Category: Investing Analysis

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.

Last week, Singapore Airlines (SGX: C6L) announced a sobering set of results for the quarter ended 31 March 2020. SIA’s latest earnings showed an operating loss of S$803 million on the back of a 21.9% fall in revenue.

I’ve got to say, though, that these figures were not unexpected. Earlier this year, SIA announced that it had grounded more than 90% of its passenger fleet as the COVID-19 pandemic effectively halted most passenger air travel around the world. 

To prepare for the sudden drop in revenue, the airline also announced that it was raising up to S$15 billion from existing shareholders. The timely injection of cash will save the company from insolvency but shareholders will still have to endure a tough few quarters ahead.

Government support cushioned the blow

Things could have been much worse had the Singapore government not stepped in to support the aviation industry. Under the jobs support scheme, the government co-funds 75% of the first S$4,600 of wages paid to each local employee for 9 months. SIA was one of the beneficiaries of this scheme.

Through the scheme, its employee expenses for the quarter were lower by 62% to S$273 million. However, this was not enough to save the company from reporting a loss for the quarter.

Part of the reason was that SIA reported a large mark-to-market loss from surplus hedges that arose due to the recent sharp fall in oil prices. This reversed most of the cost savings that SIA got from government support, capacity cuts, and other cost-savings measures. In addition, despite a fall in activity, SIA still has a lot of fixed costs, and recorded high depreciation and aircraft maintenance expenses of S$798 million.

How does the loss impact shareholders

The huge bottom-line deficit resulted in a sharp decline in the company’s book value per share. The book value per share fell from S$10.25 on 31 December 2019 to S$7.86 as of 31 March 2020.

That’s a 24% drop in just three months. In addition, the 3-for-2 rights issue at S$3 per rights share will further dilute the company’s book value per share.

Based on my calculation, and excluding further losses in coming quarters, the dilution will cause SIA’s book value per share to drop to around S$5. 

A difficult path ahead

Unfortunately for SIA shareholders, the path ahead is uncertain. In its press release, management said:

“There is no visibility on the timing or trajectory of the recovery at this point, however, as there are a few signs of an abatement in the Covid-19 pandemic. The group will maintain minimum flight connectivity within its network during this period while ensuring the flexibility to scale up capacity if there is an uptick in demand.”

In addition, management highlighted that there could be more fuel hedging losses due to weak near term demand. With half of the second quarter of 2020 over, and SIA still grounding most of its planes, I think that the next reporting quarter could be even worse than the last.

More worryingly, with no end in sight, SIA could see poor results up to the end of 2020 and beyond.

The worse is not over for the airline and I expect revenue to be much lower in the second quarter of 202,0 and losses to exceed the S$803 million recorded in the first quarter. Given this, diluted book value per share could even fall to the mid-S$4 range (or worse) after the losses are accounted for next quarter. 

Final thoughts

The aviation industry is one of the most badly-hit sectors from the COVID-19 pandemic. Warren Buffett announced earlier this month that he sold all his airlines stock after admitting he did not factor in the risk that airlines faced. Their low-profit margins and capital intensive nature made them highly susceptible to cash flow problems should disaster strike.

SIA has certainly not been spared. 

The only comfort that shareholders can take is that, with Temasek promising to buy up all of the company’s non-exercised rights, SIA will have sufficient capital to see it through this difficult period. But even so, the airline looks likely to suffer more losses and book value per share declines. Given all this, shareholders are unlikely to see its share price return to its former glory any time soon.

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.

Pushpay Holdings (ASX:PPH) may not be a company that rings a bell with many investors but it certainly warrants some attention. 

The little-known software-as-a-service (SaaS) company, which is dual-listed in Australia and New Zealand’s stock markets, has seen its share price rise by around 300% since 2016. That’s a really strong performance.

In this article, I use my blogging partner Ser Jing’s six-point investment framework to assess if Pushpay has the makings of a good investment.

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

Pushpay operates in an extremely niche market.

It provides churches and non-profit organisations with the tools to create an app to engage their communities. Customers use Pushpay to customise the design and feel of their app-interface. Customers can also communicate with their community members through the app by posting videos, audios and notifications.

Through the app, community members can make donations too. In addition, customers can access donor data, allowing church leaders to take effective next steps for better engagement with donors.

The growing popularity of Pushpay’s app service has been evident with customer numbers increasing steadily since its iOS launch in 2012. As of 31 March 2020, Pushpay boasts 10,896 customers.

Pushpay has two revenue streams: (1) Subscription revenue for its services; and (2) processing revenue, which consists of volume fees based on a percentage of the total dollar value of payments processed.

Despite operating in a niche market, Pushpay actually has quite a large addressable market opportunity. Chris Heaslip is the co-founder and ex-CEO of Pushpay; he stepped down from the CEO role in May 2019. In an interview with Craigs Investment Partners in late 2018, Heaslip said:

“Giving to churches alone is about $130 billion a year, which represents a TAM (total addressable market) of just under a couple of billion dollars. And as we continue to make good inroads in that market and expand our product functionality, we’ll look to expand into other verticals as well, such as the education or non-profit verticals which are about one and two billion dollars respectively of TAM opportunity, for about $5 billion in total.”

Pushpay’s latest annual report – for the year ended 31 March 2020 (FY2020) – mentioned that “Pushpay is targeting over 50% of the medium and large church segments [in the long term], an opportunity representing over US$1 billion in annual revenue.”

For FY2020, Pushpay processed just US$5 billion and earned a total operating revenue of US$130 million, which is still small compared to its total addressable market size.

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

Pushpay does not have the strongest balance sheet with a net debt position of US$48 million as of 31 March 2020. This is largely due to it spending US$87.5 million in FY2020 to acquire Church Community Builder, a church management system software provider.

That said, Pushpay has recently become cash flow positive and should be generating a good amount of cash in the future. In FY2020, Pushpay produced US$23.2 million in free cash flow, a marked improvement from the negative US$3.1 million seem in the prior year.

As the company continues to grow in scale, I foresee free cash flow growth in the years ahead (more on this later).

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

I think Pushpay’s executive team have so far demonstrated all of the above. The team has been extremely transparent about their goals and targets for years, and have set revenue and earnings guidance that they have been able to consistently meet or beat.

I appreciate management teams that set realistic guidance and can deliver on their targets, and so far Pushpay has done exactly that.

I believe Pushpay’s rapid growth is also a testament to management’s capability to expand the company, reach new customers, and increase the average revenue per customer.

Management has also been actively seeking to improve the company’s product. In 2019 alone, Pushpay launched numerous new functions on its app, including Donor Development, which delivers donor insights and streamlines reporting to organisation leaders.

Pushpay also launched Pushpay University in May 2019, It is an education website for Pushpay’s customers to “learn from leading experts in leadership, communication and technology, while also deepening their Pushpay product knowledge.”

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

Recurring revenue is a beautiful thing. It enables a company to focus its energy on expanding the business, knowing that it can rely on a stable source of revenue. It also means that the company can spend a bit more to acquire new customers due to the long lifetime value of its customers.

In FY2020, recurring subscription revenue made up 27.7% of Pushpay’s overall revenue. The rest was derived from commissions that the company earns for processing money that is donated through its app.

I see both sources of revenue as recurring in nature. Subscription revenue recurs as long as customers continue using Pushpay’s platform. Meanwhile, payment processing revenue recurs as long as donors keep making donations via the company’s platform; many donors tend to make repeat donations so payment processing revenue tends to recur. In FY2020, Pushpay’s total processing volume increased by 39% to US$5 billion, as the company likely increased its market share in the donor payment market.

Another metric that demonstrates the recurring nature of Pushpay’s revenue is the annual revenue retention rate. This measure the amount collected per customer compared to the previous year. This figure has consistently been north of 100%, suggesting that existing customers are paying Pushpay more each year as the amount of money they raise through the platform grows.

5. Does Pushpay have a proven ability to grow?

The SaaS company is growing quickly. The chart below illustrates its revenue growth from FY2015 to FY2020.

The growth has been driven both by an increase in the number of customers using the company’s platform, as well as the average revenue per customer.

Equally important, as Pushpay scales, more of that revenue can be filtered down to the bottom line and converted to cash flow.

The company reported its first net profit before tax in FY2020 as costs rose much slower than revenue. The relatively long customer lifespan that Pushpay has enables the company to spend more on customer acquisition, as it can reap the returns over a few years.

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

In FY2020, Pushpay demonstrated that with sufficient scale, it can turn a profit and generate free cash flow.

Previously, the company was in a high growth phase and spent a significant proportion of revenue on marketing. However, as the recurring revenue base grows, the amount spent on marketing decreases as a percentage of revenue and the young SaaS company can turn a profit and generate free cash flow.

In FY2020, Pushpay had a free cash flow margin of 17.8%, a very decent return for a company that is still growing strongly. 

Pushpay expects to earn between US$48 million and US$52 million in EBITDAF (earnings before interest, tax, depreciation, amortisation, and foreign exchange fluctuations) in FY2021. This represents 90% growth in EBITDAF from FY2020. As revenue and EBITDAF grows, we will naturally see free cash flow follow suit.

Given the large addressable market to grow into, I believe Pushpay’s free cash flow is likely to grow even faster than revenue as margins improve.

Risks

As a young SaaS company, Pushpay has a lot of potential. However, actually fulfiling that potential depends on the company’s execution. Therefore, execution risk is a major factor in its growth. The company’s ability to scale, attract and retain customers, and fend off competition, will be put to the test in the coming years.

Pushpay also spent a large chunk of cash to acquire Church Community Builder. The acquisition brought with it a ready set of new customers. However, it also stretched Pushpay’s balance sheet.

With growth a priority, management’s ability to put capital to use wisely will be crucial. Given that Pushpay has a very short history, I will monitor how management allocates its capital in the future. Poor allocation of capital could derail the company’s growth.

In addition, competition can be a major threat to Pushpay’s business. For now, Pushpay boasts a loyal set of customers who likely will find it tedious to switch apps. However, there is still a risk that other players may encroach into Pushpay’s territory.

Valuation

Valuation is perhaps the most tricky part of assessing a company. Pushpay is currently valued at around US$1.1 billion. That translates to around 70 times trailing earnings and 8.5 times sales.

On the surface that seems quite expensive. However, the company is growing its sales and profits fast. It also has a large opportunity to grow into. As mentioned by co-founder, Chris Heaslip, donors give around $130 billion to churches alone.

The currency for the $130 billion is unclear – it could be US dollars or New Zealand dollars. But either way, Pushpay’s revenue of US$130 million (NZ$216 million) is much lower than its addressable market size. Given its dominant position in its space, Pushpay can easily grow its market share.

The recent COVID-19 pandemic is also likely to accelerate the migration of donations from being made offline to online, with Pushpay the beneficiary of this trend. Indeed, Pushpay shared the following in its FY2020 annual report:

“Pushpay expects the increase in digital giving as a proportion of total giving resulting from COVID-19, to outweigh any potential fall in total giving to the US faith sector.”

The bottom line

Pushpay may not be the most recognisable SaaS company in the world, but it has got my attention. The company is revolutionalising the way churches interact with their communities.

Not only is it a great business financially, but it is also doing its part to help donors and campaigners raise funds for causes they believe in.

Despite some risks, I still think Pushpay’s risk-return profile looks really attractive right now.

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

a2 Milk Company Ltd (ASX: A2M) is one of Australia’s best-performing stocks. If you had bought shares in 2015 after its listing in Australia’s market, you would be sitting on a gain of over 3,000%.

In this article, I’ll take a look at how the company got to where it is and what’s in store for the future.

A checkered past

a2 Milk Company may be one of Australia and NewZealand’s most successful business stories, but its journey has been anything but smooth.

a2 Milk Company is actually the successor of the much-maligned A2 Corporation, which was co-founded by scientist Dr Corran McLachlan. In 1994, McLachlan began his research on the effects of milk consumption and heart disease and concluded that there was a correlation between A1 beta-casein protein (found in milk) and ischaemic heart disease, childhood type 1 diabetes, and other ailments. 

Inspired by his research, McLachlan co-founded A2 Corporation in 2000. He used genetic testing to identify cows that produced milk that contained only A2 beta-casein protein.

However, Dr McLachlan’s research on the harmful effects of A1 beta-casein protein in milk was not widely accepted by scientists. They felt the findings were correlative, rather than causative. Even today, a lot of the research done on milk with A2 beta-casein protein is funded by a2 Milk Company and there is insufficient data to prove that A1 beta-casein protein predisposes consumers to these ailments.

Moreover, A2 Corporation ran into more significant problems along the way. In 2003, both Dr McLachlan and co-founder Howard Peterson passed away. The company was also facing financial difficulties. Just five months after it went public in May 2003, A2 Corporation had to go into administration in October and was liquidated in November.

A2 Corporation set up a new subsidiary to license and sell A2 milk in Australia. It sold a stake of that to Fraser and Neave and focused on expanding its international business. By 2006, A2 Corporation was able to buy back most of the stake it sold to Fraser and Neave and by 2011, A2 Corporation finally made a profit for the first time in its history.

It raised another $20 million through a secondary listing in New Zealand and used the funds to expand its business.

A2 Corporation changed its name to a2 Milk Company in April 2014 and has since seen remarkable growth (more on this later).

Catalysts that propelled its business

Although data about the harmful effects of A1 beta-casein protein in milk is still inconclusive, a2 Milk company enjoyed two key catalysts that saw a spike in demand for A2 beta-casein milk.

First, the publication of a book titled Devil in the Milk by Keith Woodford in 2007 caused a spike in A2 milk sales in New Zealand and Australia. Woodford discussed A1 beta-casein protein and the perceived health risks.

Next, the Chinese milk scandal in 2008, which resulted in six baby deaths and 54,000 hospitalisations, led to a spike in demand for infant milk formula from trusted Australian milk companies. a2 Milk Company was one of the beneficiaries from that scandal as its milk formula sales in China exploded.

Steady growth 

FY2011 (financial year ended 30 June 2011) was the turning point for the company. After turning a profit 11 years after its founding, a2 Milk Company was able to grow its revenue and profit steadily, leading to a significant jump in its share price.

Revenue has jumped 30-fold from NZ$42 million in FY2011 to NZ$1.3 billion in FY2019. Earnings per share increased by almost 100-fold from NZ$0.004 in FY2011 to NZ$0.39.  Crucially, that growth has been fairly consistent and has continued in recent times.

The charts below show a2 Milk Company’s revenue, EBITDA (earnings before interest, taxes, depreciation, and amortisation), and basic earnings per share over the last four financial years.

Strong sales momentum

Today, a2 Milk Company is more than just a liquid milk company. As mentioned earlier, the company has its own infant milk formula and other nutritional products, such as pregnancy and Manuka products.

All its three product segments saw significant growth in FY2019. Liquid milk sales increased 23% from NZ$142.4 million in FY2018 to NZ$174.9 million. Infant nutrition has grown to become the most important product segment; in FY2019, infant nutrition revenue was up 47% to NZ$1,063 million.

a2 Milk’s three key geographic markets- (a) Australia & New Zealand; (b) China & other Asian markets; and (c) the US – saw sales growth of 28.3%, 73.6%, and 160.7%, respectively, in FY2019.

Huge potential in China & Asia and the US

a2 Milk Company already has a strong presence in Australia and New Zealand with its a2 Milk brand of fresh milk achieving an 11.2% market share in its segment. Meanwhile, its infant formula brand, a2 Platinum, is the leading brand in its category.

So the main driver of the company’s growth should come from its less developed markets in the US, China, and other parts of Asia.

a2 Milk Company’s main product in China is infant milk formula (IMF). In FY2019, infant nutrition revenue from China and Asia was NZ$393.1 million. This is still a fraction of the NZ$652.9 million in revenue that the same business-line generated in the Australian and New Zealand market. Considering that Australia and New Zealand have a combined population that is about 2% the size of China’s, you can just imagine the huge addressable market in China that a2 Milk Company could grow into.

Investing in growth

To management’s credit, a2 Milk Company is investing prudently to unlock this vast potential in China. The company has increased its physical footprint. As of 31 December 2019 its products are now sold in 18,300 stores in China, up from 16,400 in June 2019.

There’s been a steady increase in the company’s distribution store count in China, which is partly fueling the increase in brand awareness and sales in the country.

The chart below shows the store count numbers from 2017:

a2 Milk Company’s China label IMF products has also grown from a mere 2% of the product-category’s total sales in FY2016 to 22% in the first half of FY2020. This suggests that the company’s investments in marketing in China is paying dividends in terms of brand recognition.

a2 Milk Company’s infant nutrition consumption share in China has also increased from 4.8% in June 2018 to 6.6% in December 2019. That’s still a small number, and there’s potential for the company to increase wallet share in China considerably in the future.

Growth in the US has also been steady, as revenue in the first half of FY2020 jumped 116% to NZ$28 million. Although the US still represents a small fragment of a2 Milk Company’s total sales, the size of the US market could result in it becoming a more important revenue contributor in the future.

Lots of cash…

Since 2011, a2 Milk Company has completely turned its business around. From a company that had to be liquidated back in 2004, a2 Milk Company now stands on solid ground, financially. 

It boasts NZ$618 million in cash and no debt (as of 31 December 2019). It also milked NZ$286 million in free cash flow in FY2019. Its capital-light business model, decent margins, and strong free cash flow should enable it to reward shareholders with buybacks and dividends in the future.

Final words

a2 Milk Company has certainly come a long way since its bumpy start in the early 2000s. Since 2011, the company has seen tremendous growth and is in a great position to capitalise on its strong brand in China. On top of that, the company boasts lots of cash on its balance sheet that can be reinvested into growing internationally. 

Although it is currently not paying a dividend, I believe it is in a great position to start rewarding shareholders in the near future.

a2 Milk Company does come with risks though. Its stock trades at a high valuation of around 46 times trailing earnings. There are also concerns about regulatory changes in China. International expansion also has an element of risk, and a2 Milk Company has had its own share of failures, including its inability to expand meaningfully in the UK. It ultimately ended up announcing the closure of its UK business in 2019.

Nevertheless, despite the risks and high valuation, I think a2 Milk Company still has a favourable risk-reward profile. Its huge market opportunity in China alone could provide a significant tailwind for the company and I think shares at these rich valuations still have a decent risk-return profile.

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.

Many of us would have heard of Domino’s Pizza before but did you know that Domino’s has also been a great stock to own? As the leading global quick-service restaurant in the pizza category, the share price of Domino’s Pizza Inc (NYSE: DPZ) has increased a phenomenal 2600% from 2004, easily outpacing the S&P 500 in the US.

Here are some of my thoughts on this amazing company.

A capital-light business model

Just to make sure we are on the same page, the Domino’s I am referring to is the brand owner that is listed on the New York Stock Exchange. There are other Domino’s Pizza franchisees that are the master franchisees in different countries. These companies are also listed on their respective exchanges. 

Domino’s the brand owner derives its revenue from (1) royalties and fees it charges its franchisees, (2) providing the supply chain to its restaurants, and (3) franchise advertising.

Most of Domino’s restaurants are franchised outlets so the company has very little capital outlay requirements. The company spent only US$85 million in capital expenditures in 2019, while raking in US$496.9 million in operating cash flow.

This capital-light business means that most of the company’s cash flow from operations can be returned to shareholders either through share buybacks or dividends.

Strong track record of growth

Domino’s has a steady track record of growing its business. Same-store sales in the US has increased in 35 consecutive quarters, since 2010, at an average pace of 6.9%. More impressively, same-store sales in its international stores have increased for 104 consecutive quarters.

The charts below show same-store sales growth since 1997:

On top of that, the number of Domino’s stores has grown considerably over the years. Today there are over 17,000 stores in more than 90 markets worldwide. Net store numbers increased by more than 1000 each year from 2016 to 2019.

Increase in net store numbers and same-store sales growth have ultimately translated into healthy revenue growth for Domino’s. The chart below shows the global retail sales growth from 2012 to 2019.

A resilient business model

The COVID-19 pandemic has demonstrated the resilience of Domino’s business. Domino’s United States business has actually improved during the current lockdown in many parts of the US. Same-store sales in the US were up 7.1% in the first four weeks of the second quarter of 2020, and US retail sales were up 10.7% over that same period.

Internationally, Domino’s business has also done better than most. Despite many of its International stores being temporarily closed or having some operating restrictions, international retail sales were still down only 13.2% during the first 3 weeks of the second quarter.

These are impressive figures and highlights that Domino’s has the ability to keep raking in the money even in a difficult operating climate.

Potential for more growth

Although Domino’s 17,000+ store count may seem like a lot, there’s still a large market opportunity for more growth.

Domino’s currently has 6,126 stores in the US and 10,894 stores internationally. The company believes that the US market can accommodate 8,000 stores, which means Domino’s can open another 1,800+ stores in the US alone.

On top of that, its 15 largest international markets have the potential for another 5,500+ stores. The chart below shows Domino’s estimates of where their expansion opportunities lie internationally.

Domino’s is targeting to have 25,000 stores worldwide and US$25 billion in annual global retail sales by 2025. That’s a 47% increase in store count and a 71% growth from 2019’s revenue.

The risks

Domino’s is not perfect though. The company has the unwanted distinction of having negative shareholder equity.

That’s because the company has been returning more cash to shareholders than what it rakes in each year. It is tapping aggressively into the debt market to finance its share buybacks and dividends.

Management believes that its resilient business model, steady cash flows and capital-light business enables it to function well with leverage.

While I agree, I still think that the company could be a little bit more conservative to prepare itself against unforeseen circumstances.

As of 22 March 2020, Domino’s had US$389 million in cash and restricted cash, and a staggering US$4 billion in debt. It had negative shareholder equity of US$3.4 billion.

If Domino’s has an extended period of disruption to its business, it may end up running into liquidity issues.

Final words

There is much to admire about Domino’s Pizza Inc. It has an admirable track record of growth and still has room to grow into. On top of that, its capital-light and resilient business model enables the company to continually reward shareholders with dividends and share buybacks.

However, the company is not perfect and its highly-leveraged balance sheet poses some risk. Even though I think Domino Pizza Inc can provide shareholders with good returns, investors should still proceed with caution.

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.