Category: Investing Analysis

Not much has gone right for The a2 Milk Company recently. 

In its fiscal year 21 (FY21), which ended on 30 June 2021, the infant milk formula and fresh milk specialist suffered a 30.3% decline in revenue to NZ$1.21 billion from the previous financial year. Gross profit dropped even more, falling 47.4% to NZ$509.7 million, because of write-downs from inventory overload at resellers and a big decline in a2 Milk’s high margin English-label infant milk formula products.

And things are not likely to improve in the next fiscal year with management providing some bleak remarks on the overall outlook for FY22. 

As an investor with a vested interest in a2 Milk since July 2020, watching its share price slide 67% has, to put it mildly, not been a pleasant experience. The fact that the S&P 500 index has risen 47% over the same time makes it even more depressing.  

So what went wrong?

1. Flat industry growth

Although a2 Milk is a company based in New Zealand, the bulk of its revenue is driven by Chinese consumers. As such, China is a big part of its growth. But in FY21, the China infant milk formula market’s growth rate fall from a high level in previous years to flat year-on-year. Moreover, total infant milk formula volume declined.

Part of the reason was due to a decline in newborns in China. The chart below shows the number of newborns in China from 2015 to 2020 and the forecast for the next 5 years.

2. International brands losing market share

There is also a change in consumption patterns among Chinese parents. Local brands have been winning market share against multinational corporations over the past few years. The chart below shows the decline in market share among multinational corporations. 

From 2008 to 2018, Chinese consumers had a preference for international brands due to the 2008 Chinese milk scandal. In 2008, some Chinese suppliers added melamine to powdered milk to artificially boost protein levels. An estimated 54,000 victims were hospitalised and 50 babies died due to the contamination.

Understandably, Chinese mums lost confidence in local brands and began looking for alternative infant milk formulas from respected international companies. a2 Milk was one of the companies that benefited from this shift.

But with Chinese companies improving their products and finally regaining trust among consumers, local brands are starting to win back some market share in the last few years. In addition, there is a growing corner of the Chinese population who prefer to buy local brands simply because of rising patriotism in the country.  

a2 Milk’s marketing team has likely seen a surge in this consumer-group – the company felt a need to include them in its recent Investor Day presentation.

The two new types of customers that the company showcased – the “Value-seeker mum” and the “China Pride mum” – are both consumer-groups that prefer to shop for local brands.

3. Poor channel inventory management

a2 Milk sells its infant milk formula to China via (1) a Chinese-label brand that is sold in China and (2) an English-label brand that is sold in Australia to Daigous and directly to consumers through cross-border e-commerce. (Daigous are Chinese resellers who purchase goods abroad to bring back to China for re-sell to Chinese consumers.)

In FY20, around 58% of a2 Milk’s revenue came from its English-label brand, the bulk of which likely ended up with Chinese consumers via Daigous and cross-border e-commerce. 

But in FY21, it seemed like everything went wrong for a2 Milk for its English-label brand. During the year, its English-label infant milk formula revenue declined by a whopping 52.1%.

One of the major reasons for the decline was because resellers and Daigous had too much inventory. This was ultimately the fault of poor foresight and channel inventory management by a2 Milk’s previous management team. In essence, a2 Milk sold way too much inventory to Daigous and other resellers in the prior year who, in turn, could not move inventory fast enough as the COVID pandemic dragged on. As a result, the resellers and Daigous were left with ageing inventory and were forced to offer discounts to try to offload their expiring inventory.

Understandably, a2 Milk had to take initiative to reverse the situation and to stabilise pricing. First, the company offered to write down some of its reseller’s old inventory and even swapped out some of its distributors’ inventory. The company also restricted sales in the fourth quarter of FY21 to stabilise pricing and improve inventory flow. 

All these actions resulted in lower sales for its English-label brand, lower margins due to write-offs and expensive swapping of products to resale channels, and a loss in market share in both cross-border e-commerce and Daigou channels.

What’s in store in the future?

Over the past fiscal year, a2 Milk’s management had to lower the company’s forecast for the year multiple times as some of the above factors seemed to have blindsided them. I think the company’s current management team has learnt a hard lesson and has declined to give specific guidance for the next fiscal year. However, it did provide an update to say that the first half of the year is going to be choppy.

In its trading update, a2 Milk said that its China-label infant milk formula sales are expected to be “significantly down” the first half of FY22 versus the comparable period in FY21. The company also said that its English-label infant milk formula sales are expected to be down in the first half of the fiscal year. 

But can a2 Milk turn things around in the medium to long term?

In a2 Milk’s recent Investor Day event, a number of the company’s C-suite executives came together to explain their plan for the next few years. 

1. Medium-term goal to hit NZ$2 billion in annual revenue

Management has set a target of achieving NZ$2 billion in revenue in five years. This is a 66% increase from FY21, but just 15.6% above a2 Milk’s peak revenue in FY20. As an investor who first gained exposure to the company just before things turned sour, I was hoping for more lofty ambitions by the company. But this is a start. The company provided this chart to show the areas they are targeting to achieve this goal.

From the chart, we can see that management is targeting broad-based growth across its current core geographies and to enter into emerging markets such as Southeast Asia.

Management also mentioned that they are targeting an EBITDA margin in the low to mid-twenties range. This is significantly lower than the 31% EBITDA margin achieved in FY20, but higher than the meagre 10% margin seen in FY21. The margin outlook is slightly disappointing, given the heights a2 Milk reached in FY20. But it is understandable as the high-margin English-Label brand is not expected to hit the highs of yesteryears in the next five years. The bulk of revenue growth will come from the lower margin China-label brand.

2. Chinese-label brand initiatives

To achieve their NZ$2 billion revenue target, a2 Milk’s management is targeting to double the company’s Chinese-label brand sales in China from NZ$390 million to NZ$800 million. The Chinese-label brand has been one bright spot for the company in FY21. While all other segments declined, the Chinese label brand grew in FY21 and won market share via both offline channels through its distribution network of mother & baby stores in China as well as direct online channels.

There are a few key ways to drive growth.

First, the company is looking to win market share in lower-tier cities where it is under-indexed. Lower-tier cities make up 84% of the total sales value of China’s infant milk formula market but only 61% of a2 Milk’s sales come from these lower-tier cities.

In fact, there is a large dispersion in market share between a2 Milk’s market share in upper-tier cities and lower-tier cities. In upper-tier cities, the company holds a 5.8% market share from mother and baby stores but in lower-tier cities, the company only commands a share of 1.8%. 

There is a lot of room to grow in these cities and the company plans to increase its mother and baby store footprint in these areas. At the moment, a2 Milk’s products can be found in 18% of mother and baby stores, which account for 38% of total infant milk formula sales.

To win market share in lower-tier cities, the company is planning to get its product on the shelves of more mother and baby stores. The target is to be in enough mother and baby stores in China such that these stores, in aggregate, account for 50% of total infant milk formula sales in China.

In addition, there seems to be room for a2 Milk to grow its direct online channels.

Around 81% of the Chinese-label brand sales came from mother and baby stores compared to just 19% from direct online channels. While the online channels did grow by 18% from a year ago, there is still room to expand as other brands drive much more sales from online channels. The graph below on the right shows that a2 Milk’s direct online sales for its Chinese-label brand makes up only 19% of the total sales of its Chinese-label, much lower than other international players.

The key to driving direct online commerce growth is brand awareness. a2 Milk is planning to invest more in digital marketing, which should improve brand awareness in important online channels such as Tmall and JD.com.

Lastly, the company is planning to expand its product portfolio to increase its customer reach. It only has a single China-label brand that is in the ultra-premium range, the highest category for infant milk formula. To reach more consumers, a2 Milk wants to have a variety of brands at lower price points.

3. English-label brand recovery plan

As mentioned earlier, the English-label infant milk formula was the hardest hit in FY21. The pandemic affected commercial Daigou businesses hard and they ended up with excess inventory on their hands.

As Daigou lost momentum, the cross-border e-commerce channels were also hit as Daigous previously acted as social influencers who promoted a2 milk infant formula sales online too. Moreover, the shift toward local brands in China has likely led to both a near and medium-term impact on the popularity of a2 Milk’s English-label brand.

Although the company tried to paint a picture of recovery for the English-label brand, it seems like years will be needed before the brand reaches its glory days of yesteryears. a2 Milk is targeting to win back merely NZ$300 million in revenue in the medium term. For perspective, in FY20, the English-label infant formula revenue was NZ$1,081 million. The company is now targeting annual revenue of just NZ$820 million after five years. 

Still, a2 Milk outlined some initiatives to win back sales. The first is to increase reseller support by upgrading brand awareness and to try to place English-label products in offline channels as a “showroom” for the brand.

Better inventory management should also better support prices over the longer term. And lastly, management highlighted an opportunity to expand its English-label infant milk formula portfolio. Like the Chinese-label brand, a2 Milk only has a single brand of infant milk formula at the premium to super-premium category. Expanding the product portfolio can allow a2 Milk to capture a greater portion of the market.

4. Diversifying to new products and geography

Another initiative mentioned was the opportunity to expand the a2 brand. The company is looking to leverage the a2 brand to launch new products. In October 2020, the company launched UHT in China with some success.

In addition, a2 Milk has already expanded into other geographies such as Canada and South Korea recently. There has been some success in South Korea too where the company started selling in December 2019. Monthly infant milk formula volume has steadily increased since then, albeit from a low base.

a2 Milk has also prioritised Vietnam, Indonesia, Malaysia, and Singapore as expansion opportunities, targeting NZD$100 million in sales from the growth of these new markets over time.

5. Growing the ANZ and USA liquid milk market

I won’t spend too much time on these initiatives as ANZ (Australia/New Zealand) is a mature market and the room for growth here is limited. Meanwhile, the USA is still a small market for a2 Milk. Between the two countries, the company hopes to grow revenue by around NZ$200 million in the medium term through market share wins by expanding its footprint in the USA and increasing its product portfolio there. 

The bottom line: Uncertainty ahead

Shareholders of a2 Milk have been taken on a wild ride in the past few years. The company’s share price climbed from just A$2.00 five years ago to A$19.83 at its peak in 2020 as the company grew revenue quickly from FY16 to FY20. But the past year has been tumultuous for a2 Milk as its share price has since dived to less than A$6.50.

It seems like whatever could go wrong for the company in the last year has gone wrong.

But there are still a few bright spots worth highlighting. First, the company is financially robust and is still generating positive free cash flow despite the fall in revenue and profits.  As of 30 June 2021, a2 Milk had NZ$875 million in cash and short-term deposits, equivalent to about 18% of its current NZ$ 5 billion market cap.

Management has outlined what seems to be a sensible plan to get the company back on firmer footing. The Chinese-label brand also seems to be doing well and is winning market share against the larger trend of international brands losing market share to local players.

Moreover, if a2 Milk reaches its goal of NZ$2 billion in revenue and margins in the mid-twenties range, I believe its share price will rebound strongly. But that’s still a big if.

There are still many unknowns going forward and the company is in unprecedented territory at the moment. Although a2 Milk has overcome challenges in the past, its future remains littered with uncertainty. 

I’m expecting another rough interim report for FY22 and will be keeping an eye on further company updates throughout the year.

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. Of all the companies mentioned, I currently have a vested interest in The a2 Milk Company. Holdings are subject to change at any time.

I first wrote about Twilio in this blog in January 2020. Since then, Twilio’s stock price is up by more than 150%. Although Twilio is a big winner over that time frame, its stock price did fall by more than 17% last Thursday (28 October 2021), a day after it announced its 2021 third-quarter earnings report.

With the recent dive in its price, I think Twilio’s shares are back at a valuation that could give joy to the long term shareholder.

What the numbers say

The headline numbers for Twilio in the recent report were actually really solid. Revenue rose 65% year-over-year to US$740 million. Organic growth, which excludes one-off revenue and revenue from recent acquisitions, was a solid 38%. On a quarter-on-quarter basis, Twilio’s core business also grew by 2.7%. 

The dollar-based net expansion rate, a metric that shows how much more existing customers spent on Twilio’s core business, was 131%.

This is clearly a company that is still growing. For the fourth quarter of 2021, management expects revenue of between US$760 million and US$770 million, implying year-on-year growth of around 45% to 47% after excluding one-off traffic in the year-ago period that’s related to the US presidential elections.

More importantly, Twilio’s management is still very confident of its long-term prospects. Twilio’s current CFO and new COO, Khozema Shipchandler, shared the following during the latest earnings conference call:

“When we look to 2022 and beyond, we remain very confident about our ability to deliver 30%+ annual revenue growth over the next three years.

Overall, we delivered very strong results in the third quarter, and we are well positioned for a strong close to the year. We’re excited about the large opportunity ahead as we continue to help companies around the world and across industries reimagine their customer engagement.”

Lapping its Segment acquisition

Twilio has also made important acquisitions in the last couple of years. Segment, a customer data platform that helps organisations collect, clean, control, and organise their customer data, is one of Twilio’s key acquisitions in the past year.

Segment is growing even faster than Twilio’s core business. In the third quarter of 2021, Segment delivered US$52 million in revenue, up an impressive 12% sequentially. If Segment can keep that up, it will be growing revenue at more than 50% annually. 

Twilio does not include Segment in its calculation of organic growth as Segment was only acquired in late 2020. But by the first quarter of 2022, Segment will be included in the organic growth contribution and should accelerate Twilio’s organic growth starting next year.

International growth

Twilio’s business outside of the US is also growing significantly faster than in the US, a good sign that Twilio is gaining traction beyond its core markets. International revenue in the third quarter of 2021 contributed 33% of revenue, up from just 27% in the third quarter of 2020.

I think Twilio’s growth outside of the USA is a testament to the company’s execution in its go-to-market strategy internationally.

As Twilio’s international revenue scales, it should become a bigger driver of growth for the company over the long term.

Valuation

Despite strong third quarter results, Twilio’s stock price plummeted, as I mentioned earlier. Although I can only speculate on the reasons, I believe the lower organic growth projection for the fourth quarter, and the low sequential growth in the third quarter, are the main culprits for the sell-down. The announcement – released concurrently with the earnings report – that Twilio’s long-time executive, George Hu, would be stepping down as COO, may also have been one of the factors. 

These said, the sell-off has made Twilio shares much more attractive. Twilio now trades at a market cap of around US$50 billion. The customer engagement company has a revenue run-rate of US$3 billion (based on the revenue for the third quarter of 2021) and thus trades at around 17 times annualised revenue.

Twilio’s management is projecting revenue growth of at least 30% per year over the next three years. At the low end of the forecast, this should already lead to revenue more than doubling to US$6.6 billion by the last quarter of 2024. 

Given its gross margin of around 57%, I think Twilio can achieve a steady-state free cash flow margin of around 20% eventually. And as a high-growth software company, I expect Twilio to trade at more than 50 times normalised free cash flow by then, which should give it a market cap of more than US$65 billion.

Bear in mind that these numbers above are based on 30% annual revenue growth, which is at the bottom of management’s expectations. I believe Twilio should grow even faster than 30% as Segment is growing at 50% and Twilio’s core business dollar-based net expansion rate is still above 130%. 

In addition, the market can easily give Twilio a much larger valuation multiple if Twilio is still projecting healthy growth then.

Final thoughts

With the recent drop in Twilio’s share price, the stock looks attractive again. Jeff Lawson, the founder and CEO of Twilio, is a great operator and technical leader and appears to be skillful with capital allocation. For instance, he has made excellent decisions to grow the company through astute acquisitions and to integrate these services with its core offering (Segment is a good example).

Lawson described his vision for the company in the recent earnings conference call:

“The customer journey is a conversation, from when a customer first meets a company, all the way through becoming a customer, buying, repeat buying, returning, getting support or whatever else the customer needs. All of that is one conversation between the customer and the company. Our platform provides the tools for companies to manage every part of that journey, with Twilio Engage, Frontline, Messaging X, Flex and more. One conversation on one platform to unlock endless possibilities. That’s the Twilio customer engagement platform.”

Given this vision, I think Twilio is in the early innings of its long-term mission and should be able to grow for years to come.

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. Of all the companies mentioned, I currently have a vested interest in Twilio. Holdings are subject to change at any time.

When news that Manchester United re-signed Cristiano Ronaldo broke a few weeks ago, the football club’s stock price climbed by 10% in just a few hours.

As a big football fan, this got me curious on the economics of a football club. I decided to do some research to find out if a stock like Manchester United (NYSE: MANU) is really worth considering.

This article is about what I found out. For full transparency, I should state that I am a Liverpool fan. But don’t worry, I didn’t let that influence (I hope) my analysis of Manchester United’s stock. So let’s begin.

How Manchester United and other football clubs make money

Football clubs like Manchester United boast a huge and international fanbase. The fans are the reason behind the club’s ability to generate hundreds of millions of pounds in revenue. Football clubs earn money directly from fans by selling merchandise to these fans.

The fans are also what drive the commercial appeal of a football club. Sponsors pay tens of millions of pounds to have their logo on Manchester United’s kit. This makes sense, as sponsors know that fans will be watching the team play and having their brand on a big-name club like Manchester United is a great avenue for brand marketing.

Manchester United also competes in some of the biggest football competitions in the world, which fans around the world want to watch. These competitions -such as the Premier League and the UEFA Champions League – negotiate massive broadcasting deals with broadcasters. Some of the money from these broadcasting deals are distributed to the football clubs who play in these competitions. 

Lastly, clubs also earn from matchday revenue, which are derived from ticket and other matchday-related sales to attendees. Old Trafford, Manchester United’s fully-owned stadium, can seat 74,140 fans and is one of the largest football club stadiums in the United Kingdom. In the pre-COVID days, Old Trafford was consistently 99% full during matchdays. 

The chart below shows the revenue breakdown of Manchester United in the financial year ended 30 June 2020 (FY2020).

Costs of running its business

With its massive fanbase, and as one of the most popular clubs not just in the UK but across the globe, Manchester United has no problem generating revenue year after year. But the cost of running a club like Manchester United is the real sticking point if you are looking at it as an investor.

In order to remain a competitive football club and to win fan appeal, the club has to spend significant dough to sign the top (and most marketable) players. Buying a player from another club can cost tens of millions, and even hundreds of millions, of pounds. In addition, in order to retain and attract talent, Manchester united needs to pay highly sought-after players extremely competitive wages that can go up to hundreds of thousands of pounds a week.

In FY2020, Manchester United’s wages and other employee benefit expenses amounted to a staggering £284 million, or 55% of revenue.

On the income statement, money spent on acquiring players is not immediately recorded as an expense. Instead these expenses are capitalised on the balance sheet and amortised over time, which can significantly distort the profitability of the club. Player sales may also artificially distort operating profits for a particular year. As such, I prefer to look at the cash flow statement to see if Manchester United has been able to generate a growing stream of cash flow over the years. The chart below shows Manchester United’s free cash flow from FY2015 to FY2020.

To calculate free cash flow, I took operating cash flow and deducted capital expenses (the bulk of it is for stadium upkeep) and the cost of player purchases, and added back the amount earned from player sales.

From the chart, we can see that Manchester United’s free cash flow can be fairly unpredictable. This is due to the unpredictability of player purchases and player sales.

Another wildcard is that the club’s operating cash flow is also not stable as some of the broadcasting revenue from certain competitions depends on the club’s progress in these competitions. This creates a further degree of uncertainty. For example, during the 2017/2018 season, Manchester United exited the Champions League in the group stages, which resulted in lower operating cash flow for the year.

To make matters more complicated, Manchester United is also not guaranteed entry into the UEFA Champions League each year – entry into the tournament largely depends on the club’s position at the end of the season in the Premier League. The UEFA Champions League is a major source of revenue for the club. During the 2019/2020 season, on top of a loss of matchday revenue because of COVID, Manchester United also did not qualify for the Champions League and only played in the Europa League, which resulted in lower revenue and operating cash flow.

Balance sheet

Due to the unpredictable nature of a football club’s cash flow, I believe its balance sheet needs to be fairly robust.

Unfortunately, Manchester United again seems thin in this area. The club ended 31 March 2021 with £443.5 million in net debt consisting of around £84.7 million in cash and £528.2 million in debt. Throw in the amount Manchester United paid in July and August this year for signing a few star footballers in Cristiano Ronaldo, Jadon Sancho, and Raphael Varane, and the club’s net debt likely has increased further.

Although the signing of Ronaldo should bring in more commercial revenue for Manchester United, the club’s financial standing still seems risky, given the high cost of running a football club and the unpredictable nature of its cash flow.

My thoughts on Manchester United as an investment

Owning shares of a football club like Manchester United may seem like a novelty and a great conversation starter. But the unpredictability of its business makes it an unappealing investment to me.

The club is in a constant struggle to balance profitability and keeping the fans happy. But its profitability and its fans are inextricably linked as fans are the main reasons for the club’s commercial success in the first place. Upset this balance and the empire comes crashing down.

From a valuation perspective, Manchester United currently has a market cap of around £2.08 billion. To me, this doesn’t seem cheap. In the six years ended 30 June 2020, the club only generated a cumulative £53.3 million in free cash flow or an average of around £8.9 million per year. This translates to a price-to-average free cash flow ratio of 225.

In the nine months ended 31 March 2021, the club had negative free cash flow of £10.9 million. And given the recent player purchases of Ronaldo, Sancho and Varane, I think it will end the year with even more cash burn. 

Although there is always the possibility that a rich businessman may offer a premium valuation to take the club private simply for the media publicity and the novelty of owning a club like Manchester United, the numbers from a business perspective are not appealing. Although I’m a huge football fan, I’m definitely not a fan of investing in Manchester United.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in the shares of any company mentioned. Holdings are subject to change at any time.

In an April 2020 article published in this website, I named Sembcorp Marine Ltd (SGX: S51) as a company that could face a liquidity crisis. 

I wrote,

“Another one of Temasek’s investments, Sembcorp Marine could face a similar fate to Singapore Airlines. Sembcorp Marine is highly dependent on the health of the oil industry and faces major disruptions to its business amid tumbling oil prices (oil prices are near 20-year lows now). 

Like Neo Group, Sembcorp Marine has more short-term debt than cash on its balance sheet. That’s extremely worrying given that credit may dry up during this trying time. As of 31 December 2019, Sembcorp Marine had S$389 million in cash and a staggering S$1.42 billion in short-term borrowings. In addition, the company had S$2.98 billion in long-term debt.

And let’s not forget that Sembcorp Marine also has heavy expenses. In the quarter ended 31 December 2019, Sembcorp Marine racked up S$29 million in finance costs alone and also had a negative gross margin. The company also spends heavily on capital expenditures just to maintain its current operations. Sembcorp Marine was free cash flow negative in 2019 after spending S$316 million in capital expenditures.”

Surviving but at what cost?

Back then, it was pretty clear to me that Sembcorp Marine was in a fight for survival. The company was bleeding cash and had more than a billion dollars in debt to pay in the next 12 months. It didn’t have enough cash on hand to repay its borrowings and was also facing heavy ongoing operational expenses. 

True enough, my guess that Sembcorp Marine would go down the same route as Singapore Airlines has played out. In the year and a quarter since my article, the company has raised a significant amount of cash through two rights issues, massively diluting shareholders. 

On 2 September 2020, Sembcorp Marine closed its first rights issue, raising S$2.1 billion and at the same time, increasing its number of shares outstanding from 2 billion to 11.4 billion. Sembcorp Marine used S$1.5 billion to pay off debt and the rest to shore up its balance sheet but it also diluted existing shareholders massively. Even shareholders who bought up their full allotment of the rights issue would have suffered painful shareholder value destruction.

But this was not the end of it. On 24 June 2021, the company proposed to raise an additional S$1.5 billion through another rights issue of up to 18.8 billion shares. The full allotment will definitely be filled as DBS has underwritten a third of the shares and Sembcorp Marine’s major shareholder, Temasek (one of the Singapore government’s investment arms), has agreed to take its full allotment and any remaining rights. This second rights issue will increase the share count by another 150%.

When the dust eventually settles, the total number of shares outstanding would have risen from around 2 billion before the first rights issue to slightly more than 31 billion. That’s a staggering increase of more than 1,400%. Put another way, initial shareholders who owned the “original” 2 billion shares used to own 100% of the company. Today, these shares represent just under 7% of the company.

A tanking stock price

Unsurprisingly, the market has reacted appropriately to the massive dilution of Sembcorp Marine’s shareholders. Since I first wrote about Sembcorp Marine in April 2020, its share price has plunged by 72% from 33 cents per share to 9.3 cents per share. 

Shareholders who bought into the first rights issue at 20 cents per share are already down more than 50% on that investment, even though the rights were priced at a discount to the “theoretical ex-rights price” back then.

And even after raising a combined total of S$3.1 billion through the two rights issues, Sembcorp Marine still has more debt than cash and is still facing the same old story of cash flow issues.

In the first half of 2021, the company, even with significant one-off working capital tailwinds, had a net cash outflow from operations of S$1.9 million. Excluding working capital changes, Sembcorp Marine had negative operating cash flow of S$479 million. Throw in the capital expenditure of S$23.7 million for the period to maintain operations, and the company is still burning significant amounts of cash.

Though the balance sheet is less leveraged now, the company is still not out of the woods yet. If things don’t turn around operationally, don’t be surprised to see another round of cash injections.

Learning points

Just because a company is “too important to fail” doesn’t mean that shareholders will not face crippling losses. Although Sembcorp Marine seems to be a strategic asset that Temasek will continue to support, survival doesn’t mean shareholders are saved. On the contrary, while the company is in better shape today than in 2019, its shareholders are much worse off.

There were clear red flags for investors. Sembcorp Marine’s worsening free cash flow generation, poor near-term liquidity, and dependence on external factors that were beyond the company’s control (such as oil price movements) were major warning signs that investors should have been looking out for. 

I feel for Semcorp Marine shareholders who have lost a chunk of their investment. But this episode also serves as an important lesson and a handy reminder on what red flags to look out for and how to avoid the next investing mistake.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently do not have a vested interest in any shares mentioned. Holdings are subject to change at any time.

Amazon.com Inc (NASDAQ: AMZN) and Tesla Inc (NASDAQ: TSLA) are two closely watched companies by the investment community. I also happen to have investment exposure to the both of them. 

For the first six months of 2021, the two companies reported relatively poor free cash flows. Amazon reported negative free cash flow and Tesla’s free cash flow margin, while much higher than in the past, was still just 4% of revenue.

Although the free cash flow numbers for both companies may seem disappointing at first, there are signs that point to significant margin expansion in the future. To understand why, we need to know the difference between maintenance and expansion capital expenditure.

Two types of capital expenditures

Free cash flow is calculated by deducting capital expenditure from cash flow from operations. 

Capital expenditure is cash spent on assets that will only be expensed in the future. 

I broadly classify capital expenditure into two categories: Maintenance and expansion. Maintenance capital expenditure is money that is spent on assets to replace existing infrastructure to maintain a company’s current operations. Expansion capital expenditure is cash spent on new assets to expand the business.

In any given period, I monitor whether a company’s capital expenditure is mostly maintenance or expansionary in nature. If it’s the latter, then the company can improve its free cash flow margin when expansion works are complete. Amazon and Tesla both fall into this category.

Amazon 

Amazon reported a negative US$0.3 billion in free cash flow in the second quarter of 2021. It also reported a negative US$8 billion in free cash flow in the first quarter of 2021.

This resulted in an ugly-looking trailing twelve-month free cash flow profile that dropped to US$12 billion from US$32 billion a year ago. The disappointing free cash flow numbers were largely due to a significant increase in capital expenditure to US$47 billion from just US$20 billion a year ago.

These figures may look concerning at first but the reality is different. Amazon’s capital expenditure was mostly for expanding its fulfilment network and growing its cloud computing business, Amazon Web Services (AWS). In Amazon’s latest quarterly filing, the company explained:

“Cash capital expenditures… primarily reflect investments in additional capacity to support our fulfilment operations and in support of continued business growth in technology infrastructure (the majority of which is to support AWS), which investments we expect to continue over time.”

In addition, Amazon’s free cash flow was also impacted due to fluctuations in working capital needs which I believe are non-recurring in nature. 

Tesla 

Similarly, Tesla’s free cash flow looks set to improve after it completes its expansion phase. Tesla is in the midst of building two new production factories in Texas, USA and Berlin, Germany. The company is also expanding its factory in Shanghai, China. These expansion programs involve significant capital expenditure but will lead to higher production capacity for Tesla in the future. Tesla wrote in its recent quarterly filing:

“Cash flows from investing activities and their variability across each period related primarily to capital expenditures, which were $2.85 billion for the six months ended June 30, 2021, mainly for construction of Gigafactory Texas and Gigafactory Berlin and expansion of Gigafactory Shanghai and $1.00 billion for the six months ended June 30, 2020, mainly for Model Y production at the Fremont Factory and construction of Gigafactory Shanghai and Gigafactory Berlin.”

From an operational point of view, Tesla is, in fact, handsomely cash flow positive already. In the first six months of 2021, Tesla reported US$3.77 billion in operating cash flow from US$22.3 billion in revenue, good for a 17% operating cash flow margin.

As Tesla scales and its expansionary capital expenditure become a smaller percentage of revenue, I believe that its free cash flow margin will likely approach 10% or even more.

Closing thoughts

Although the amount of free cash flow produced by a company may be a good broad indicator of the company’s performance, the devil is in the details. For both Amazon and Tesla’s case, free cash flow has been disappointing in recent times but I think in the long-run both companies look set to increase their free cash flow significantly

Amazon is spending heavily on expanding its e-commerce fulfilment network and its AWS infrastructure and its working capital requirements have increased significantly, which sets it up nicely for growth.

Similarly, Tesla’s free cash flow has been low due to significant spending on building new factories and expanding existing ones. Although I expect Tesla to continue building new factories in the future, the company will eventually reach a point of significant scale where expansion capital expenditure become a much smaller drag on free cash flow.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Amazon.com Inc and Tesla Inc. Holdings are subject to change at any time.

Netflix Inc (NASDAQ: NFLX) may have disappointed some shareholders with its most recent earnings report for the second quarter of 2021. Although the streaming giant added 1.5 million net new subscribers in the quarter, slightly above its own forecast of 1 million, its forecast for the next quarter missed consensus estimates.

Analysts had expected to see 5.86 million net new subscribers in the third quarter of 2021 but Netflix’s own forecast was for 3.5 million net new subscriber additions.

The year-to-date and forecasted net subscriber additions in 2021 has significantly slowed compared to yesteryears too. The chart below shows Netflix’s year-to-date net subscriber additions per year for 2017 to 2021.

Some investors may also be concerned that Netflix’s subscriber growth in North America may have hit a brick wall as Netflix lost around 430,000 subscribers in that region. 

Should long-term shareholders be concerned?

On the surface, it does seem worrying that Netflix’s subscriber growth has been slowing but there is a flip side to the story.

Netflix cited a few reasons for the slower growth so far this year. The first is due to the pull-forward of new subscribers in 2020. During the COVID-induced lockdown in 2020, there was a huge spike in net subscriber additions as people looked for new forms of entertainment. Consequently, some subscribers who may have joined in 2021, ended up starting their subscriptions in 2020.

In addition, Netflix’s subscriber growth typically coincides with the marketing that’s done in line with new content releases. COVID-related production delays in 2020 led to a lighter slate of content releases in the first half of 2021.

As such, Netflix’s slower subscriber growth in 2021 may be a one-off, with subscriber growth potentially accelerating again in the future.

It is also worth mentioning that the company’s North America net subscriber count has declined in the past. In the second quarter of 2019, Netflix lost 0.1 million subscribers from the region but since then, it has added nearly 7.5 million net subscribers, showing that it is possible that the region could still surprise on the upside.

Huge addressable market

I also think it’s worth mentioning that streaming is still a relatively new phenomenon and Netflix and other streaming companies are still in the early days of disrupting cable TV. During Netflix’s earnings video interview for the second quarter of 2021, its chief financial officer, Spencer Neumann, said:

“We are roughly 20% penetrated in broadband homes, and we talked on the last call that there’s 800 million to 900 million either broadband or pay-TV households around the world outside of China. And as we continue to improve our service and the accessibility of our service, we don’t see why we can’t be in all or most of those homes over time if we’re doing our job. And then, if you look at the range from an APAC region where we’re only roughly 10% penetrated, so clearly early days”

Netflix also announced that it will be adding games to its service. This will increase the value of a Netflix subscription and give it the pricing power to slowly increase membership prices.

Reaching operating leverage

And there is another positive that shareholders should be pleased about.

Although Netflix has been profitable accounting-wise in the recent past, its higher year-on-year spending in content has resulted in significant cash burn. This is set to change. During its latest earnings conference call, Netflix reiterated its stance that it will be free cash flow neutral for 2021, showing that it has reached sufficient scale to internally fund its own content slate. Any additional membership growth from here should incrementally add to its free cash flow margin.

In fact, Netflix has been so confident about its cash flow position that it repurchased 0.5 million shares in the second quarter of 2021.

Final words

Although Netflix’s forecast for the third quarter of 2021 fell short of expectations, there is still much to like about Netflix as a company and an investment. 

Not only is the content slate for 2022 looking bright, but Netflix is also starting to see signs of positive cash flow and operating leverage. Any incremental growth in revenue should start to generate free cash flow. 

Given the huge addressable market, new content in the latter half of 2021 and in 2022, and the launch of its gaming service, I think the likelihood of Netflix reaccelerating its net new subscriber additions seem highly probable.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Netflix Inc. Holdings are subject to change at any time.

Tech stocks have taken a pummeling this month so far. If you’re a long-term holder of tech stocks and are feeling the pinch, you’re not alone.

Some of the tech stocks that I have a vested interest in have nosedived too.

For some of the companies that I have a stake in, the chart below shows how far off their recent highs their share prices are as of 14 May 2021.

It’s clear that the companies above have experienced sharp falls in their share prices from recent highs. The most prominent is Teladoc, which provides telehealth-consultation services – its share price has fallen by more than 50% from its peak.

But as a long-term investor, I am prepared to hold through these drawdowns. As long as I think that the stock can appreciate meaningfully over the longer term, I would not want to sell.  

To me, what’s more important is that the stocks are cheap in relation to their long-term fundamental growth potential – which I think is the case.

In fact, with the recent drop in tech stock prices, many of our portfolio companies now trade at what I think is “value” territory.

Valuations

The table below shows the recent revenue growth of the same 12 stocks in the earlier chart.

Although the share prices of the companies listed above have fallen through the roof, their businesses have actually been growing rapidly.

Revenue growth for the most recently reported quarter was between 26% (Tencent) and 369% (Zoom). Although market participants are expecting a growth-deceleration going forward as comparisons start to become more difficult in the latter part of 2021, the recent revenue-growth numbers do speak to the solid execution of the aforementioned companies.

Even with the difficult comparisons going forward, many of these companies are still expecting double digit growth for this fiscal year.

Moreover, given the tailwinds in many of the industries that these companies operate in, I expect most, if not all of them, to continue to compound revenue at upwards of 20% per year for years.

After the recent tech sell-off, these stocks are also trading at much more palatable valuations. The chart below shows the price-to-sales ratios of the 12 companies.

The trailing price-to-sales ratios of the 12 companies have declined, as share prices have fallen while revenue has grown.

The current multiples look attractive to me, given the tailwinds behind the companies listed above. I won’t go into too much detail here on why I think these multiples make sense now but you can have a look at an article I wrote on price-to-sales valuations to get a better idea of my thought process.

What matters

Volatility is part and parcel of investing.

Rather than worry about drawdowns, I prefer to monitor a company’s fundamentals to see if it can recover. Based on what I’ve seen so far, the companies that I have a vested interest in (the 12 companies listed above are not exhaustive) may have seen their share prices fall, but their business fundamentals remain solid.

Even when they were at their recent highs, I felt that these stocks would be worth much more in a decade’s time. Today, as prices have fallen from their peaks, they can provide even more long-term upside potential.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Mercado Libre, Tesla Inc, Tencent Holdings, Zoom Video Communications, Wix.com, Afterpay, Shopify, MongoDB Inc, Sea Ltd, Okta Ltd, The Trade Desk and Teladoc Health Inc. Holdings are subject to change at any time.

Earlier this week, Singapore Press Holdings Limited (SGX: T39) announced a proposal to spin off its media business. The media business involves the publishing of newspapers, magazines, and books and one of the key newspapers is The Straits Times.

I’m not an SPH shareholder. But if I was, I’d be infuriated with SPH’s plan.

Unlike normal spin-offs or sales, SPH shareholders will not get a stake in the media business that is spun off, nor will SPH get cash from the deal. Even worse, SPH is proposing to “donate” cash and shares to the new entity. That’s adding insult to injury for SPH shareholders.

While true that SPH’s media business has been on the decline, its media arm was still profitable up to FY2020 (financial year ended 31 August 2020) and recorded only its first full-year loss that year. More importantly, the media business holds valuable assets that could be sold off instead of “given away” for free.

In its investor presentation on its proposal, SPH said that its net asset value will drop to S$3.36 billion from S$3.60 billion after the restructuring. 

Effectively, SPH will be “giving away” S$238 million for free to this spun-off entity and shareholders will get nothing in return. This includes S$80 million in cash, S$20 million in SPH REIT units (23.4 million units), and S$10 million in SPH shares (6.9 million shares) that SPH is proposing to “donate” to the new spin-off.

In fact, of the S$238 million that SPH will lose in net asset value, S$237 million are in the form of tangible assets recorded on the books. Some of the assets that the company wants to “give away” include the SPH Print Center and SPH News Center that still have 13 years and 10 years remaining on their leases, respectively. These are valuable tangible assets that could be sold.

Let’s not forget that The Straits Times and all its other media brands hold intangible brand value that is not reflected on SPH’s balance sheet too. I would assume that a strategic buyer would have to pay a premium over tangible assets to acquire SPH’s media business.

And although the media business made losses in FY2020 and the first half of FY2021, proper management and the right strategies could potentially salvage the business by enhancing its digital revenue streams further. This is best showcased by other major foreign news outlets such as The Washington Post which Jeff Bezos turned around with a digital strategy after acquiring it in 2013.

Yes, I understand that The Straits Times is an important national newspaper that needs to be tightly regulated. But this restructuring deal is completely unfair to SPH shareholders.

Even though SPH is marketing the restructuring as a good thing as it is removing “dead weight” from the business, I’m not sold. And judging by the sell-off after the announcement – a 15% decline in SPH’s share price on the day after the proposal was released – it seems market participants aren’t either. The reality is that SPH’s media business can be sold, instead of given away.

Giving away money and shares for free is just rubbing salt in the wound for SPH shareholders, some of whom are retail investors who have stuck by the company for years. 

If I was a shareholder of SPH, I’d definitely be voting against the restructuring deal.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any companies mentioned. Holdings are subject to change at any time.

It was a busy week of earnings. All members of FAAMG (Facebook, Alphabet/Google, Amazon, Microsoft, and Apple) released their results for the first quarter of 2021 within a few days of each other. I rounded up some of the key figures and management quotes. 

For those who want the short version, all five companies reported stellar growth – despite coming off massive revenue bases – and seem well-positioned for growth. And here’s the long version.

Alphabet Inc (NASDAQ: GOOG)

The parent company of search giant, Google kicked things off with another impressive set of results. Revenue jumped 34% to US$41.2 billion, driven by broad-based growth from its advertising businesses, other services, and Google Cloud. 

Google Advertising was up 32% from a year ago to US$44.7 billion, as Youtube ad revenue grew by around 50% to US$6.0 billion. 

Google Cloud revenue grew 46% to US$4.0 billion and operating losses in the segment narrowed to just US$974 million from US$1.7 billion, demonstrating improving operating leverage.

The tech behemoth is now sitting on US$135 billion in cash and marketable securities. It announced that it would be using US$50 billion to buy back shares in the future. At its current market cap, that would reduce the share count by around 3%.

Sundar Pichai, CEO of Alphabet and Google, said that with the economy rebounding, the company’s product releases are returning to a regular cadence.

For example, Google Maps will be releasing Indoor Live View, which helps users navigate airports, transit stations, and malls using augmented reality. Google News Showcase, which Google is investing US$1 billion in, is also showing some momentum as it added more than 170 publications across 12 countries during the first quarter of 2021.

Management also believes that Google Cloud will eventually become profitable with increasing scale. Ruth Porat, CFO of Alphabet and Google, shared the following during Alphabet’s latest earnings call:

“As for Google Cloud, our approach to building the business has not changed. We remain focused on revenue growth, and we will continue to invest aggressively in products and our go-to-market organization given the opportunity we see. The operating results in Q1 in part reflect some notable items in the quarter, first, the lapping of the unusually high allowances for credit losses recorded in the first quarter of 2020 as I already mentioned; and second, lower depreciation expense due to the change in estimated useful lives, although the dollar benefit will diminish throughout the course of the year across segments. As we have noted previously, operating results should benefit from increased scale over time; however, at this point, we do remain focused on continuing to invest to build the Cloud organization for long-term performance.”

Apple Inc (NASDAQ: AAPL)

The most valuable company in the world reported a whopping 54% increase in revenue to US$89.6 billion compared to a year ago.

There was broad-based growth across Apple’s suite of hardware products of the iPhone, Mac, iPad, and other devices. iPhone sales grew 66% to US$47.9 billion, driven by the strong popularity of the new iPhone 12 series. iPad and Macs continue to see strength as work and study from home have become commonplace globally. Mac sales were up 70% to US$9.1 billion while iPad sales were up 79% to US$7.8 billion. Services revenue also grew, albeit at a slower pace than hardware sales, at 26% to US$16.9 billion.

Apple is now sitting on US$82.6 billion in net cash (total cash & investments minus total debt) after generating US$56.9 billion in free cash flow in the six months ended 31 March 2021.

Despite the run-up in Apple’s share price over the last 12 months, the company’s CFO, Luca Maestri, still feels that buybacks are a good way to allocate some of the company’s excess capital. He said in the latest earnings conference call:

“We continue to believe there is great value in our stock and maintain our target of reaching a net cash neutral position over time. Given the confidence we have in our business today and into the future, our board has authorized an additional 90 billion for share repurchases. We’re also raising our dividend by 7% to $0.22 per share, and we continue to plan for annual increases in the dividend going forward.”

Microsoft Corporation (NASDAQ: MSFT)

The tech giant reported another outstanding set of results, continuing its strong run from 2020. Revenue was up 19% to US$41.7 billion, operating income surged 31% to US$17.0 billion, and non-GAAP diluted earnings per share spiked 39% to US$1.95.

Microsoft saw broad-based growth across almost all of its products. Its Office Commercial and Office Consumer products, together with their respective cloud services, gew up 14% and 5%, respectively. In terms of revenue growth, Linkedin rose 25%, Windows OEM was up 10%, Xbox content grew 34%, and cloud computing services provider Azure spiked by 50%. 

As usual, Microsoft CEO Satya Nadella spent a good chunk of time at the company’s latest earnings conference call discussing Azure. He said:

“As the world’s COGS become more digital, computing will become more ubiquitous and decentralized. We are building Azure to address organizations’ needs in a multi-cloud, multi-edge world.

We have more data centre regions than any other provider, including new regions in China, Indonesia, Malaysia, as well as the United States.

Azure has always been hybrid by design, and we are accelerating our innovation to meet customers where they are. Azure Arc extends the Azure control plane across on-premises, multi-cloud, and the edge, and we’re going further with Arc-enabled machine learning and Arc-enabled Kubernetes.”

He also added that Microsoft is positioned to meet the data analytics demands of its clients. He explained:

“ The next-generation analytics service, Azure Synapse, accelerates time to insight by bringing together data integration, enterprise data warehousing, and big data analytics into one unified service. No other provider offers the limitless scale, price-performance, and deep integrations of Synapse. With Spark integration, for example, organizations can handle large-scale data processing workloads. With Azure Machine Learning, they can build advanced AI models. With Power BI, anyone in the organization can access insights. 

We are seeing adoption from thousands of customers, including AB InBev, Dentsu, and Swiss Re. Queries performed using Synapse have increased 105 per cent over the last quarter alone. 

We are leading in hyper scale SQL and non-SQL databases to support the increasing volume, variety, and velocity of data. Customers continue to choose Azure for their relational database workloads, with SQL Server on Azure VMs uses up 129 per cent year over year. And Cosmos DB is the database of choice for cloud-native app development – at any scale. Transaction volume increased 170 percent year over year.”

Facebook Inc (NASDAQ: FB)

It was nothing short of an amazing quarter for Facebook. Revenue was up 48% to US$26.2 billio, with advertising revenue jumping 46% to US$25.4 billion. Facebook enjoyed a 30% increase in the average price per ad, and a 12% hike in the number of ads shown.

With monthly active users growing more slowly and ad load reaching optimum levels, Facebook said that ad prices will be its primary driver of growth for the rest of 2021.

The company also lowered its 2021 capital expense outlook from US$21-23 billion to US$19-21 billion.

COO Sheryl Sandberg spent some time in the latest earnings conference call addressing the impact to Facebook’s business stemming from changes to Apple’s privacy policy which lets users opt out of tracking. She said:

“Yes, there are challenges coming to personalized advertising and we’ve been pretty open about that. We’re doing a huge amount of work to prepare. We’re working with our customers to implement Apple’s API and our own Aggregated Events Measurement API to mitigate the impact of the iOS14 changes. We’re rebuilding meaningful elements of our ad tech so that our system continues to perform when we have access to less data in the future. And we’re part of long-term collaborations with industry bodies like the W3C on initiatives like privacy enhancing technologies that provide personalized experiences while limiting access to people’s information.

It’s also on us to keep making the case that personalized advertising is good for people and businesses, and to better explain how it works so that people realize that personalized ads are privacy-protective.

Small businesses don’t have to understand the alphabet soup of acronyms they’ll need to comply with, but they do need to have confidence that they can still use our tools to reach the people who want to buy what they’re selling in a privacy-safe way. We’re confident they can, and that they can continue to get great results as digital advertising evolves.”

The other thing that caught my attention is Facebook’s recent success with Oculus (the company’s AR/VR platform) and the company’s focus on doubling down on AR/VR technology. Facebook CEO Mark Zuckerberg said,

“I believe that augmented and virtual reality are going to enable a deeper sense of presence and social connection than any existing platform, and they’re going to be an important part of how we’ll interact with computers in the future. So we’re going to keep investing heavily in building out the best experiences here, and this accounts for a major part of our overall R&D budget growth.”

He added,

“One interesting trend is that we’re seeing the app ecosystem broaden out beyond games into other categories as well. The most used apps are social, which fits our original theory for why we wanted to build this platform in the first place. We’re also seeing productivity and even fitness apps. For example, we launched a tool so people can subscribe to services like FitXR to do boxing and dancing in VR just like they would for biking on Peloton.

We introduced App Lab so developers can ship early versions of their apps directly to consumers without having to go through the Oculus Store. Between App Lab and streaming from PCs, we’re pioneering a much more open model of app store than what’s currently available on phones today.

Over time, I expect augmented and virtual reality to unlock a massive amount of value both in people’s lives and the economy overall. There’s still a long way to go here, and most of our investments to make this work are ahead of us. But I think the feedback we’re getting from our products is giving us more confidence that our prediction for the future here will happen and that we’re focusing on the right areas.”

Amazon.com Inc (NASDAQ: AMZN)

The e-commerce and cloud computing juggernaut rounded things off on Friday morning (Singapore time) by announcing a spectacular set of results.

Net sales was up 44% to US$108.5 billion. As a result, operating income was up by 122% to US$8.9 billion, and diluted earning per share up 213% to US$15.79. Revenue from AWS – the company’s cloud computing services provider -grew 32% to US$13.5 billion and us now a US$54 billion sales run rate business. Amazon has also breached the 200 million paid Prime members mark worldwide. The company’s business outside of North America reported its 4th consecutive quarter of profitability and generated more than a billion dollars in profit for the first time.

Amazon’s high margin third-party seller services and subscription services businesses increased revenue by 60% and 34% respectively. Brian Olsavsky, CFO of Amazon, sees more growth for AWS even in a post-pandemic world. He shared the following in Amazon’s latest earnings conference call:

“During COVID, we’ve seen many enterprises decide that they no longer want to manage their own technology infrastructure. They see that partnering with AWS and moving to the cloud gives them better cost, better capability and better speed of innovation. We expect this trend to continue as we move into the post pandemic recovery. There’s significant momentum around the world, including broad and deep engagement across major industries.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in the shares of Facebook, Amazon, Alphabet, Microsoft and Apple. Holdings are subject to change at any time.

Coinbase is the talk of Wallstreet. It will begin trading on the NASDAQ through a direct listing tonight. Coinbase allows users to buy and sell crypto assets such as Bitcoin and Ethereum and its business has been on a tear of late. Revenue doubled in 2020 and then surged over 900% in the first quarter of 2021. 

Its shares have recently traded privately at a company-valuation of close to US$100 billion, making it even more valuable than traditional stock exchanges like NASDAQ Inc (NASDAQ: NDAQ) and Intercontinental Exchange Inc (NYSE: ICE), which is the parent company of the New York Stock Exchange.

Coinbase’s high valuation and strong business performance come as interest in cryptocurrencies spiked in 2020 and early 2021.

With the hype around Coinbase, I decided to take a quick look at its prospectus and note down some reasons for and against investing in it. Here’s my list.

Reasons to invest

Rocketing recent growth: Coinbase’s business has catapulted recently with the surge in demand and interest in crypto assets. Investors use recent growth as a proxy for what is to come in the future. 

Profitable business: Unlike most tech companies seeking to go public, Coinbase is already a profitable business. In fact, it is very profitable. In 2020, Coinbase generated US$322.3 million in net income from US$1.3 billion in revenue, giving it an impressive net income margin of 24.8%. In the first quarter of 2021, Coinbase announced that it made between US$730 million to US$800 million in net income from US$1.8 billion in revenue.

Operating leverage: Coinbase can improve its margins further with operating leverage. As demonstrated in the first quarter of 2021 , its net income margin improved to around 41%, compared to 24.8% for the whole of 2020. If Coinbase’s take rates remain steady, its margin can improve due to the low marginal cost for servicing each additional transaction.

Big addressable market(?): Crypto bulls will argue that Bitcoin and other crypto-assets will become must-own financial instruments. Coinbase has gone as far as to say: “Our objective is to bring crypto-based financial services to anyone with a smartphone, a population of approximately 3.5 billion people today.” For perspective, Coinbase had 56 million users at the end of March 2021.

Secure platform and trusted brand:  With a crypto-exchange playing the role of custodian of crypto-assets, users need to trust that the platform is secure and reliable. Coinbase CEO, Brian Armstrong explained in his Founder letter: “Trust is critical when it comes to storing money. From the early days, we decided to focus on compliance, reaching out to regulators proactively to be an educational resource, and pursuing licenses even before they were needed. We invested heavily in cybersecurity, built novel key storage mechanisms, and obtained a cybercrime insurance policy. We even developed ways for customers to custody their own cryptocurrency safely, so they didn’t need to trust us at all. Most importantly, we built a culture that doesn’t take shortcuts or try to make a quick buck.” While building security is expensive and a gruelling task, it should put Coinbase in a good position to win costumers looking to start their crypto journey.

Network effect and scale provide liquidity: As one of the biggest crypto exchanges in the world, Coinbase boasts scale and can hence provide better liquidity which gives users better prices on their trades.

Reasons not to invest

Revenue impacted by prices of crypto assets: Coinbase acknowledges on its prospectus that the prices of crypto assets can impact demand for buying, selling, and trading them. There was a steep decline in crypto asset prices in 2018 which Coinbase said adversely affected its net revenue and operating results. Should similar price declines in crypto assets occur in the future, Coinbase’s revenue may again fall sharply.

Highly dependent on Bitcoin and Ethereum: Although Coinbase supports the exchange of other cryptoassets, the bulk of its transaction volume and revenue comes from Bitcoin and Ethereum. In 2020, these two cryptocurrencies drove over 56% of Coinbase’s total trading volume on its platform. As such, a sudden fall in transaction volume in these two crypto assets can have a big impact on Coinbase’s revenue.

Competition: Unlike stock exchanges, the barriers to entry to become a crypto exchange is much smaller. Although Coinbase has built up a solid reputation, margins can be easily eroded if more aggressive brokers come up with innovative ways to eat market share. In an article for Fortune, Shaun Tully argues that Coinbase’s high transaction fees will not last. At the moment, Coinbase charges an average fee of around 0.46%. In comparison, stock exchanges such as ICE and NASDAQ each make 0.01% on each dollar of securities traded. Tully writes:

“It can’t last, says Trainer. He predicts that fees for trading cryptocurrencies will follow a similar downward trajectory as those in stocks, possibly all the way to zero. Coinbase’s slice of each transaction is so big, and its profits so gigantic, that rivals can slash what they’re charging and still mint huge profits. “Competitors such as Gemini, Bitstamp, Kraken, Binance, and others will likely lower or zero trading fees to take market share,” he says. “If margins are that good, you invite competition.” That will start a “race to the bottom” similar to the contest for market share that triggered the collapse, then virtual elimination, of stock commissions in 2019. Trainer also expects traditional brokerages to soon offer trading in cryptocurrencies, further pressuring Coinbase’s rich fees.”

High valuation: As mentioned earlier, Coinbase could start trading at a valuation of around US$100 billion. This translates to around 14 and 32 times its annualised first-quarter revenue and net profit, respectively. Although those numbers may not seem that high (compared to other tech firms) at first glance, the possibly volatile nature of Coinbase’s business, and possible impending margin compression, might suggest otherwise.

Final words

If Coinbase’s US$100 billion valuation comes to fruition, it can begin life as a public company as one of the 100 biggest companies in the world, even ahead of established names such as Postal Savings Bank of China (SHA: 601658), Softbank Group Corp (TYO :9984), and Starbucks (NASDAQ: SBUX). 

This is a staggering achievement for a company that was founded only around 10 years ago. This does not mean Coinbase is a good investment going forward though. Investors need to consider the host of factors that could impact its eventual return for shareholders. Hopefully, this list provides a good starting point for investors who are thinking of investing in Coinbase.

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