Category: Investing Analysis

The Chinese gaming market is expected to grow 14% per year from 2019 to 2024. One company that is likely to benefit from this is HUYA Inc (NYSE: HUYA).

Instead of competing directly with other gaming companies, HUYA Inc is a gaming streaming platform where gaming fans can watch live video game content. It earns money by selling advertising space, and virtual items to users.

The virtuous loop

HUYA is one of two (the other being DouYu) dominant live-game streaming platforms in China. HUYA also hosts eSports events, which are professional e-gaming tournaments.

As a leading player in the game streaming industry in China, HUYA boasts a large network of streamers and viewers. This has resulted in a network effect.

Streamers create content for viewers, which leads to more viewers. The ability to reach a larger audience attracts more streamers to choose HUYA as their streaming platform. More streamers leads to more content for viewers, and round and round the flywheel goes.

Track record of growth

HUYA has demonstrated that it has been able to use its industry-lead to great effect.

The monthly average users on its platform, HUYA Live, grew 28.8% to 150.2 million in the fourth quarter of 2019 compared to the same period a year ago. The number of paying users increased fairly proportionately by 27.6% to 13.4 million. But most impressively, the average spend per paying user increased by a staggering 40.6% to RMB 595.2 in 2019 compared to RMB 423.1 in 2018. 

Putting everything together, HUYA’s revenue from live streaming (virtual gifts) spiked by 79.5% in 2019. Its advertising revenue also saw an 81% increase. The strong growth is nothing new for HUYA as it merely extends its winning streak of growth since 2016. The table below shows HUYA’s total net revenues from 2016 to 2019.

A profitable business model

HUYA’s amazing growth is one thing but, to me, the most important aspect of any business is whether it has cost structures that enable it to turn a profit. HUYA ticks this box. The Chinese live gaming streaming platform was operationally profitable in 2018 and 2019. Margins have also started to widen as HUYA starts to enjoy economies of scale. 

In the first quarter of 2020, HUYA reported an operating profit margin of 5.8% compared to just 1.8% in the same quarter last year.

As HUYA continues to increase its topline, I expect margins to improve substantially as its operating expenses increase much slower than revenue.

Robust balance sheet and positive free cash flow 

As of 31 March 2020, HUYA had no debt, and RMB 10.3 billion (US$1.45 billion) in cash, cash equivalents, restricted cash, short-term deposits, and short-term investments. 

It also generated around RMB 1.9 billion in free cash flow in 2019. It has been producing positive operating cash flow and free cash flow since 2017.

With its strong cash position and the ability to generate cash from its core business, HUYA has the financial muscle to continue spending on expanding its product offering and to grow its user and streamer base.

Strategic owners

Another thing that HUYA has going for it is that Tencent Holdings is its majority shareholder. In April this year, Tencent exercised its option to acquire an additional 16.5% of shares from HUYA’s previous owner, JOYY. After the transfer of shares, JOYY has 43% total voting power, while Tencent Holdings has 50.9% of the voting rights.

Tencent is the world’s largest video gaming company. It owns some of the biggest game developers in the world such as Riot Games, which owns League of Legends. Tencent also has strategic stakes in game developers such as Supercell (the makers of Clash of Clans) and Epic Games (whose platform was used to develop Fortnite).

I think that HUYA can leverage its relationship with Tencent to further consolidate its position as one of the top video game live streaming platforms in China.

Risks

A discussion about any company will not be complete without talking about the risks. As a Chinese company listed in America, the big risk that everyone is talking about is the possibility that Chinese companies may be forced to delist from the US stock market.

On top of that, Chinese companies listed in America do so via American depository receipts (ADRs), which in turn own an interest in a variable interest entity (VIE). This VIE has contractual rights to participate in the economic interests of the actual operating company in China. The structure is really complex, and there could be potential loopholes where certain parties can use to exploit owners of the ADRs. Although this has not been done before for HUYA, there is that possibility that investors need to be aware of. Moreover, if China’s regulatory authorities should deem the VIE contracts to be invalid in the future, owners of the ADRs could be wiped out.

There is execution risk too. HUYA is still a relatively young company and was only listed in 2018. 

In addition, Chinese companies face regulatory risks that could derail its growth. The Chinese government has been known to implement very strict rules on internet companies – that could potentially disrupt HUYA’s business.

Competition is another factor to keep in mind. For now, HUYA enjoys a strong position as one of two big players in this space in China. But things could change if new entrants emerge that somehow have a better platform and are able to attract streamers.

Final Words

I’m keeping an eye on HUYA. It operates in a fast-growing market and I expect to see double-digit growth for at least a few years. In addition, the company is already profitable, has enough cash on its balance sheet for expansion, and has strategic shareholders that it can leverage.

On HUYA’s valuation, the company currently trades at around 3.3 times 2019’s revenue. Based on its current gross margin of around 18% and the potential economies of scale as it grows, I think HUYA can easily settle at a 10% operating margin.

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

Cancer is a brutal disease and one of the leading causes of death in the developed world. Worldwide, the disease struck more than 17 million people in 2018 with that figure expected to mushroom. 

One company that is doing its part in the fight against cancer is NovoCure Ltd (NASDAQ: NVCR).

Founded in 2000, NovoCure has developed a cancer therapy called tumour treating fields, which inhibits tumour growth and may causes cancer cells to die.

In this article, I take a look at the medical research behind its technology and whether NovoCure is a potential multi-bagger.

Technology behind Novocure

Novocure was founded 20 years ago by Professor Yoram Palti who believed that he could use electric fields to destroy cancer cells.

I don’t want to go too deep into the technicalities but to appreciate Novocure, it is important to understand the basics behind its technology.

In short, cellular proteins in cancer cells need to position themselves in a particular way during cell division in order for cells to divide. Tumour treating fields use alternating electric fields specifically tuned to target cancer cells, disorientating the position of the cell proteins and disrupting cell division.

It is equally important that tumour treating fields also do not stimulate or heat tissues and has minimal damage to healthy cells, with the only side effect being mild to moderate skin irritation.

From theory to practice

Novocure has done an excellent job of turning Professor Palti’s theory into real-life clinical practice. Today, tumour treating fields is approved in certain countries for the treatment of adults with glioblastoma and in the US for mesothelioma. These are two of the most difficult forms of cancer types to treat.

For instance, life expectancy for newly-diagnosed Glioblastoma, the most common type of brain cancer in adults is typically less than two years. 

Today, there is a growing body of research that shows that tumour treating fields therapy can extend the life expectancy of patients when it is used together with other therapies.

The chart from Novocure’s investor presentation shows the survival rate of patients with and without tumour treating fields (Optune) treatment.

Source: Novocure investor presentation 2020

Out of the cohort of 450 patients, 388 received a survival benefit from the use of tumour treating fields. The 5-year survival rate was 13% in the cohort that used tumour treating fields combined with chemotherapy (TMZ or Temozolomide) compared to just 5% in the cohort that used chemotherapy alone.

In fact, the efficacy and minimal side effect of Tumour treating fields as a therapy has led to the National Comprehensive Cancer Network promoting it to a category 1 recommendation for newly diagnosed Glioblastomas,

Growing the number of indications

Tumour treating fields as a therapy could potentially be used on a wide variety of other cancer types. As mentioned earlier, it is FDA approved for (1) recurrent and (2) newly diagnosed glioblastoma and received FDA-approval for (3) Mesothelioma last year.

On top of that, it is undergoing phase III trials for four other indications, namely (1) brain metastasis, (2) non-small cell lung cancer, (3) pancreatic cancer and (4) ovarian cancer. This could significantly increase the company’s addressable market opportunity.

It is also in Phase II trials for liver cancer and preclinical trials for a host of other cancer types. The charts below summarise where the company is at in terms of commercialising its product for the other indications.

Source: Nocovure Investor relations website

Source; Novocure Investor relations website

In its 2019 annual shareholder letter, CEO Asaf Danziger and executive chairman Bill Doyle, reiterated their commitment to innovation saying, 

“We are increasing investments in engineering efforts intended both to improve time on therapy and to maximize the energy delivered to patients’ tumours. Specifically, our teams are working to design and develop improvements to our transducer arrays and to our transducer array layout mapping software intended to increase Tumor Treating Fields intensity and, as a result, survival.

We believe innovation has the potential to improve patient outcomes and to extend our intellectual property protection into the future as we invent enhancements to our products. Our commitment to innovation resulted in 33 new patent applications in 2019, alone.”

From an investors point of view

From a medical standpoint, Novocure’s Tumour Treating Fields technology looks very promising. 

But as investors, we also want to see that the company has the finances to continue funding its research and can drive adoption to grow its revenue.

There are two things I want to see in a promising company like Novocure- (1) a solid balance sheet so that it does not need to raise too much capital to fund its growth and (2) at least some signs that the company is turning its FDA-approval into meaningful revenue growth.

Novocure has both.

The chart below illustrates its net revenues from 2016 to the first quarter of 2020.

Source: Novocure investor presentation 2020

Novocure has also partnered with a Chinese company, Zai, to launch its Tumour treating fields in China. The partnership is already starting to bear fruit with US$2 million in net revenue recorded in greater China in the first quarter of 2020, a 100% increase in from Q4 of 2019.

It is worth noting that Novocure turned operationally and free cash flow positive in 2019. Novocure also has a robust balance sheet with around US$332 million in cash, cash equivalents, short-term investments and restricted cash and no debt. 

Market opportunity

According to Novocure’s S-1 in 2015, Tumour treating fields is broadly applicable to a variety of solid tumours with an annual incidence of 1.1 million people in the United States alone.

Novocure charges around US$21,000 per month for Optune, its tumour treating fields device that is used to treat glioblastomas. Supposing that Novocure sells its other tumour treating fields products at a similar price range, Novocure will have a market opportunity of US$277 billion ($21,000 x 12 months x 1.1million patients) in the United States alone.

That’s of course assuming that Tumour Treating Fields therapy can be FDA-approved for the whole range of applications. 

Valuation

At the time of writing, Novocure had a market cap of US$6.3 billion. On the surface, that seems expensive if you use traditional metrics to value the company. Novocure only had US$351 million in net revenues and US$262 million in gross profits in 2019. 

Based on current share prices, it trades at 17.9 times 2019’s sales and 24 times gross profit. Those numbers are hard to stomach and would certainly be deemed expensive for most companies.

However, Novocure, to me, is not like most companies. 

In the most recent quarter, revenue grew 39% from a year ago. The growth figure could start to accelerate as its core markets mature and Tumour treating fields gains FDA-approval for other indications.

It is also worth remembering that based on my calculations it has a US$277 billion market opportunity. If it can penetrate just 5% of that, its current US$6.7 billion market cap will be a steal.

Final words

Novocure has all the makings of an excellent company. Its technology can potentially be used in a wide array of different indications and is already generating positive free cash flow.

It has a solid track record of growing revenue. Gaining FDA-approval for other use cases could potentially be a catalyst for much greater things for the company. With all that said, it does look like Novocure has all the ingredients for success.

That said, I do acknowledge that as with any biotech firm, there are risks. The risks that it cannot get FDA-approval for other indications or adoption of its product is slower than expected can hinder growth and can lead to other companies catching up with it.

The technology is also very new and widespread adoption will depend on how quickly Novocure can push clinicians to recommend it as a form of treatment. 

But despite these risks, to me, the probability and magnitude of the upside outweigh the risk. With its market cap still small compared to its total addressable market opportunity, I think if it can execute and fulfil its vast potential, Novocure could easily become a multi-bagger based on today’s price.

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

As a B2B (business-to-business) cloud software provider, Datadog Inc (NASDAQ: DDOG) may not be a household name to non-developers and IT engineers. However, it definitely caught my attention.

The monitoring and analytics platform for developers, IT operations, and business users is one of the fastest-growing software companies and has some of the best-in-class metrics to boot.

Despite less than a year as a public company, Datadog’s share price is already double from its first trading day in September 2019. In this article, I share my thoughts on Datadog.

A huge market opportunity

Companies that house their data in the cloud can end up with a complex web of data and information that is difficult to monitor. This is where Datadog’s platform can help. It provides monitoring services across public cloud, private cloud, on-premise, and multi-cloud hybrid environments.

Datadog estimates that the IT Operations Management market will represent a US$37 billion market opportunity in 2023, with the company’s services addressing US$35 billion of that.

Compare that to Datadog’s 2020 first-quarter annual revenue run-rate of around US$524 million, and you can see just how much potential lies ahead.

Growing into its own

Datadog is doing a great job in executing its growth strategy. The software-as-a-service (SaaS) company saw its revenue grow by 98% and 83% in 2018 and 2019 respectively.

In the first quarter of 2020, revenue increased by 87% year-over-year as the number of large customers (with an annual run rate of US$100,000 or more) surged to 960 from 508 a year ago.

Moreover, management expects revenue to increase to between US$555 million and US$565 million for the whole of 2020.

Growing customer base

But, to me, the most appealing thing about Datadog’s business is that the company has some of the best-in-class metrics for SaaS companies.

Datadog has recorded gross margins of 75% to 77% over the past three years, and even had positive GAAP (generally accepted accounting principles) operating income in the first quarter of 2020.

Recording a profit is pretty amazing for a company that is growing as fast as Datadog is.

The reason why Datadog can be so operationally efficient even at this high rate of growth is that it has one of the best-in-class customer acquisition cost (CAC) ratios. The CAC payback period measures how long the company takes to earn back the marketing dollars spent to acquire a new customer. It is calculated as the implied annual run rate gross margin from new customers divided by sales and marketing spend of the prior quarter.

Alex Clayton, general partner at venture capital firm Meritech Capital, recently provided a fantastic chart comparing Datadog’s CAC payback period against other listed SaaS companies (note, the lower the number, the better).

From the chart, you can see that Datadog recovered all its marketing cost to acquire a new customer in around 10 months. That’s only behind video-conferencing software provider Zoom, and well below the 30-month median for SaaS companies.

Customers spending more on its platform

Datadog’s existing customers also continually spend more on its platform. In the first quarter of 2020, Datadog’s dollar-based net retention rate (DBNRR) was above 130% for the 11th consecutive quarter. The DBNRR measures the change in spending for all of Datadog’s customers a year ago compared to the same group of customers today; it includes positive effects from upsells and negative effects from downgrades and customers who leave.

Datadog charges customers base on usage, so the more users (the customer’s employees) that use the platform, the more the customer pays Datadog. 

In addition, Datadog has consistently introduced more products on its platform. Datadog uses a land-and-expand growth model. The company first wins customers over to use one product before cross-selling other products to them.

The chart below, taken from Datadog’s IPO prospectus, shows the annual revenue run rate of cohorts (customers that started using the platforms) from 2012 to 2018.

As you can see, each colour on the graph fattens over the years. This means that the cohorts are collectively spending more money on Datadog’s platform.

Robust balance sheet

Datadog raised around US$648 million during its September 2019 IPO. As of March 2020, Datadog had US$794 million in cash, cash equivalents, and marketable securities and no debt. This is a great financial position.

In addition, Datadog announced in late May 2020 that it is raising US$650 million through a convertible notes offering. The conversion price of US$92.30 per share represents a 21% premium to the company’s share price at the time of writing.

The offering should further strengthen Datadog’s balance sheet. The convertible price after 5 years should not dilute shareholder interests by too much as well. As the company is already free cash flow positive (more on this below), I expect management to use the new-found cash to make strategic acquisitions to improve its core offering, or invest in R&D to launch new products.

Free cash flow 

As mentioned above, Datadog is already generating free cash flow. In fact, the company generated positive operating cash flow in 2017, 2018, and 2019; and had positive free cash flow in 2018 and 2019. In the first quarter of 2020, Datadog had US$19.3 million in free cash flow.

That’s equivalent to a free cash flow margin of 14.7%, decent for a company that is seeing such strong growth.

As the company grows, I expect Datadog’s free cash flow margin to widen and easily settle at 30% or more.

History of successful innovation and new products

Much of Datadog’s success has come from its constant innovation and creation of new products. The firm initially offered just infrastructure monitoring but soon expanded its service to monitor the entire technology stack.

This single pane view of the entire technology stack proved extremely popular and is one of the reasons why the company’s DBNRR is so high.

Going forward, innovation and technology upgrades will be key in ensuring that Datadog maintains its market position in this highly competitive space.

Final words

Datadog has the potential to become one of the top dogs in its industry.

But there are also risks such as execution risk and the threat of competition. It also hard to ignore Datadog’s extremely rich share price: The company’s market capitalisation is around 45 times its annual revenue run rate (based on revenue for 2020’s first quarter). This means that a lot of Datadog’s future growth is already being baked into its share price.

However, if Datadog manages to fulfill its potential and captures just 10% of its market opportunity, I think its future market capitalisation will be much higher than it is today.

Moreover, given its recurring income stream, position as a leading player in its space, high margins, operational efficiency and history of innovation, I think Datadog has a good chance of rewarding shareholders five to ten years down the road.

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.

*Editor’s note: The article mistakenly stated that the free cash flow for the first quarter of 2020 was US$23 million and free cash flow margin was 17.3%. However, the correct figures are 19.3% and 14.7%. The article has since been updated to reflect that.

Sembcorp Industries (SGX: U96) dominated the business headlines in Singapore last week. The utilities and marine engineering conglomerate announced on 8 June 2020 that it would be completely spinning off its marine engineering arm – Sembcorp Marine (SGX: S51) – through a complex deal.

As part of the deal, there will be an injection of capital into Sembcorp Marine via a rights issue. Prior to the announcement, Sembcorp Marine was already a listed company in Singapore’s stock market, but it had Sembcorp Industries as a majority shareholder.

I won’t be explaining the deal in detail because others have already done so. My friend Stanley Lim has created a great video describing the transaction for his investor education website Value Invest Asia. Meanwhile, another friend of mine, Sudhan P, has written a great piece on the topic for the personal finance online portal Seedly. 

What I want to do in this article is to share an observation I have about the state of Sembcorp Industries’ business. I think my observation will be useful for current and prospective Sembcorp Industries shareholders.

The market cheers 

On the day after the Sembcorp Marine spin-off was announced, Sembcorp Industries’ share price jumped by 36.6% to S$2.09. So clearly, the market’s happy that Sembcorp Industries can now be a standalone utilities business (the company has other small arms that are in urban development and other activities, but they are inconsequential in the grand scheme of things). It’s no surprise.

Sembcorp Marine’s business performances have been dreadful in recent years. The sharp decline in oil prices that occurred in 2014 – something not within Sembcorp Marine’s control – has been a big culprit. Another key reason – a self-inflicted wound – was Sembcorp Marine’s decision to load up on debt going into 2014. The table below shows Sembcorp Marine’s revenue, profit, cash, and debt from 2012 to 2019:

Getting rid of Sembcorp Marine will allow Sembcorp Industries’ utilities business (the segment is named Energy) to shine on its own. But there’s a problem: The economic quality of the Energy segment has deteriorated significantly over time. This is the observation I want to share. Let me explain.

Low energy

There are two key reasons why I think Sembcorp Industries’ Energy segment has gone downhill. 

First, over the six year period from 2013 to 2019, the Energy segment’s revenue and power production and water treatment capacities all grew – the power production capacity even increased substantially. But the segment’s profit did not manage to grow. In fact, it had declined sharply. Sembcorp Industries does report a separate profit figure for the Energy segment that excludes exceptional items. But the exceptional items are often gains on sale of assets and/or impairment of asset values. To me, these exceptional items are not exceptional; they reflect management’s day-to-day decision-making in allocating capital.

The table below shows the Energy segment’s revenue, profit, power capacity, and water-treatment capacity in each year from 2013 to 2019:

Second, the Energy segment’s return on equity has fallen hard from a respectable 19.3% in 2013 to a paltry 5.3% in 2019. Here’s a table illustrating the segment’s return on equity for this time period:

The sharp fall in the Energy segment’s return on equity, coupled with the decline in profit, suggests that the economic quality of the segment has worsened materially over the past few years. 

Some final words

It’s unclear to me how much of the Energy segment’s power and water capacities were actually in operation as of 2013 and 2019. So it’s highly possible that most of the increase in the capacity-figures seen in the period are mostly for projects that are still under development.

If this is the case, then there may still be a big jump in the Energy segment’s profit and return on equity in the future. But if it isn’t, then the business performance of the Energy segment in the past few years is troubling. If the Energy segment’s numbers can’t improve in the future, the overall picture for Sembcorp Industries still looks overcast to me even if Sembcorp Marine is no longer involved.

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

Companies that make good capital allocation decisions compound value over time. A great example is Warren Buffett’s Berkshire Hathaway. 

Berkshire has only paid a dividend once, in 1967. Since then, it has not paid any dividend to its shareholders, and has reinvested its earnings instead.

From 1965 to 2018, Buffett has expertly grown Berkshire’s book value per share by 18.7% annually . Its share price has mirrored that performance, climbing by 20.5% over the same period – compounded, that’s a gain of 2,472,627%.

It is, therefore, evident that a management team’s ability to make good capital allocation decisions is a key factor in compounding shareholder wealth. 

But how can we tell whether a management team can make the right decisions to grow shareholder wealth?

A track record of great capital allocation decisions

The most obvious thing to look at is how effective have management’s capital allocation decisions been in the past?

In Warren Buffett case, it’s easy to tell that his decisions have worked out tremendously well. We can judge the overall quality of his decision-making by the growth of Berkshire’s book value per share. But we can also judge his individual investment decisions. One of the key investments that Buffett makes for Berkshire is the purchase of stocks. For this, we can observe the changes in the price of the stocks from when he bought them to today.

But not all capital allocation decisions are so easily measured. Many decisions that a company’s management team makes are based around future earnings and include investments in intangibles which may not be easily calculated.

Measuring success

To me, a good way to measure whether a company has been allocating capital wisely is through its return on equity. If a company has consistently managed to earn high returns on equity, it shows that the capital allocation decisions have been sound.

The return on equity is calculated by dividing a company’s net profit over its shareholders’ equity. Generally speaking, there are two things that we want to see here. First, the return on equity figure should be consistently high. Second, shareholders’ equity should increase over time.

How to measure the success of private acquisitions?

The success of private acquisitions is difficult to quantify. Companies can make acquisitions for a variety of reasons which will not pay off financially for years, sometimes even decades. Just look at Facebook’s purchase of Whatsapp for example. Facebook paid US$21.8 billion for Whatsapp in 2014 and has yet to really monetise the app. 

So instead of looking at the direct financial gain, we could judge acquisitions based on a variety of other factors. Here are some questions you can ask when deciding if an acquisition was prudent:

• Does the acquisition improve the company’s competitive position?
• What reasons were given by management on why the acquisition was made?
• Was the acquisition price in line with other deals made recently?
• What other financial benefits can the acquirer make from the acquisition?
• How was the acquisition funded? If debt was used, how much and would that put the company in a weak financial position?

Investors also need to give an acquisition time to play out. It may be best to only judge whether an acquisition was successful at least two to three years after the acquisition was made.

When should a company pay dividends?

Another critical thing in the evaluation of management’s capital allocation chops is to gauge whether the company is prudently rewarding shareholders through dividends or buybacks.

Not all companies need to reinvest their entire earnings into the business. This may be true if a company has a very mature business and only needs to reinvest a small per cent of its earnings. In such an instance, I prefer to see the company return capital to shareholders either through dividends or share buybacks.

The last thing I want to see is a company hoarding large amounts of cash for no apparent reason. Having a strong balance sheet is very important. But holding too much cash will also be a big drag on the company’s return on equity.

Investors who receive dividends could put the cash to much better use.

Final words

Identifying good capital allocation decisions is important when it comes to our search for companies that can grow shareholder wealth. A company with a great business may still end up squandering its money if its managers are incompetent with capital allocation.

As minority shareholders in public-listed companies, stock market investors need to find companies with managers that they trust can put their capital to good use.

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.

Small business owners will tell you how much of a hassle accounting can be. This is why it’s no surprise that cloud-based accounting software is growing in popularity. Not only do they automate part of the accounting process, but cloud software is also accessible over multiple devices, is easily shareable, have multiple add-on features to integrate other aspects of the business, and are automatically upgraded over the cloud.

Xero Limited (ASX: XRO), as one of the first cloud software-as-a-service (SaaS) accounting tools provider, is one of the beneficiaries of this trend. Xero originated in New Zealand and is listed in the Australia stock market. Today, it dominates its core Australia and New Zealand markets, and counts more than 2 million subscribers worldwide.

Using my blogging partner Ser Jing’s six-point investment framework, I analyse whether Xero has the potential to be a long-term compounder.

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

Xero, as of 31 March 2020, served 2.285 million customers. Of which, around 1.3 million were from Australia and New Zealand, 613,000 from the UK, 241,000 in North America, and 125,000 in the rest of the world.

These numbers are tiny compared to the total number of SMEs (small, medium enterprises) in the regions. It is estimated that Australia and New Zealand have around 2.2 million and 487,000 SMEs, respectively. Meanwhile, the US has more than 30 million and the UK has 5.9 million.

Accounting is something that every company needs to do. But, cloud accounting penetration is still small. In the UK, North America, and the rest of the world, cloud adoption for accounting software is still less than 20%. This means cloud accounting software companies can grow into a largely untapped market. Yes, there are numerous players, such as Intuit’s QuickBooks, or MYOB in Australia, but the global market could be big enough for a few large players to coexist.

Xero is by far the market leader in Australia and New Zealand – and growth has slowed down there. However, Xero’s growth in other markets is still robust as subscriber count in the UK, North America, and the rest of the world increased by 32%, 24%, and 51%, respectively, in the fiscal year ended 31 March 2020 (FY2020).

Even if  Xero is able to win just 10% of the total addressable market in the English speaking world, it could see a multi-fold increase in revenue.

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

It is important that Xero has the financial resources to oversee the spending that is required to gain market share in its relatively younger markets. On this front, Xero looks to be in good shape.

As of 31 March 2020, it had cash and short term deposits of NZ$536 million, and NZ$424 million in debt in the form of convertible notes. The convertible notes only mature in 2023 and can be settled in shares. As such, Xero has financial flexibility should it choose not to settle the notes in cash.

More importantly, Xero turned the corner in FY2020 as it recorded its first annual profit. The company also generated positive free cash flow. This should provide further ammunition for the company to pursue its organic growth goals or to make a strategic acquisition.

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

Xero’s management team has so far demonstrated all three of these qualities. Xero has been able to grow consistently in its core markets due to strategic investments in its products, offering an open-source system for developers to build apps on its platform. It is also consistently adding new features to its product to cater to customers needs.

In FY2020, Xero rolled out Xero Tax in the UK to enable customers to digitally prepare files accounts and tax returns. It also rolled out HQ VAT in the UK so that customers can fulfill the UK government’s “Making Tax Digital” requirements.

Xero’s steady growth in revenue and its market-leading position in its home market in New Zealand and Australia is testament to the strength of management’s execution so far.

As Xero operates in a crowded market, innovation will be key when it comes to who can gain more market share. Xero has done well in this space so far and has consistently spent large sums of money upgrading its software. This innovative mindset will be vital in the company’s quest to gain meaningful market share in its less developed markets.

Glassdoor ratings are not always the most reliable, but it can be a good indicator of whether a company’s CEO is pushing the right buttons to motivate and keep his staff happy. Steve Vamos, the current CEO of Xero, boasts a solid Glassdoor rating of 89%. Vamos took over from Xero founder Rod Drury two years ago and has continued the company’s fast growth.

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

Recurring revenue is a wonderful thing to have for any business. It allows the business to plan for the future more accurately and to expend more resources on growing the business rather than retaining existing customers.

Xero has a beautiful base of recurring revenue. Its recurring subscription revenue made up 97% of total revenue in FY2020. Customers typically pay a monthly subscription for Xero’s software services.

Xero has created a sticky customer base for a few reasons. First, once you get started on Xero, it is hard to get out of it. That’s because customers have all their data logged into the software. Moving that data from one software to another can be a gruelling task.

Second, Xero has accountant partners who use Xero software. These accountant partners attract clients and in turn get rewarded by being listed on the Xero advisor directory, which gives them access to other clients. This has created a virtuous cycle that keeps on giving for both accountants and Xero.

The stickiness of Xero’s customer base is demonstrated by the low churn rate. In Xero’s last two financial years, the monthly churn rate for its customers was 1.1% and 1.13%. This means almost 99% of Xero’s customers continue using its services month after month.

5. Does Xero have a proven ability to grow?

I think the answer to this is a clear yes. Xero started as a tech start-up in 2006, and has grown from just a few thousand customers in its early days to one that serves more than 2 million worldwide.

It has executed its growth strategy well even as it expands internationally. The chart below is a visual representation of the growth in Xero’s user base over the past 11 financial years.

Perhaps more importantly, the user base growth has translated meaningfully into annualised monthly recurring revenue (AMRR). In FY2020, AMRR grew by 29%, while operating revenue grew 29%.

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

Xero reached an inflection point in FY2020. The company registered its first-ever operating profit. It was also the second consecutive year that the company generated positive free cash flow.

I believe Xero’s free cash flow margins can improve as it scales.

Xero boasts a high gross margin of 85.2%, which means that it has the potential to earn very high net profit margins should other costs decrease as a percentage of revenue.

As the company scales, I expect sales and marketing expenses to decrease as a percentage of revenue. Currently, sales and marketing expenses are 43.6% of revenue. This has a lot of room to drop, especially as revenue grows.

Xero’s product and design costs have also been north of 30% of revenue. Although product-upgrades are a necessary expense to keep Xero ahead of its competitors, the company has complete control over how much to spend on development costs. As it scales, this cost should also decrease as a percentage of revenue.

Risks

The biggest threat to Xero is competition from other accounting SaaS players. As mentioned earlier, accounting software is a crowded space. There are big-name players such as Intuit’s Quickbooks and Sage that are fighting for market share.

Xero, while dominant in Australia and New Zealand, will need to execute its growth strategy well to grow in its less developed markets.

Customers store important information on Xero’s software. A cyber attack could reduce trust among its users.

Inability to execute its expansion outside of its core markets is another risk for Xero. The company’s shares are currently priced for growth (more on this below) so if the company cannot match investors’ expectations, the share price may fall.

As a company that serves largely SMEs, Xero is also affected by the COVID-19 pandemic. The healthcare crisis could cause millions of SMEs to permanently close its doors. Xero may, in turn, suffer a significantly higher churn rate during this time and lower gross subscriber additions. In its recent earnings update for FY2020, Xero’s management wrote,

“[T]rading in the early stages of FY21 has been impacted by the COVID-19 environment. The continued uncertainty surrounding COVID-19 means it would be speculative for us to say anything more at this time on its potential impact on our expected performance for FY21.”

Valuation

The final piece of the analysis is to find out what is a good price to pay for the company. I like to compare what I think is a potential future value of the company in five to 10 years’ time versus the company’s current market cap.

Based on very rough estimates, let’s assume Xero can penetrate 80% of all SMEs in its core market in ANZ, 20% in the more developed UK market, and 10% in the young and competitive US market.

This translates to slightly over 9 million customers. The average revenue per user remains at around NZ$30 a month, which means Xero will earn revenue of about NZ$3.2 billion.

Let’s make two more assumptions. First, it can earn a net profit margin of 25% (which to me is conservative considering its gross margin of 85%), and second, the market is willing to price it at 30 times earnings. This will mean that Xero will command a market cap of around NZ$24 billion in five to 10 years’ time. Currently, Xero has a market cap of NZ$13.2 billion. 

Last words

Xero has all the makings of a great company. It boasts (1) a huge addressable market to tap into, (2) a strong balance sheet, (3) a management team with a track record of solid execution, (4) a proven track record of growth, (5) recurring revenue and (6) the ability to generate steady and high free cash flow margins.

Its market cap today also gives it room to grow further. 

There are risks, though. Execution risks and competition can stifle its growth. However, given all that I’ve seen so far, the risk-reward profile still is fairly appealing to me.

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.

China has one of the most advanced e-commerce economies in the world. It boasts the world’s largest e-commerce market, with a volume of US$1.94 trillion in 2019. That’s more than thrice the US e-commerce market, which ranks second.

Much of that volume was fueled through China’s largest e-commerce player, Alibaba Group Holdings Limited (NYSE: BABA).

The e-commerce giant has already seen the price of its US-listed shares close to triple from the IPO level of US$68 in 2014. In this article, I take a look at some of the major trends fueling Alibaba’s growth.

A powerful network effect

Alibaba is the biggest player in China’s e-commerce space. However, that does not mean that it has run out of room to grow. China’s e-commerce market is still expected to grow by double digits well into the mid-2020s. Alibaba is the undisputed leader in 2019, taking in 55.9% of retail e-commerce sales, with second place JD.com some way off at 16.7%.

As the market leader, Alibaba’s B2C (business-to-consumer) platform, Tmall, is well placed to ride on the coattails of the growing e-commerce market. It is the platform of choice for businesses to launch their new products. More than 50 million new SKUs were launched in Tmall in 2018 alone. In Alibaba’s 2019 investor day presentation, the company stated that new products made up 53% of Tmall Apparel’s total GMV in August 2019.

This demonstrates the power of Tmall’s network effect. The large number of annual active accounts on Tmall attracts new product launches on the platform, which in turn, creates value for users. This is a virtuous cycle that can keep on giving for Alibaba.

A global presence

Besides Taobao and Tmall in China, Alibaba also has a global e-commerce presence. Alibaba has invested heavily into Lazada and Ali Express. Lazada is a fast-growing e-commerce platform in Southeast Asia, while AliExpress is a global retail market place that enables consumers across the globe to buy directly from manufacturers and distributors in China.

Tmall Global is a platform where overseas brands and retailers can reach Chinese consumers.

With e-commerce growing quickly in Southeast Asia and other parts of the world, Alibaba has planted the seeds to take advantage of this secular uptrend.

A high margin model

Alibaba’s unique business model creates a high margin, cash-generating business. Instead of holding its own inventory, Alibaba monetises its high user base through auxiliary services. This includes pay-for-performance marketing services which bump merchants up in the search list, or display marketing services where merchants pay for display positions.

In addition, Alibaba also earns commissions on transactions based on a percentage of the transaction value.

In the fiscal year ended 31 March 2020 (FY2020), Alibaba recorded a free cash flow margin (free cash flow as a percentage of revenue) of 25% in US dollar terms. This free cash flow margin includes the other non-profitable businesses that Alibaba is currently trying to grow (more on this later).

Targeting growth

Though founder Jack Ma has stepped down from the hot seat, Alibaba has kept its foot on the pedal.

It has set a hard target of serving more than 1 billion Chinese consumers, and to facilitate more than RMB10 trillion of consumption on its platforms, by 2024. This translates to 50% growth in GMV in the next four to five years.

I think Alibaba can likely achieve its target on both counts. So far, its 780 million consumers in China account for around 85% and 40% of the Chinese population in developed and less developed areas, respectively. As internet penetration increases in the less developed regions, I think the gap in user penetration between the developed and less developed regions will narrow.

Alibaba has also set its sights on growing its global e-commerce platforms. Lazada is Southeast Asia’s fastest-growing e-commerce platform with 50 million annual active users.

And though Shopee is a strong competitor to Lazada in the region, I think the market in Southeast Asia is big enough for two large players to coexist. 

Cloud Computing: an important growth driver

Besides its core e-commerce segment, Alibaba also has cloud computing, digital media, and innovation initiatives.

The three other segments are relatively small compared to its core e-commerce business but Alibaba Cloud could potentially become an important source of profits and cash flows in the future.

Alibaba Cloud is the world’s third largest, and Asia Pacific’s largest, infrastructure-as-a-service and IUS (Infrastructure Utility Service) provider. Similar to Amazon Web Services, Alibaba Cloud emerged due to Alibaba’s need to operate its websites at a massive scale. Subsequently, Alibaba decided to monetise this technology by providing it to other third party customers.

Clouding computing is Alibaba’s fastest-growing segment, with revenue growth of 62% year-on-year in FY2020.

Although this segment is still unprofitable, cloud services could be a hugely profitable and high margin business as demonstrated by Amazon Web Services. As Alibaba scales its cloud computing business, it can possibly become a profitable high margin business.

Risks

As with any company, there are risks. Chinese companies have come under scrutiny after the recent high profile case of Luckin Coffee’s fraudulent business activities. The US has also threatened to delist Chinese companies from their stock exchanges. 

If you buy into Alibaba’s shares on the NYSE (New York Stock Exchange) in the US, you are also only the owner of an ADR (American depository receipt) of a variable interest entity (VIE) that in turn has an interest in Alibaba’s economics. This ownership structure may not be as robust as owning a direct interest in a company.

There is also the risk that Alibaba is not able to execute its growth strategy well, especially in Southeast Asia where there is stiff competition from numerous players.

Alibaba’s shares are also priced at a premium to the broader market. At its current share price, it trades at around 25 times FY2020’s earnings and 29 times free cash flow. If Alibaba is not able to grow as fast as the market expects, there may be a valuation compression.

Final thoughts

Alibaba comes with its own set of risks. The VIE structure, high valuation, and competition in Southeast Asia are just some of the risks to note.
But Alibaba also has the potential to become a good long-term investment. It is a dominant player in a fast-growing market, has a network effect that is difficult to erode and its cloud computing segment could become an important cash generator in the future.

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

The term, multi-baggers, when applied to the stock market, was coined by legendary investor Peter Lynch in his book One up on Wall Street. 

It refers to a stock that delivers more than a 100% return on our investment. Seasoned investors will tell you that just having a few multi-baggers in your portfolio can make a world of a difference.

Imagine if you had used just 1% of your portfolio to buy Netflix in 2007 at US$2.57 per share. You’d have a 163-bagger in your portfolio today. That 1% position will now be worth 163% of your initial portfolio. Even if the other 99% of your portfolio went to zero, you’d still be sitting on a positive return.

But how do we unearth such long-term winners? Here are some things that I consider when looking at which stocks can be multi-baggers over the next few years.

Potential market opportunity

The amount of revenue that a company can earn in the future is a key factor in how valuable the company will be worth.

As an investor, I’m not focused on quarterly results or what percentage year-on-year growth a company achieves in the short-term. Instead, I’m more focused on the total addressable market and how much the company could make a few years out.

Let’s take Guardant Health as an example. The company is one of the leading liquid biopsy companies. It has non-invasive tests to identify cancers with specific biomarkers for more targeted therapy. In addition, the company is developing non-invasive tests that could detect early-stage cancer, which has a market opportunity of more than US$30 billion a year. Together with its late-stage precision oncology test, Guardant Health has a market opportunity of more than US$40 billion in the US alone.

Guardant Health is still in its infancy with just US$245 million in revenue in the last 12 months. If its early-stage cancer tests gain FDA approval and is adopted by insurance companies, Guardant Health could easily increase its sales multiple folds.

Clear path to profitability

Besides increasing revenue, companies need to generate profits and cash flow too. As such, investors need to look at free cash flow and profit margins.

For fast-growing companies that are not yet profitable, I tend to look at gross margins. A company that has high gross margins will be more likely to earn a profit during its mature state.

Using Guardant Health as an example again, the liquid biopsy front-runner boasts 65% gross margins on its precision oncology testing. Such high margins mean that the company can easily turn a profit with sufficient scale as other costs decrease as a percentage of sales.

An enduring moat

To fulfil its potential, the company needs to be able to fend off its competition. A moat can come in the form of a network effect, a superior product, a patent or other competitive edges that a company may have over its competitors.

On a side note, I don’t consider first-mover advantage a moat unless it operates in an industry where a network effect is a valuable moat.

In Guardant Health’s case, the company’s tests are protected by patents, which prevents other companies from copying their products. 

Management that can execute

Potential is one thing, but can the company execute its plans? This is where management is important. The company’s CEO needs to have a clear vision and execution plan. 

Management is a touchy subject and requires a lot of subjective analysis. My blogging partner, Ser Jing, wrote an insightful article recently on how we can assess the quality of management.

Comparing current market cap with the potential market cap

Finally, after identifying a company that has a high probability of growing sales and profits multiple folds, we need to assess if its current market cap has room to grow into a multi-bagger.

It’s no use buying into a company that has all its future earnings baked into its market value.

If Guardant Health can increase its sales to just 20% of the US$40 billion addressable market in the US alone, and generate a 25% profit margin, it will earn US$2 billion in profit annually.

Assuming the market is willing to give it a price-to-earnings multiple of 30, that translates to a US$60 billion market cap.

At the time of writing, Guardant Health’s market cap is around US$8.3 billion. If Guardant Health can execute its growth strategy well over the next 5 to 10 years, it can become a multi-bagger.

Final words

Multibaggers can be the difference between a market-beating portfolio and an average one.

However, finding a multi-bagger is not easy. The company needs to tick many boxes. And even so, there is always the risk that the company does not fulfil its potential. In Guardant Health’s case, biopharmaceutical companies have to jump through many hoops to earn the honey pot at the end of the rainbow.

For the liquid biopsy market, Guardant Health needs its early-stage cancer test clinical trials to (1) meet its primary end goals, (2) gain regulatory approval, (3) earn trust from insurance companies and finally ,(4) be adopted by clinicians. These hurdles will not simply fall over and there are risks that the company will fall flat in any one of these.

As investors, we therefore, need to consider the risk-return profile of a company before deciding if the it makes sense for our 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.

I’ve made my share of mistakes while investing that ended up as expensive lessons.

In this article, I share one particularly painful mistake and three lessons that I took from it.

What happened?

In October 2015, I bought shares of Chipotle Mexican Grill Inc (NYSE: CMG). At that time, Chipotle’s share price had fallen 25% from its peak following a Salmonella outbreak at one of its outlets. As such, I managed to pick up shares at US$564 per share, compared to the previous high of US$749.

I had been eyeing Chipotle for some time and thought that it was a great opportunity to buy shares.

Chipotle was a fast-growing fast-casual restaurant chain in the US that still had a huge market opportunity to expand into. Its food – Mexican fare- were popular and its comparable sales stores were consistently in the mid-to-high single digits or higher. The company was ambitiously expanding its store footprint in North America. I also thought the decline in its share price was unwarranted and that its sales would not be that greatly impacted due to an isolated food-safety incident.

Unfortunately, Chipotle suffered a few more setbacks shortly after I bought my shares. The company reported another four separate E- Coli and norovirus outbreaks at its restaurants.

The news spread across the country and customers started being cautious about going to Chipotle.

A challenging period for Chipotle and selling my shares

What I thought was going to be a mild bump on the road for Chipotle, ended up being an extended period of depressed sales. The effects of negative publicity hurt Chipotle’s bottom line hard. Chipotle reported its first quarterly loss as a public-listed company in the first quarter of 2016.

Same-store sales declined 30% from a year ago. Marketing campaigns to get customers back in stores were not cheap either.

Stores that once had long queues were now empty and Chipotle had to resort to country-wide marketing campaigns and offering 1-for-1 burrito deals to bring customers back. The efforts had minimal impact and I was getting worried that customers will not come back.

Unsurprisingly, investors were getting nervous too. Chipotle’s share price fell from the price I bought to a low of US$370 in mid-2016. 

Chipotle’s share price eventually climbed to US$483 in May 2017 and I took the opportunity to sell my shares. At that time, Chipotle’s shares – despite having a price 15% lower than my purchase – still seemed too expensive for me. Chipotle’s shares traded at 48 times forward earnings (due to the depressed earnings at that time) and I lost confidence in the company’s growth prospects.

A turn of fortunes

This is not a story of me buying a company that ended up a poor investment. It actually is a tale about me not giving my investment time to fulfill its potential. 

I knew from the get-go that Chipotle was well-loved by customers. An American friend of mine who was living in Europe at that time constantly told me the thing he missed most about the US was Chipotle.

Chipotle was a brand that was loved – and its customers would eventually come back. After a change in CEO in March 2018, Chipotle’s fortunes changed dramatically. Its marketing efforts started to pay dividends. The company grew its online sales channels, and drive-throughs fueled an increase in sales.

Same-store sales improved. In the fourth quarter of 2019, Chipotle’s same-store sales increased by 13.4%, a third consecutive quarter of double-digit growth. 

You can probably guess what has happened to its share price. Chipotle’s shares today trade at around US$1,050 apiece, more than double the price I sold my shares at.

Lessons learnt

Although I technically lost only 15% of my investment in Chipotle, I had in fact missed out on a near-100% gain by selling early. That’s an extremely expensive mistake, especially when I consider that I would have been much better off doing nothing, rather than actively trying to manage my portfolio.

From this experience, I took away three important lessons.

Lesson 1: Companies with great products are more resilient

Customers love Chipotle. That’s an important reason why Chipotle was well-placed to recover from the bad press after the food-safety outbreaks at its restaurants. In addition, Chipotle was determined to improve its food safety and the steps taken also regained customer confidence. 

Lesson 2: Give companies time to prove their worth

I held Chipotle’s shares for a mere one-and-a-half years. That’s not enough time to allow a company to prove itself. I should have been more patient and given management more time to turn the company around. Given that Chipotle was a brand that customers loved, it was only a matter of time before queues started returning. 

A well-known Warren Buffett quote comes to mind: “Time is the friend of the wonderful company, the enemy of the mediocre.”

Lesson 3: Forget about quarterly results- think long term

Wall Street’s focus on quarterly results can lead to wild gyrations in the stock prices of companies. This miss by a penny, beat by a penny compulsion can lead to a significant price-value mismatch between a company’s long term value and its share price.

Clearly, my decision to sell Chipotle’s shares was because I was focused on the company reporting negative same-store sales growth over a year, rather than looking much further into the future.

Final thoughts

“The trick is, when there is nothing to do, do nothing.”

Warren Buffett

It is often tempting to actively manage our portfolios. But moving in and out of stocks due to short-term gyrations in price and earnings is a fool’s game. It is not only time-consuming, but may also end up as expensive mistakes. I certainly learnt that the hard way with Chipotle.

I hope that by sharing some of the lessons I learnt from this mistake, other investors will not fall victim to the same expensive mistake that I made.

My blogging partner, Ser Jing, also wrote a great article about why he owns Chipotle shares. His fortunes with this company were very different from mine. You can head here to find out why he still owns shares in Chipotle.

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.

Square Inc (NYSE: SQ) is a fintech company that provides seller tools, financing for small businesses, and peer-to-peer payments for individuals.

It started life as a company that enabled small businesses to accept card payments with a mobile phone and an attached square “scanning device”. Since then, Square has widened its offering to sellers, and launched Cash App, a mobile payment service that allows individuals to transfer money to each other using just their phone.

Square has been one of the darlings of the US stock market, with its share price up around six-fold since the first day it went public in late 2015. The strong adoption of Square’s POS (point-of-sales) system and Cash App’s surging popularity have led to that strong stock performance.

But I think there is still more to come from this fast-growing Fintech firm.

Huge market opportunity for payment growth

As with other payment solutions, Square takes a cut of every dollar transacted using Square’s software. 

The more payments Square processes, the more it earns. In 2019, despite a 25% increase in transaction-based revenue growth, Square still accounted for only a small fraction of the total gross payment volume (GPV) in the US. In 2019, Square’s GPV was US$106.2 billion, compared to total US gross sales of more than US$10 trillion.

Square started off as a payment tool for small businesses but has since begun targeting larger businesses, which provides a much larger market opportunity.

Square has done quite well in reaching out to larger businesses. In the first quarter of 2020, percentage of GPV from larger sellers (more than US$125k in GPV) increased to 52%, up from 47% and 51% in the same quarter in 2018 and 2019, respectively.

Cash App growing in popularity

Square launched Cash App in 2013 to compete with peer-to-peer payment services and e-wallets such as Paypal’s Venmo.

Since then, Cash App’s popularity has exploded and has been one of the key drivers of growth for Square. The beauty of payment solutions is that the bigger the network, the more value the system holds for users. Cash App’s growing popularity will be a virtuous cycle for more users and transactions in the future.

The Covid-19 pandemic has also led to an increased adoption for Cash App services. Users now use Cash App as a tool to send funds for fundraising, donations, and to reimburse one another for supplies during this period of social distancing.

Square disclosed that Cash App’s gross profit skyrocketed 115% year-over-year in the first quarter of 2020.

That’s a continuation of a longer-running trend. The charts below show the growth in Cash App’s monthly active users.

In addition, Square has been able to increase the monetisation rate of each active customer it has on its platform.

Cash App is currently available in the US and the UK. However, it was only in March that Cash App allowed cross-border payments, further increasing the value proposition that Cash App brings to the table.

Cash App started small, but has since grown astronomically and now accounts for close to 40% of Square’s total net revenue.

Product-focused management

Square’s CEO and co-founder, Jack Dorsey, is one of the most respected entrepreneurs today. He is also known as the visionary leader behind the popular products that his companies produce. Besides Square, Dorsey is also the co-founder and CEO of the social media platform, Twitter.

While some argue that Dorsey should focus his energy squarely (sorry) on one company, so far the results of Square have been extremely strong. And there is nothing to suggest that Dorsey is out of wits leading two companies at the same time. 

Square has also been successful in implementing new features into both its POS software and its Cash App. The increase in revenue and user growth are also testament to Square’s solid execution of its growth strategy.

Solid free cash flow and decent balance sheet

While Square is still reporting a GAAP loss, the company has turned free cash flow positive. The payment solutions provider generated US$101 million, US$234 million and US$403 million in free cash flow in 2017, 2018 and 2019 respectively.

In 2019, it recorded a free cash flow margin of 8%. For a company that is growing revenue fast, I expect its margins to improve in the future.

Square’s balance sheet also remains strong with US$2.5 billion in cash, cash equivalents, and short-term investments in debt securities, as of 31 March 2020. It only held US$1.8 billion in long-term debt, giving it good financial standing to continue to invest in growth.

Black marks?

However, Square is not perfect. Despite reporting strong free cash flow generation, Square’s only GAAP profit was in 2019. The company then returned to the red in the first quarter of 2020 as increase in expenses exceeded revenue growth.

One of the big reasons why the company has been reporting losses but generating cash is its heavy stock-based compensation. Stock-based compensation does not burn cash but it increases the number of outstanding shares and dilutes existing shareholders.

In Square’s case, stock-based compensation has resulted in an increase in the number of diluted shares from 341.6 million in 2016 to 466.1 million in 2019. The dilution has resulted in existing shareholders owning a smaller fraction of the company.

It is normal for fast-growing tech companies to pay out a large chunk of its compensation in shares. That said, Square’s revenue has increased at a faster rate than its stock-based compensation which is a good sign. But the company’s stock-based compensation is still something I’m watching.

In addition, Square also sports an expensive-looking valuation to me. As of the time of writing (20 May 2020), Square had a market cap of US$34.8 billion. That translates to around nine times trailing sales and more than 90 times free cash flow, assuming a 10% free cash flow margin.

I think that Square can justify such a high valuation, but it needs to execute its growth strategy perfectly and any hiccups could see a valuation compression in the stock.

Final words

There are risks, as I mentioned earlier. But there is also much to admire about Square. From a company with ambitions to help small businesses accept credit card payments, Square has grown to a company that offers a wide range of fintech services and now serves individuals through its Cash App.

The company boasts a strong track record of growth, has an innovative leader who is willing to invest in new products, and a balance sheet that is flushed with cash. All of which puts it in a strong position to ride on the tailwinds of the expanding payments ecosystem.

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.