Category: Investing Analysis

Most of you reading this would be familiar with Uniqlo.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Risks

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

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

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

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

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

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

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

Valuation

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

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

PayPal Holdings (NASDAQ: PYPL) is one of the 50-plus companies that’s in my family’s portfolio. I first bought PayPal shares for the portfolio in June 2016 at a price of US$38, again in November 2018 at US$83, and yet again in June 2019 at US$117. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with PayPal’s share price being around US$116 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 PayPal shares. 

Company description

PayPal was first listed in the US stock market in February 2002, but it was acquired by e-commerce site eBay just a few months later. The acquisition made sense for PayPal, as the company could tap on eBay’s larger network of users and gross merchandise volume.

Interestingly, PayPal outgrew eBay over time. Eventually, PayPal was spun off by eBay in mid-2015 through a new IPO. On the day of PayPal’s second listing, its market capitalisation of around US$47 billion was larger than eBay – and has since nearly tripled.

It’s likely that even for us living in Singapore, we have come across PayPal’s online payment services. But there is more to the company. PayPal’s payments platform includes a number of brands – PayPal, PayPal Credit, Braintree, Venmo, Xoom, and iZettle – that facilitate transactions between merchants and consumers (and also between consumers) across the globe. The platform works across different channels, markets, and networks.

PayPal recently added discount-discovery services for consumers to its portfolio. It announced a US$4 billion acquisition of Honey in November 2019 that closed earlier this month. According to PayPal, Honey “helps consumers find savings as they shop online.” Honey has around 17 million monthly active users, partners with 30,000 online retailers across various retail categories, and has helped its user base find more than US$1 billion in savings in the last 12 months.

PayPal’s revenue comes primarily from taking a small cut of its platform’s payment volume. This transaction revenue accounted for 90.3% of PayPayl’s revenue of US$12.8 billion in the first nine months of 2019. Other business activities including partnerships, subscription fees, gateway fees, service-related fees, and more (collectively known as other value added services) comprise the remaining 9.7% of PayPal’s net revenue. 

The US was PayPal’s largest country by revenue in the first nine months of 2019 with a 53.2% share. In a distant second is the UK, with a weight of 10.5%. No other single country made up more than 10% of the company’s net revenue.

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 PayPal.

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

PayPal’s business is in digital and mobile payments. According to a 2018 PayPal investor presentation, this market is worth a staggering US$110 trillion, as shown in the chart below. For context, PayPal raked in just US$17.0 billion in revenue in the 12 months ended 30 September 2019 based on US$676.2 billion (or just US$0.676 trillion) in payment volume that flowed through its platform.

Around 80% of transactions in the world today are still settled with cash, which means digital and mobile payments still have low penetration. This spells opportunity for PayPal. 

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

PayPal’s balance sheet looks rock-solid at the moment, with US$5.0 billion in debt against US$6.9 billion in cash, as of 30 September 2019. The picture is likely to change with the aforementioned US$4 billion acquisition of Honey, but we will only know when PayPal announces its 2020 first-quarter results (which should take place sometime in April this year).

I’m not worried though, because PayPal has a storied history of producing strong free cash flow which I’m going to discuss later.

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

On integrity

PayPal’s key leader is CEO Dan Schulman, who’s 61 this year. In 2018, the lion’s share of the compensation for PayPal’s key leaders (including Schulman and a handful of other senior executives) came from the following:

• Stock awards that vest over a three-year period
• Restricted stock awards that depend on the growth in PayPal’s revenue and free cash flow over a three-year period
• (Specifically for Schulman) Stock awards that depend on the performance of PayPal’s share price over a five-year period

PayPal’s compensation structure for its key leaders has emphases on free cash flow, multi-year-vesting for stock awards, and a dependence on the company’s long-term share price movement. I think this structure aligns my interests as a shareholder with the company’s leaders.

Moreover, PayPal requires its CEO and other senior executives to hold shares that are worth at least three to six times their respective base salaries. This results in skin in the game for PayPal’s leaders. As of 29 March 2019, Schulman himself controlled 719,297 PayPal shares that are collectively worth around US$80 million at the current share price; other members of the company’s senior management team each controlled around US$11 million to US$14 million worth of shares.

On capability and innovation

Some members of PayPal’s senior management team have relatively short tenures with the company, as illustrated in the table below. But together, they have accomplished plenty since PayPal’s separation from eBay.

First, the company has grown its network of users impressively since the spin-off. The table below shows how PayPal’s transactions, payments volume, and active accounts have changed from 2014 to the first nine months of 2019.

Second, PayPal has made a number of impressive acquisitions in recent years under Schulman. They are:

• Digital international money-transfer platform Xoom (acquired in November 2015 for US$1.1 billion). The platform’s money-transfer network covers more than 160 countries.
• iZettle, a provider of solutions to small businesses for the acceptance of card payments and sales management and analytics (acquired in September 2018 for US$2.2 billion).  PayPal acquired iZettle to strengthen its payment capabilities in physical stores and provide better payment solutions for omnichannel merchants. I believe that a retailer’s ability to provide a seamless omnichannel shopping experience is crucial in today’s environment. When iZettle was acquired, it operated in 12 countries across Europe and Latin America, and was expected to deliver US$165 million in revenue and process US$6 billion in payments in 2018.

Third, PayPal has been striking up strategic partnerships in many areas since becoming an independent company. The slides below from PayPal’s 2018 Investor Day event says it all: PayPal had no strategic partners when it was still under eBay!

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

I mentioned earlier that PayPal’s primary revenue source is payments that take place on its platform. And when I discussed PayPal’s management, I also pointed out that the company had processed 8.9 billion transactions in the first nine months of 2019 from 295 million active accounts (at the end of 2018, PayPal had 267 million active accounts, of which 21 million are merchants).

I think that these high numbers highlight the recurring nature of PayPal’s business. It’s also worth noting that there’s no customer-concentration: No single customer accounted for more than 10% of PayPal’s revenues in 2016, 2017, and 2018.

5. A proven ability to grow

PayPal returned to the stock market only in 2015, so I don’t have a long track record to study. But I’m impressed by what the company has.

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.” PayPal fits the bill. A few key things to note:

• Revenue has increased in each year from 2012 to 2018, and has compounded at a healthy clip of 18.2% per year.
• Net profit was always positive, and has increased by 17.6% per year.
• PayPal has not diluted shareholders too. Its 68% growth in net profit from 2015 to 2018 is similar to the 71% jump in diluted earnings per share (EPS) over the same timeframe. 
• Operating cash flow and free cash flow were always positive in each year, and the two important financial metrics have compounded at impressive annual rates of 23.2% and 28.1%, respectively. 
• PayPal’s operating cash flow and free cash flow in 2018 had enjoyed a one-time boost from the sale of the company’s US consumer credit receivables portfolio in July that year. But even after making the relevant adjustments, PayPal’s operating cash flow and free cash flow for the year would still be strong at US$4.1 billion and US$3.3 billion, respectively. 
• PayPal’s balance sheet was stellar throughout, given the high net cash position. 

PayPal continued to grow in the first nine months of 2019. Revenue was up 14.1% to US$12.8 billion, driving a 32.5% jump in net income to US$1.95 billion (diluted EPS grew 34.4% to US$1.64). Operating cash flow and adjusted free cash flow came in at US$3.3 billion and US$2.8 billion, respectively; adjusted free cash flow was up 25% from US$2.2 billion a year ago.

I see two notable traits in PayPal’s network: 

• PayPal has a global reach. It is able to handle transactions in over 200 markets, and allow its customers to receive money in 100 currencies, withdraw funds in 56 currencies, and hold PayPal account balances in 25 currencies.
• I believe PayPal’s business exhibits a classic network effect. Its competitive position strengthens when its network increases in size. When I discussed PayPal’s management earlier, I showed that the volume of payments and number of transactions increased faster than the number of accounts. This means that PayPal’s users are using the platform more over time – to me, this indicates that PayPal’s platform is becoming more valuable to existing users as more users come onboard.

I also want to point out two payment services providers that are in PayPal’s portfolio; I think that they are crucial for the company’s future growth:

• The first is mobile payments services provider Braintree, which was acquired in 2013 for US$713 million. Braintree provides the technological backbone for the payment tools of many technology companies, including ride-hailing app Uber, cloud storage outfit DropBox, and accommodations platform AirBnB. Braintree helps PayPal better serve retailers and companies that conduct business primarily through mobile apps.
• The second is digital wallet Venmo (acquired by Braintree in 2012), which allows peer-to-peer transactions. Venmo is highly popular among millennials in the US, and PayPal reported that there were more than 40 million active accounts for the digital wallet in 2019’s first quarter. During 2019’s third quarter, Venmo’s total payment volume surged by 64% from a year ago to US$27 billion (and up more than five times from just three years ago in the third quarter of 2016). The annual run rate of Venmo’s total payment volume has also now exceeded US$100 billion. Meanwhile, monetisation of Venmo has progressed at a rapid clip. The digital wallet’s annual revenue run rate in 2019’s third quarter was nearly US$400 million, double the US$200 million seen in 2018’s fourth quarter.

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

PayPal has excelled in producing free cash flow from its business for a long time, and has huge growth opportunities ahead. There’s no reason to believe these will change any time soon. 

Valuation

I like to keep things simple in the valuation process. In PayPal’s case, I think the price-to-free cash flow (P/FCF) ratio is a suitable gauge for the company’s value. That’s because the payment services outfit has a strong history of producing positive and growing free cash flow.

PayPal carries a trailing P/FCF ratio of around 38 at a share price of US$116, after adjusting for the one-time boost to the company’s free cash flow in 2018. This ratio looks a little high relative to history. For perspective, PayPal’s P/FCF ratio was only around 28 in the early days of its 2015 listing.

But I’m happy to pay up, since PayPal excels under my investment framework. 

The risks involved

There are six key risks I see in PayPal.

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

Second, there’s eBay’s relationship with PayPal. When the two companies separated, they signed a five-year deal – expiring in July 2020 – for PayPal to help eBay process payments. eBay announced in 2018 that it would not renew the deal when it expires (although PayPal will still be a payment-button on eBay’s site through July 2023). eBay accounted for 8% of PayPal’s total payment volume (TPV) in 2019’s third quarter. But PayPal’s management expects the percentage to fall to “well under 5%” by the end of 2020. eBay’s also a waning presence in e-commerce, so I don’t think it holds any importance to PayPal’s future growth. During 2019’s third quarter, PayPal’s total TPV (excluding currency movements) grew by 27% despite the 3% decline in eBay’s TPV (similarly excluding currency movements) on PayPal’s platform.

The third risk I’m watching is regulations. The payments market is heavily regulated. What PayPal can take per payment-transaction could be lowered in the future by regulators for various reasons.

The fourth risk concerns recessions. I don’t know when a recession (in the US or around the world) will occur. But when it does, payment activity on PayPal’s platform could be lowered. PayPal’s business was remarkably resilient during the last major global economic downturn in 2008 and 2009. Back then, eBay had no revenue-growth from its main e-commerce platform. But the segment that consisted primarily of PayPal produced strong double-digit revenue growth in both years. PayPal’s a much larger company today, so it may not be able to grow through a future recession that easily – but its historical track record is impressive.

The US$4 billion acquisition of Honey represents the fifth risk. I want to be clear: I like the deal and I think it will work out great. But it’s still a risk. Let me explain. Honey’s revenue in 2018 was over US$100 million, with growth of more than 100% –  and the company was already profitable. In a recent article, Ben Thompson from Stratechery shared how the acquisition can lead to upside for PayPal’s business:

“The most important effect, according to Schulman, was on PayPal’s relationship with consumers. Now, instead of being a payment option consumers choose once they have already committed to a purchase, PayPal can engage with consumers much higher in the purchase funnel. This might be one step higher, as would be the case with coupon search, but it could also be around discovery and calls-to-action, as might be the case with the app or notifications and price-tracking…

…Honey is also an intriguing way for PayPal to actually make money on Venmo in particular. Honey’s audience skews heavily female and millennial, which means there is a lot of overlap with Venmo, and there is a good chance PayPal can really accelerate Honey’s adoption by placing it within its core apps (which it plans to do within the next 6 to 12 months)…

…If PayPal, via Honey, knows exactly what you are interested in buying, and can make it possible for merchants to offer customized offers based on that knowledge, well, that may be a very effective way to not only capture affiliate revenue but also payment processing revenue as well. Demand generation remains one of the most significant challenges for merchants… And here the fact that PayPal has 24 million merchant partners versus Honey’s 30,000 is a very big deal.”

But Honey is PayPal’s largest acquisition ever, and the deal comes with a steep price tag of US$4 billion. Assuming Honey can grow its revenue by 100% in 2019, PayPal is effectively paying 20 times revenue for the discount discovery company. I will have to face a situation of PayPal writing down the value of Honey if the integration of the two fails to live up to expectations.

Lastly, I’m mindful of succession risk. PayPal’s CEO, Dan Schulman, is already 61 this year. Fortunately, PayPal’s key leaders are mostly in their mid-fifties or younger.

The Good Investors’ conclusion 

I think the transition from cash to cashless payments holds immense opportunities for companies. I also think a payment company with a wide network of consumers and merchants (PayPal, for instance) stands a good chance of being one of the eventual winners. 

Furthermore, PayPal has a robust balance sheet, a proven ability to generate strong free cash flow, high levels of recurring revenues, and an excellent management team whose interests are aligned with shareholders. PayPal’s P/FCF ratio is on the high end, but I’m happy to pay up for a top-quality business.

Every company has risks, and I’m aware of the important ones with PayPal. They include competition, regulation, and more. But after weighing the risks and rewards, I’m still happy to allow PayPal to be pally with 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.

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

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

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

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

Company description

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

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

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

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

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

I think Lululemon can do both.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4. Are its revenue streams recurring in nature?

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

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

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

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

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

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

5. Does Lululemon have a proven ability to grow?

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

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

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

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

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

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

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

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

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

Risks

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

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

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

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

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

Valuation

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

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

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

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

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

The Good Investors’ Conclusion

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

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

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

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

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

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.