroads in physical retail. Amazon Go is the company’s bricks-and-mortar retail store that requires no checkout. Customers walk into an Amazon Go store, grab what they want, and simply leave. Amazon Go is powered by computer vision, sensor fusion, and deep learning. The company reported in the second quarter of 2019 that it had 13 Amazon Go stores across the US, namely in Seattle, Chicago, San Francisco, and New York.  In August 2017, the company also acquired Whole Foods Market, an organic grocer, for US$13.2 billion. Whole Foods Market has around 500 physical stores today in North America and the UK. 
• In early 2018, Amazon set up a non-profit entity together with the US banking giant J.P. Morgan Chase, and Warren Buffett’s Berkshire Hathaway. The non-profit was named Haven in early 2019 and is meant to tackle rising healthcare costs in the US. In September 2018, Amazon acquired online pharmacy and drug delivery outfit PillPack in 2018 for US$753 million. Then in September 2019, Amazon launched Amazon Care, its telemedicine and in-person healthcare platform. As far as I know, Amazon Care is currently only available for Amazon’s employees in Seattle. Shortly after in October, Amazon acquired Health Navigator, a digital healthcare startup, and grouped it under the Amazon Care platform. All these moves by Amazon suggest that it’s working hard to crack the US$3.5 trillion US healthcare market.
• Amazon has been flexing its financial muscle in video streaming. The company’s original content budget for 2019 for its Prime Video streaming service is estimated to be around US$6 billion. The streaming market is rapidly growing. And although Netflix is a formidable – and larger – presence in the space, there is likely enough room for more than one winner. 
• In Amazon’s 2018 annual report, it included for the first time “transportation and logistics services” companies as its competitors. Amazon started leasing delivery planes for the first time in 2016 and it is expected to have a fleet of at least 70 delivery aircraft by 2021. The company is also investing US$1.5 billion to develop an air cargo hub in Kentucky with a scheduled 2021 opening date. 

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

Amazon meets this criteria. As of 30 September 2019, the company’s balance sheet held US$22.5 billion in debt and US$37.1 billion in lease liabilities against US$43.4 billion in cash and marketable securities.

There’s more debt than cash, but Amazon has been adept at generating cash flow. That’s something I will discuss later.

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

On integrity

Jeff Bezos, 55, has been leading the charge at Amazon since he founded the company. Today, he’s Amazon’s president, CEO, and chairman. I believe that Bezos’s compensation plan with Amazon shows that he’s a leader with (a) integrity, and (b) interests that are aligned with the company’s other shareholders, myself included. There are a few key points to note:

• Bezos’s cash compensation in Amazon was merely US$81,840 in 2018. His annual cash compensation has never exceeded that amount at his request, because he already has a large stake in Amazon. His total compensation in 2018 was US$1.68 million if business-related security expenses were included. But even then, the sum is more than reasonable when compared to the scale of Amazon’s business.
• Bezos has never received any form of stock-based compensation from Amazon, because he believes he is already “appropriately incentivised” due to, again, his large ownership stake in the company.
• As of 25 February 2019, Bezos controlled 78.8 million Amazon shares (16% of the existing shares) that are worth around US$141 billion at the current price. Bezos divorced his wife, MacKenzie Sheri Tuttle, in July 2019 and transferred a quarter of his Amazon shares to her. This means that Bezos still controls roughly 59 million Amazon shares with a current market value of around US$105 billion. In my opinion, Bezos’s huge monetary stake in the company puts him in the same boat as other shareholders.

On capability and innovation

There’s so much to discuss about Bezos’s accomplishments with Amazon and his ability to lead innovation at the company. But for the sake of brevity, I want to focus on only a few key points.

First is Amazon’s tremendous track record of growth. There will be more details later, but as a teaser, consider that Amazon’s revenue has increased from just US$148 million in 1997 to US$232.9 billion in 2018. Over the same period, operating cash flow was up from less than US$1 million to US$30.7 billion.

Second is Amazon’s willingness to think long-term, and experiment and fail. I want to highlight Amazon’s long-term thinking through something Bezos said in a 2011 interview with Wired. Reading Bezos’s words directly will give you a window into his genius. Here are Bezos’s words in 2011 (emphasis is mine) :

“Our first shareholder letter, in 1997, was entitled, “It’s all about the long term.” If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people.

But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that. Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue. At Amazon we like things to work in five to seven years. We’re willing to plant seeds, let them grow—and we’re very stubborn. We say we’re stubborn on vision and flexible on details.”

Amazon has the courage to constantly seek new ground. Often, the trail turns cold. A sample of Amazon’s long string of failures include: The Fire Phone (Amazon’s smartphone); Amazon Wallet (Amazon’s digital payments service); Amazon Local Register (a device to help mobile devices process credit cards); and Destinations (Amazon’s hotel-booking website). But sometimes the trail leads to gold. Bezos has written about this topic. Here’s a relevant excerpt from Amazon’s 2015 shareholders’ letter (emphases are mine):

“One area where I think we are especially distinctive is failure. I believe we are the best place in the world to fail (we have plenty of practice!), and failure and invention are inseparable twins. To invent you have to experiment, and if you know in advance that it’s going to work, it’s not an experiment. Most large organizations embrace the idea of invention, but are not willing to suffer the string of failed experiments necessary to get there.

Outsized returns often come from betting against conventional wisdom, and conventional wisdom is usually right. Given a ten percent chance of a 100 times payoff, you should take that bet every time. But you’re still going to be wrong nine times out of ten. We all know that if you swing for the fences, you’re going to strike out a lot, but you’re also going to hit some home runs.

The difference between baseball and business, however, is that baseball has a truncated outcome distribution. When you swing, no matter how well you connect with the ball, the most runs you can get is four. In business, every once in a while, when you step up to the plate, you can score 1,000 runs. This long-tailed distribution of returns is why it’s important to be bold. Big winners pay for so many experiments.”

The following is another relevant passage on the company’s willingness to experiment, from Bezos’ 2018 shareholders’ letter (emphases are mine):

“Sometimes (often actually) in business, you do know where you’re going, and when you do, you can be efficient. Put in place a plan and execute. In contrast, wandering in business is not efficient … but it’s also not random. It’s guided – by hunch, gut, intuition, curiosity, and powered by a deep conviction that the prize for customers is big enough that it’s worth being a little messy and tangential to find our way there.

Wandering is an essential counter-balance to efficiency. You need to employ both. The outsized discoveries – the “non-linear” ones – are highly likely to require wandering.

AWS’s millions of customers range from startups to large enterprises, government entities to nonprofits, each looking to build better solutions for their end users. We spend a lot of time thinking about what those organizations want and what the people inside them – developers, dev managers, ops managers, CIOs, chief digital officers, chief information security officers, etc. – want.

Much of what we build at AWS is based on listening to customers. It’s critical to ask customers what they want, listen carefully to their answers, and figure out a plan to provide it thoughtfully and quickly (speed matters in business!). No business could thrive without that kind of customer obsession. But it’s also not enough. The biggest needle movers will be things that customers don’t know to ask for. We must invent on their behalf. We have to tap into our own inner imagination about what’s possible.

AWS itself – as a whole – is an example. No one asked for AWS. No one. Turns out the world was in fact ready and hungry for an offering like AWS but didn’t know it. We had a hunch, followed our curiosity, took the necessary financial risks, and began building – reworking, experimenting, and iterating countless times as we proceeded.”

One instance for Amazon of the trail leading to gold is, of course, AWS. It has been a smashing success. When AWS was 10 years old, it was bigger than Amazon was at the same age and was growing at a faster rate. The table below shows AWS’s outstanding revenue and operating income growth since 2014. Bear in mind that AWS has grown despite Amazon having lowered the service’s price a total of 67 times from its launch in 2006 to September 2018 – voluntarily. 

I think it’s worth noting too that AWS has a commanding lead over other cloud computing platforms. In 2018, the IaaS (infrastructure-as-a-service) segment in the cloud computing market was US$32.4 billion, according to Gartner; AWS accounted for nearly half of that.

The third key point I want to discuss about Amazon’s management is Jeff Bezos’s unique obsession over the customer experience. In fact, I think it is an unreplicable competitive advantage, because it stems from Bezos’s own unique way of thinking. You can’t clone Jeff Bezos – at least not with current science!

In his 2003 shareholders’ letter, Bezos illustrated his willingness to dent Amazon’s short-term sales for longer-term benefits (emphasis is mine):

“Another example is our Instant Order Update feature, which reminds you that you’ve already bought a particular item. Customers lead busy lives and cannot always remember if they’ve already purchased a particular item, say a DVD or CD they bought a year earlier.

When we launched Instant Order Update, we were able to measure with statistical significance that the feature slightly reduced sales. Good for customers? Definitely. Good for shareowners? Yes, in the long run.”

I mentioned earlier that AWS has dropped prices over the years for the benefit of customers. Back in his 2005 shareholders’ letter, Bezos already gave an excellent window on his thinking behind his obsession on lowering prices for customers. He thinks it can build strong customer loyalty that is not easily measurable but that is real. Most importantly, he thinks this loyalty translates into higher future free cash flows for Amazon. I agree. Here’s what Bezos wrote (emphases are mine):

“As our shareholders know, we have made a decision to continuously and significantly lower prices for customers year after year as our efficiency and scale make it possible. This is an example of a very important decision that cannot be made in a math-based way.

In fact, when we lower prices, we go against the math that we can do, which always says that the smart move is to raise prices. We have significant data related to price elasticity. With fair accuracy, we can predict that a price reduction of a certain percentage will result in an increase in units sold of a certain percentage.

With rare exceptions, the volume increase in the short term is never enough to pay for the price decrease. However, our quantitative understanding of elasticity is short-term. We can estimate what a price reduction will do this week and this quarter. But we cannot numerically estimate the effect that consistently lowering prices will have on our business over five years or ten years or more.

Our judgment is that relentlessly returning efficiency improvements and scale economies to customers in the form of lower prices creates a virtuous cycle that leads over the long term to a much larger dollar amount of free cash flow, and thereby to a much more valuable Amazon.com. We’ve made similar judgments around Free Super Saver Shipping and Amazon Prime, both of which are expensive in the short term and—we believe—important and valuable in the long term.”

The last point I want to discuss regarding Jeff Bezos’s leadership is the unique corporate structure he has built in Amazon. Tech entrepreneur Zack Kanter wrote an amazing blog post in March 2019 (please read it!) that describes Amazon’s brilliant culture. Here’re the key passages (italics are his):

“In 2002, Jeff Bezos had the most important insight he would ever have: in the world of infinite shelf space – and platforms to fill them – the limiting reagent for Amazon’s growth would not be its website traffic, or its ability to fulfill orders, or the number of SKUs available to sell; it would be its own bureaucracy.

As Walt Kelly put it, “we have met the enemy, and it is us.” In order to thrive at ‘internet scale,’ Amazon would need to open itself up at every facet to outside feedback loops. At all costs, Amazon would have to become just one of many customers for each of its internal services.

And so, as told by former Amazon engineer Steve Yegge, Jeff Bezos issued an edict: 1) All teams will henceforth expose their data and functionality through interfaces, 2) teams must communicate with each other through these interfaces, 3) all interfaces, without exception, must be designed from the ground up to be exposed to developers in the outside world, and 4) anyone who doesn’t do this will be fired.

This principle, this practice, this pattern, would enable Amazon to become the sprawling maze of complexity that it would eventually become without collapsing under its own weight, effectively future-proofing itself from the bloat and bureaucracy that inevitably dragged down any massive company’s growth.”

Bezos’s edict that Kanter mentioned allows Amazon to innovate rapidly. That’s because any service or technology that Amazon builds for internal uses can very quickly be pushed to external customers when the time is right. In fact, that was how AWS came to be: It was first developed to meet Amazon’s own computing needs before it was eventually shipped to the public.

So after a really long discussion on Amazon’s leadership (and that’s after I tried to be as brief as possible!), I want to make it very clear: My investment in Amazon is also very much a long-term bet on Jeff Bezos. 

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

Amazon’s business contains highly recurrent revenue streams. There are a few key things to note:

• According to Statista, there were 206.1 million unique visitors to Amazon’s US sites in the month of December 2018. These are visitors who are likely using Amazon’s online retail sites to purchase products regularly. 
• Amazon also has subscription businesses, most notably Amazon Prime. Subscribers to Amazon Prime gain access to free shipping (from two days to two hours depending on the products), the Prime Video streaming service, and more. Amazon Prime typically charges subscribers US$12.99 per month or US$119 per year. In his 2017 shareholders’ letter, Bezos revealed that Amazon Prime had more than 100 million paying subscribers around the world.
• AWS provides cloud computing services, and that is likely to be something its customers require all the time, or frequently. AWS also sometimes enters into significant long-term contracts of up to three years.

I also want to point out that it’s highly unlikely that Amazon has any customer concentration. The company’s retail websites welcome hundreds of millions of visitors each month, and AWS also has “millions of customers” ranging from startups to large enterprises, and government entities to nonprofits. 

5. A proven ability to grow

The table below shows Amazon’s important financial figures from 1997 to 2018:

There are a few points to note about Amazon’s financials:

• Revenue has compounded at an amazing rate of 42% from 1997 to 2018; over the last five years from 2013 to 2018, Amazon’s topline growth was still excellent at 25.6%. The company also managed to produce strong revenue growth of 29% in 2008 and 28% in 2009; those were the years when the global economy was rocked by the Great Financial Crisis.
• Operating cash flow has increased markedly for the entire time frame I’m looking at. The compound annual growth rates from 2007 to 2018, and from 2013 to 2018, were robust at 32% and 41%, respectively. Moreover, just like Amazon’s revenue, the company’s operating cash flow had strong growth in 2008 and 2009.
• Free cash flow, net of acquisitions, has mostly been positive and has also stepped up significantly from 1997 to 2018. But it’s worth noting that Amazon has spurts of heavy reinvestments into its business which depresses its free cash flow from time to time. I also want to point out that 2017 was an anomaly because of the huge US$13.2 billion Whole Foods Market acquisition I mentioned earlier. 
• The balance sheet was in a net cash position in most years, and even when there was debt, it looks trivial compared to the company’s cash flows.
• Amazon has been diluting its shareholders, but the dilution has happened at a glacial pace of 3% annually since 1997. From 2007 to 2018, the annual increase in the diluted share count has been just 1.5%, which is negligible given the rate at which Amazon’s business is growing.

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

Jeff Bezos has attached his 1997 shareholders’ letter to every subsequent shareholders’ letter he has written. In the 1997 letter, Bezos wrote:

“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”

In Amazon’s 2018 annual report, the company stated that its “financial focus is on long-term, sustainable growth in free cash flows.”

The two comments above – from Bezos’ 1997 shareholders’ letter and from Amazon’s latest annual report – highlights the emphasis that the online retail giant places on free cash flow. I like this focus. And crucially, Amazon has walked the talk. Its free cash flow has grown over time as I mentioned earlier, and hit US$15.1 billion in 2018 and US$18.0 billion over the last 12 months. 

Valuation

I like to keep things simple in the valuation process. Given Amazon’s penchant for free cash flow (which is absolutely correct!), I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value when free cash flow is abundant. When free cash flow is light because Amazon is reinvesting into its business, the price-to-sales (P/S) ratio will be useful. 

With US$18.0 billion in free cash flow right now, Amazon has a P/FCF ratio of around 49 at the current share price. That’s a high valuation. But Amazon is still growing rapidly – revenue was up nearly 24% in the third quarter of 2019, which is incredible and all the more impressive given the company’s already massive revenue base. More importantly, Amazon aces my investment framework. For that, I’m happy to pay up. 

The risks involved

Key-man risk is an important concern I have with Amazon. Jeff Bezos is an incredible and fair businessman in my opinion. If he ever leaves the company for whatever reason, his successor will have giant shoes to fill – and I will be watching the situation closely.

I also recognise that there’s political risk involved with Amazon. The company has been under scrutiny from US regulators for antitrust reasons, but I’m not too concerned. In his 2018 shareholders’ letter, Bezos gave a succinct sweep of the retail landscape which shows that Amazon’s share of the overall market is still tiny: 

“Amazon today remains a small player in global retail. We represent a low single-digit percentage of the retail market, and there are much larger retailers in every country where we operate. And that’s largely because nearly 90% of retail remains offline, in brick and mortar stores.”

Staying with political risk, current US president Donald Trump is at loggerheads with Jeff Bezos. Amazon recently lost out on a cloud computing contract (worth up to US$10 billion) with the US’s Department of Defense, and the company has accused Trump of meddling with the outcome of the deal. It does not help too that the Amazon CEO’s personal ownership of the high-profile US national newspaper, Washington Post, likely also pulls political attention toward Amazon. 

Lawmakers in the US, such as Elizabeth Warren, have even gone as far as to propose plans to break up large technology firms in the country, including Amazon. I’m not worried about a break up, because it could actually unlock value for Amazon’s shareholders. For example, it’s possible that an independent AWS could win more customers compared to its current status. It was reported in 2017 that Walmart had told its technology vendors not to use AWS. Nonetheless, I’m keeping an eye on politicians’ moves toward Amazon.

Lastly, there’s valuation risk. Amazon is priced for strong long-term growth. I’m confident that the company can continue growing at high rates for many years into the future, but there’s always the risk that the wheels fall off the bus. If Amazon’s growth slows materially in the years ahead, the high valuation will turn around and bite me. It’s something I have to live with, but I’m comfortable with that.

The Good Investors’ conclusion

In my view, Jeff Bezos is one of the best business leaders the world has seen. I have good company. Warren Buffett, himself an extraordinary investor, called Bezos “the most remarkable business person of our age” in a 2017 interview. Charlie Munger, Buffett’s long-time right-hand man, also said around the same time that Bezos “is a different species.”

Amazon has Bezos as its leader, and that in itself is an incredible competitive advantage for the company. Besides excelling in the management-criteria within my investment framework, Amazon also shines in all the other areas: 

• The company is operating in large and growing markets including online retail, cloud computing, and digital advertising. Moreover, it is constantly on the hunt for new opportunities.
• Amazon’s balance sheet carries a fair amount of debt, but is still robust when the debt is compared to its cash flows.
• The nature of Amazon’s business means there are high levels of recurring revenues.
• The company has an amazing long-term track record of growth – its business even managed to soar during the Great Financial Crisis.
• Amazon has a strong focus on generating free cash flow, and has proven to be adept at doing so.

The company’s valuation – based on the P/FCF ratio – is on the high side on the surface, and that’s a risk. But Amazon is a very high quality business, in my view, which means the high valuation currently could be short-term expensive but long-term cheap. Other important risks I’m watching with Amazon include key-man risk and scrutiny from politicians. 

After weighing the risks and potential rewards, I’m more than happy to have Amazon 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.

Berkshire Hathaway (NYSE: BRK-B) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Berkshire shares for the portfolio in August 2011 at a price of US$70 and again in September 2015 at US$130. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with Berkshire’s share price being around US$223 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 Berkshire shares.

Company description

Berkshire is one of the most fascinating companies I have come across.

The story starts in 1965, when Warren Buffett took over the company because of anger. Back then, Buffett was a hedge fund manager. He had bought Berkshire shares a few years prior because they were cheap compared to the company’s assets.

In 1964, Berkshire’s then-leader, Seabury Stanton, offered to buy Buffett’s shares for US$11.50 each. Buffett agreed to sell. But Stanton’s official offer was slightly lower, at US$11.375 per share. Buffett was livid about being lied to, to the extent that he amassed a controlling stake in Berkshire to fire Stanton.

Berkshire was merely a struggling textile manufacturer when Buffett became its leader. But over the years, Buffett has thoroughly transformed the company through numerous inspired acquisitions and deft stock market investments.

Charlie Munger joined Berkshire in 1978. But for many years prior, he and Buffett were already collaborating. In fact, Munger helped Buffett to refine his already formidable investing prowess. 

Today the 88-year old Buffett and 95-year old Munger continue to lead Berkshire as chairman and vice-chairman, respectively. The company can also be rightfully described as a truly diversified conglomerate, with more than 60 subsidiaries across a wide range of industries. Here’s a sample of the companies under Berkshire’s umbrella:

• Berkshire Hathaway Reinsurance Group – provider of insurance products to other reinsurers and property, casualty, life, and health insurers globally
• GEICO – second largest insurer in the US auto insurance market (share of 13% at end-2018)
• Burlington Northern Santa Fe – one of the North American continent’s largest railroad companies
• Berkshire Hathaway Energy – one of the largest energy utilities in the US, and the second-largest residential real estate brokerage firm in the same country
• IMC International Metalworking Companies – among the top three manufacturers of consumable precision carbide metal cutting tools in the world 
• Precision Castparts – manufacturer of metal parts and components that go into aircraft
• Borsheim’s – fine-jewellery retailer
• Nebraska Furniture Mart –  furniture retailer (as its name suggests) 
• See’s Candies – chocolate and confectionary producer 

Berkshire’s reach extends beyond its subsidiaries. It also has a massive investment portfolio that is worth more than US$220 billion as of 30 September 2019. The portfolio consists of shares of more than 40 publicly traded companies that are mostly listed in the US. Some of them are also in my family’s portfolio, such as Apple, Amazon.com, and Mastercard. The investment portfolio is overseen by Buffett, Munger, Todd Combs, and Ted Weschler. 

Investment thesis

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

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

Berkshire is already a massive company, with US$247.8 billion in revenue in 2018. But I believe there’s still plenty of room to run for the conglomerate, although I’m not expecting rapid growth. 

I think a growth rate in the high single-digit or low double-digit percentage range for Berkshire is reasonable. This is because Berkshire’s diversified collection of US stocks and high-quality subsidiaries puts it in a great position to ride on the US’s long-term economic growth.

There are a few points I want to expand on. First is regarding the US economy. Over the years, Buffett has not been shy in sharing his enthusiasm about the US . In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind.

It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.

There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.

Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”

(Do read the “The American Tailwind” section of Buffett’s 2018 letter.)

To build on Buffett’s American Tailwind idea, I want to highlight that the working-age population in the US is estimated to increase by 13% from today to 2050. That’s one of the brightest demographics among developed economies across the world. Here’s a chart from Morgan Housel showing this:

The second point I want to expand on is the quality of Berkshire’s subsidiaries. If you’re a long-time observer of Berkshire, you’ll know that a durable competitive advantage is one of the key qualities that Buffett seeks when making acquisitions. 

There are numbers to prove this point: Berkshire’s manufacturing, service, and retailing businesses earn healthy after-tax returns on net tangible assets while holding plenty of cash and using very little debt. The table illustrates this from 2012 to 2016 (the last year that Buffett reported the after-tax return on net tangible assets employed by this group of businesses).

A last note from me on Berkshire’s room for growth: Buffett and Munger are, in my eyes, two of the best investors in the world today, and they’re still constantly looking for bargains in the stock market and private businesses to acquire to strengthen Berkshire’s portfolio. 

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

As of 30 September 2019, Berkshire’s balance sheet has US$102.2 billion in borrowings – that’s a fair amount of debt. 

But Berkshire also has a massive cash hoard of US$128.2 billion, including US$53.4 billion in short-term investments in US Treasury bills, which can be considered as cash for liquidity purposes. So Berkshire does have tremendous resources to invest for growth as well as withstand shocks.

There are huge insurance businesses within Berkshire. So I think it’s also important for me to watch the company’s ability to payout huge insurance claims from time to time. 

Buffett believes that “the annual probability of a US mega-catastrophe causing [US]$400 billion or more of insured losses is about 2%.” For perspective, a US$400 billion insured-loss is nearly four times the highest amount that the US has seen since 1980. This is illustrated in the chart below (the dark blue bars indicate insured losses in each year):

In the event that US$400 billion of insured losses happen in a year, Berkshire’s share would be just US$12 billion or so. This is a huge sum of money. But it is far less than the annual earnings the company expects from its non-insurance businesses. For context, Berkshire’s non-insurance businesses generated US$20.8 billion in pre-tax income in 2018, up 24% from 2017. Although Berkshire will be bruised by a US$400 billion mega-catastrophe event in the insurance industry, most other insurers would go bust according to Buffett. 

The diversification present in Berkshire adds another layer of financial resilience. I mentioned earlier that the conglomerate controls over 60 subsidiaries across many industries. This is also true of Berkshire’s investment portfolio. The 40-odd stocks in the portfolio belong to technology, banking, media, consumer products, and more.

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

On integrity

Buffett’s overall reputation, in business and in life, is pristine. The excerpt below, taken from Berkshire’s latest official proxy statement released in March 2019, will also shine tremendous light on the integrity of Buffett and Munger (emphases are mine):

“Due to Mr. Buffett’s and Mr. Munger’s desire that their compensation remain unchanged, the Committee has not proposed an increase in Mr. Buffett’s or Mr. Munger’s compensation since the Committee was created in 2004. Prior to that time, Mr. Buffett recommended to the Board of Directors the amount of his compensation and Mr. Munger’s.

Mr. Buffett’s annual compensation and Mr. Munger’s annual compensation have been [US]$100,000 for more than 25 years and Mr. Buffett has advised the Committee that he would not expect or desire such compensation to increase in the future…

...Mr. Buffett will on occasion utilize Berkshire personnel and/or have Berkshire pay for minor items such as postage or phone calls that are personal. Mr. Buffett reimburses Berkshire for these costs by making an annual payment to Berkshire in an amount that is equal to or greater than the costs that Berkshire has incurred on his behalf.

During 2018, Mr. Buffett reimbursed Berkshire [US]$50,000. Berkshire provides personal and home security services for Mr. Buffett. The cost for these services was approximately [US]$290,000 in 2018. Berkshire’s Board of Directors believe that in light of Mr. Buffett’s critical role as Berkshire’s CEO and given that Mr. Buffett spends a significant amount of his time while at home on Berkshire business matters that such costs represent bona fide business expenses.

None of Berkshire’s named executive officers use Company cars or belong to clubs to which the Company pays dues. It should also be noted that neither Mr. Buffett nor Mr. Munger utilizes corporate-owned aircraft for personal use.”

Buffett and Munger earn their riches predominantly from their ownership of Berkshire shares. As of 6 March 2019, Buffett controlled Berkshire shares that are worth around US$90 billion at the current price; Munger’s stake also makes him a billionaire (around US$1.5 billion). These high ownership stakes give me comfort that their interests are aligned with mine.

Although Buffett and Munger’s philanthropic actions are not directly-related to investing, I think they speak volumes about the characters of the two elder statesmen of business. The actions also inspire me, so I want to include a brief discussion. In 2006, Buffett pledged to donate more than 99% of his wealth to charitable causes during his lifetime or at his death. Since then, Buffett has already given more than US$34.5 billion to charities. Munger, meanwhile, has given hundreds of millions of dollars over the past 30 years toward the building of school facilities.

On capability

On the topic of capability, Berkshire’s track record of growth since 1965 has been nothing short of stunning. More on this soon.

On innovation

For a long time, Buffett was averse to technology stocks because he couldn’t understand them (he first broke the duck by investing in IBM in 2011, and of course Berkshire now has a big stake in Apple). So it’s no surprise that Berkshire is not the first name that comes to mind if we mention the word “innovation.”

But what Berkshire lacks in technological innovation, it makes up for with a unique mindset in business.

Let’s first talk about Buffett’s view toward acquiring companies. I want to discuss this because acquisitions will be one of Berkshire’s key growth drivers in the years ahead. The excerpts below from Berkshire’s 2008 shareholders’ letter are instructive (emphases are mine):

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).

Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.

Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing.

A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.”

I believe that Buffett’s mindset of wanting to be long-term (eternal?) owners when acquiring companies, alone, is a competitive advantage in the private markets that is not easily replicable. Berkshire has walked the talk of being a responsible long-term owner of businesses and implementing decentralised management – these traits have made the conglomerate a preferred buyer when owners of good private family-built businesses are looking to sell. In his 2018 shareholders’ letter, Buffett again emphasised that Berkshire wants to be a long-term owner of the businesses that it acquires:

“You may ask whether an allowance should not also be made for the major tax costs Berkshire would incur if we were to sell certain of our wholly-owned businesses. Forget that thought: It would be foolish for us to sell any of our wonderful companies even if no tax would be payable on its sale. Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.” 

Some of you reading this may be wondering, “Is Buffett’s competitive advantage in acquiring companies really so simple? Isn’t that easy to replicate?” My response will be something Munger once said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.

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

There are two main components to Berkshire’s operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there’s high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that’s something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility. Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A proven ability to grow

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire’s 2018 annual report, and it shows the incredible 18.7% annual growth in the company’s book value per share since 1965, the year Buffett assumed control. ‘Nuff said.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” So why the focus on Berkshire’s book value per share? That’s because Berkshire’s main assets for many decades were public-listed stocks. Although, it’s worth pointing out that the company’s book value per share is increasingly losing its relevance as a measure of the company’s intrinsic economic worth  – Berkshire’s main value now resides in its subsidiaries.

It must also be said that Berkshire’s no slouch when it comes to free cash flow. The table below shows the record of the conglomerate’s annual growth in free cash flow of 11% going back to 2007. I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

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

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don’t see any reason to believe that Berkshire’s ability to generate cash from its businesses will change any time soon.

Valuation

In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.”

The four groves Buffett mentioned refers to Berkshire’s (1) insurance operations, (2) non-insurance businesses, (3) ownership stakes in a quartet of companies – Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J – that it shares control with other parties, and (4) treasury bills, cash, and fixed-income investments.

I like to keep things simple in the valuation process, so I’m going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire’s book value per share is losing relevance in being a proxy for the company’s true economic worth, so there’s a contradiction. I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett’s recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is “below Berkshire’s intrinsic value.”

Buffett publicly stated in his 2018 shareholders’ letter that over time, Berkshire is likely “to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.” From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company’s PB ratio was clearly higher than 1.2 and averaging around 1.4.

The risks involved

Succession is the biggest risk I’m watching with Berkshire. Buffett and Munger are both getting on in years – I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler. All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire’s culture.

I am confident in Buffett and Munger’s succession plan. But it remains to be seen whether Berkshire’s dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I’m watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion. For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there’s no upper limit to Mother Nature’s wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

The Good Investors’ conclusion 

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability. The conglomerate excels against my investment framework by having (1) the American Tailwind behind its back; (2) a diverse collection of excellent businesses; (3) a robust balance sheet and finances; (4) strong recurring revenues; (5) a great track record of growth; and (6) two brilliant leaders at its helm who have been there for decades – Warren Buffett and Charlie Munger – and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire’s business is in insurance) are two big risks for the conglomerate that I’m watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range. 

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.