Tag: business analysis
Dollar General Business Breakdown

Dollar General Business Breakdown

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Dollar General is one of the largest discount retailers in the United States. They offer low-cost products (mostly below $10), that are frequently used and replenished. Such as food, snacks, health and beauty aids, cleaning supplies, and many more. 

Selling low-cost consumables at convenient locations encourages repeating revenue. For example, whether it’s good times or bad times we will need to buy our toothpaste. Because it’s a low-cost product, we are less price sensitive and buy wherever is most convenient.

Compare this to buying automobiles. During bad times we delay your purchase and continue driving our old car. Because it is a big-ticket item, we will compare prices across multiple dealerships and negotiate for the best price.

Consumables drive most of the sales for DG

There are some favorable dynamics that allowed Dollar General to generate a 20.2% CAGR for shareholders since 2012.

Business Breakdown

Here is what Dollar General has to say about its value proposition. Only 2 out of 3 is true, make a guess which is false!

From DG’s annual report

If you have guessed low prices, you got it right!

From the above table, a bottle of Coca-Cola costing $1 will be priced at $1.31 at Dollar General, $1.13 at Costco, $1.25 at Walmart, and $1.30 at Target.

This article by business insider sums up why Dollar General product seems cheap, but in fact, it isn’t.

What truly sets them apart from their competitors is their niche in serving the under-served areas. Most of their stores are set up in small towns, where it doesn’t make economical sense to have a Walmart or Costco.

Based on the above, Dollar General creates local monopolies as they expand their presence in rural regions across the US—where it doesn’t make economical sense for big retailers to enter and the market is too small to warrant another discount retailer from setting up.

While a customer will drive 30 or 45 minutes for their weekly shopping at Costco, it is much more convenient to drive 10 minutes to Dollar General for something like a bottle of Coke.

Consumables which account for 78% of their sales are what keep customers coming back. Dollar General rightfully charged less for items such as toothpaste, soap, etc. They understood that it is important to get the customers into their store by offering lower prices on everyday essentials.

Customers who come in for what they need often end up with items they don’t need. Dollar General charge higher margins for non-consumables—home products, apparel, etc.

Stellar Operating Metrics

Dollar General post some impressive numbers.

Revenue has grown steadily from 1994 to 2019 without a single declining year. In the most recent decade, it has grown at approximately 8% CAGR. From $13 billion to $27.8 billion in 2020.

The company has grown its stores from 6,700 stores in 2004 to 16,278 in 2019. 

Most impressively, the company’s same-store sales (SSS) have increased every single year. A tough feat to achieve for retailers.

SSS is an important metric watched by analysts and investors. A flat or declining SSS may indicate that the company may have overexpanded, reaching a saturation point.

With revenue and sss rising every year, it tells me a few things:

  • They do well regardless of the economy; whether it’s boom or bust, people need to get their daily necessities.
  • They have further room to grow and have not reached a saturation point.
  • E-commerce (i.e. Amazon) which has caused the death of retailers did not impede their business model. Likely due to the nature of small-sized transactions and conveniently located stores.

Innovation

Dollar General has invested significantly in its digital operations and launched its mobile app.

The company’s mobile app allows the company to utilize data and target its customers more effectively through digital coupons and discounts. 

 It’s DG Pickup has seen increased adoption as customers enjoy the convenience of contactless pickup.

From their Q2 2020 earnings call, the benefit to Dollar General comes from customers buying even more items when they come to pick up their online orders:

“…when the customer comes in to pick up her order, she’s actually buying additional items inside the store, which then is increasing that basket size to above where we normally would see our basket size.”

The company has also launched its scan-and-go technology in selected stores since 2018, which increases convenience and potentially reduces labor costs in the future.

Dollar General has online shipping available as well as “Auto Delivery,” a recent addition that allows customers to have products shipped directly to their door on a recurring basis. Which makes the revenue stickier for Dollar General.

According to the company’s website, with each recurring order, you save 5% off their retail price and receive free shipping on recurring orders over $25.

My 2-cents

Dollar General is a well-managed company whose business model has shown to be resilient against economic downturns and the threat of e-commerce. 

In this COVID-19 environment, the company has delivered crushing results. With SSS up 12.2% and gross profit up 24.4% in the latest quarter. This is likely due to a combination of hoarding, work from home arrangement which encouraged consumers to shop at the nearby Dollar General, etc.

It’s good that the company moved fast to adopt pick-up services in light of the pandemic and the digital transition came in very timely.

However, I do not expect growth to persist at such a high clip. The market appears to be very buoyant about the company’s growth prospects given that they are trading at historically high valuations.

P/E chart of Dollar General

For more insights on Dollar General’s intrinsic value calculator using Warren Buffett’s Equity Bond Method, check out VintageValueInvesting.com breakdown of the company!
Understanding restaurant franchises – Domino’s Pizza

Understanding restaurant franchises – Domino’s Pizza

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For anyone looking to start learning how to invest, I would always recommend starting with products or services you use. Being a foodie myself, F&B naturally falls within my circle of competence!

Before we dive into today’s main topic, please allow me to sidetrack a little.

When selecting F&B companies as investment, always choose companies with products that could become part of their customer’s routine. Even better if it’s a little addictive.

Think Starbucks.

Coffee is something that could be consumed daily (or must be consumed daily for some) and customers seldom change their daily routine. Once you find something that suits your taste and the location is convenient, people generally don’t change due to homeostasis.

Slap on a membership program (including its own mobile payment) and premium branding, its product becomes extremely sticky.

Just take a look at how Starbucks mobile payment towers over mainstream mobile payment.

As Mohnish Pabrai highlighted: Recurring Revenue Stream (RSS) is the most important thing for a business.

It is no wonder Starbucks has done remarkably well for its shareholders.

I would avoid restaurant businesses like the Cheesecake Factory, Applebee, etc. Consumers usually patronize on special occasions and are less likely to visit the same restaurant to celebrate birthdays, anniversaries repeatedly.

When it is not part of their customers routine to visit these restaurants, they have to battle it out. Spending a large amount on marketing and promotions to bring in different customers every day.

Alright, now that this is out of the way, let’s jump to the core part of the article!

Enter Domino’s

Domino's stock price growth vs. Big Tech
Chart taking from theatlas.com

We always hear about tech stocks generating immense wealth for shareholders due to their scalability and capital light business model.

Who knew Domino’s could outperform them?

3 observations from the chart:

  1. The franchise model is able to scale rapidly, and
  2. is capital-light.
  3. Americans Consumers can eat Pizza over and over.
Excerpt on Domino’s business model from its 10-K

Domino makes money largely by collecting franchise fees and providing its franchisees with supplies (i.e. dough, etc).

U.S. Franchise Agreements are contracts entered with individual franchisees for 10 years. Domino collects roughly 11.5% of its franchisee’s revenue. This is made up of 5.5% royalty fees and 6% for group marketing expenses.

Master Franchise Agreements are bigger contracts that give the franchisee exclusive rights to operate in certain areas. Domino’s collect one-time upfront fees for a long-term agreement (>10 years) and an upfront fee whenever a new store is opened.

On a recurring basis, they collect 3% of revenue as royalty fee.

Last but not least, they make money through their supply chain (e.g. selling dough to its franchisees).

Higher profitability

Due to the cost of sales (i.e. raw materials), the margins on the supply chain are much smaller when compared to collecting royalties (there’s no COS when collecting franchise fees).

Domino’s do have company-owned stores as well. Though they contribute much lesser to the bottom line with a margin of 23.7%.

A margin of 23.7% means Domino’s makes approximately $1.42 from the $5.99 pizza below:

Domino's New Coupon Gets You a Large, 2-Topping Pizza for Only $5.99

Here we can appreciate the difference in operating margin amongst U.S. stores, Supply Chain, and International Franchise.

Segment breakdown from Domino’s 10-K

Note that their U.S. Stores is a mixture of franchise agreements.

Specifically, they have 342 company-owned stores and 5,784 franchise stores in the U.S.

Store count as of 2019 from Domino’s 10-K

Capital-light model

Notice the difference in capital expenditures (capex) between a combined strategy of franchise and company-owned (U.S. Stores) and 100% franchise (International Franchise).

The capex required to generate an additional dollar of sales under the International Franchise (100% franchise) is way lesser than the U.S. Stores (a mixture of company-owned & franchise)!

In fact the amount of capex required for franchises is almost non-existent.

This shows the power of capital-light businesses!

With the franchise model, Domino’s do not have to come up with the capital required to set up stores, buy new equipment, etc. The franchisees’ will be the one who come up with that capital!

Compare this with the Chipotle business model where 100% of their stores are company-owned. They need to have capital locked in for working capital needs, buying of equipment, renovation, staff uniforms, and many more before they could start making money.

Side note: This is not to say company-owned models are inferior. In investing as with life it is always wise not to take an extreme stance. I will write about company-owned models in my future articles. Subscribe to be notified!

Conclusion

There’re many benefits to investing in a franchise model—higher margins, low capital intensity, and scalability. We need to appreciate how much capital it frees up for a company, in terms of initial start-up costs and working capital requirements.

‘The three most harmful addictions are heroin, carbohydrates, and a monthly salary. ‘

Nassim Nicholas Taleb

Let’s not forget recurring revenue streams, the revenue from the royalties is extremely sticky and when it comes to pizza, consumers seldom change their preferences.

So much so that Domino’s stock has outperformed the top tech companies. As investors, we can afford to ignore pharma, SaaS, oil & gas sectors if they are not in our circle of competence. Sometimes the next big winner is just something simple, easily understood, and delicious…

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How to analyze SaaS companies?

How to analyze SaaS companies?

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Software as a Service (SaaS) companies share prices skyrocketed since March 2020 as the market recognized that COVID-19 has caused rapid digitalization. SaaS companies also have a fantastic characteristic – recurring revenue.

Understanding its moat

Despite most of the SaaS companies commanding lofty valuations, not all of them will meet the high expectations set out by investors. We have to first ask ourselves if this company has a moat – e.g. high switching costs.

Is it easy for competitors to woo their customers over?

Consider Adobe and Zoom, both offering their software services for a subscription fee.

Most designers will find it impossible to switch Adobe due to the amount of time spent learning the software. They’re taught this in school and would be very resistant to master another designing software. Doing this would be akin to having to pick up another language for work.

Zoom’s success has been dependent on its user interface — its ease of use. You don’t have to set up an account and it is not cluttered with buttons. However, ease of use is a double edge sword. Users can easily switch away when Zoom stops innovating and delivering added-value to fend off competition.

Comparing Adobe and Zoom, Adobe has a much stronger moat (i.e. switching cost). Its users are locked in and thus Adobe is able to extract value for a longer period (higher lifetime value).

This is important as SaaS companies spend huge capital outlay (i.e. sales and marketing expenses) in acquiring customers. With distribution costs near zero, the optimal strategy is to acquire as many customers as possible.

Read our earlier articles on marketing and R&D expenses to understand why SaaS companies appear unprofitable at first!

Its returns are very dependent on its ability to retain customers. Bringing us to our first metric – churn rate.

Churn Rate

Churn rate measures the percentage of customers who canceled their subscription over the period. The best way to think about this is how much gross profits were lost as a result of customers canceling their subscription?

The churn rate provides us insights into how sticky the software is and it is a key determinant of profitability for the company.

Lower churn rates equate to longer customer lifespan. This directly translates to higher lifetime value (LTV) of each customer.

The longer a customer stays subscribed, the more value may be extracted from the initial capital outlay – customer acquisition cost (CAC).

Churn rate may be expressed in the formula below:

For example, you have 100 users each paying $100 per month for your software. Taking the typical gross profit margin of 80% for most SaaS companies (GPM ranges between 75% – 80% for mature SaaS companies).

This gives us a gross profit of $8,000 per year (100 x $100 x 80%).

Say 20 users dropped out that year. Resulting in a loss of $2,000 in gross profits ($100 x 20). The churn rate would come up to 25% ($200/$800).

Customer Lifespan is simply the inverse of churn rate. With a 25% churn rate, the projected customer lifetime is 4 years (inverse of 25%).

Understanding the churn rate will allow us to know the Lifetime Value (LTV) of a customer.

Lifetime Value

LTV is how much I can expect to receive from each customer on average over the lifespan of their subscription.

LTV may be expressed in the formula below:

Knowing the LTV gives me an idea of whether the customer acquisition cost (CAC) provided good returns.

It helps answer the question – Did acquiring these customers bring in more profits than what it cost?

Customer Acquisition Cost

CAC is the total sales and marketing cost to acquire each customer. This includes items such as salaries of sales staff, advertisement expenses, and everything else it took to successfully onboard the customer.

CAC may be expressed in the formula below:

Let’s say it costs $1,000 in a year to acquire 100 new paying customers. Our CAC will be $10.

In other words, it costs, on average $10 to bring in one new customer!

By knowing the LTV and CAC, we can understand if the company can make more profit from a customer than the total cost of acquiring them.

Unit economics

Unit economics is simply an evaluation of profitability on a per-customer basis. Copying Buffett’s euphemism, CAC is what you pay and LTV is what you get. SaaS companies are ‘profitable’ if LTV exceeds CAC.

A useful way to evaluate this is to look at the LTV to CAC ratio:

Ideally, this ratio should be between 3 and 5. The company’s customers are providing profits three to five times the cost to acquire them.

If it is below 1, that would mean that the cost spent to acquire a customer is higher than their lifetime value. Some companies start off with below 1 to get a network effect going (e.g. Grab and Uber offering massive discounts initially). However, this is ominous if it persists over a prolonged period.

If it is above 5, the company could be missing out on valuable opportunities. Customers are bringing in huge returns and companies may want to spend more on sales and marketing to quickly scale the business.

Update: Insightful discussion on LTV-CAC ratio with the team from Moneywisesmart below:

The timing of the LTV would affect the Internal Rate of Return (IRR) of customers (time value of money). Also, shorter payback times are advantageous as less working capital is required. This in turn provides companies the ability to scale faster.

Conclusion

It is important to understand the LTV vs CAC trade-off when evaluating businesses. Especially for SaaS companies, this metric must be closely studied to understand its profitability.

Bluegrass Capital put it across succinctly, “If I can find a company that invests $1 in acquiring a customer and they can get back $3 to $5 in gross profits, it doesn’t matter to me if the EBITDA margin is negative or positive.”

For many of the SaaS companies today, they are spending heavily today to scale. These companies will not appear profitable today but would be highly profitable in the future, provided they have a strong moat and sound unit economics.

To end off, I will re-share this gem from Marcelo Lima’s 2Q 2018 letter:

In our future article, we will go through a case study on evaluating a SaaS company.

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Facebook’s Incredible Business Model – Part I

Facebook’s Incredible Business Model – Part I

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This write-up will be broken down into 2 parts. In this first part, we will discuss Facebook’s business model and metrics for measuring its success.

Facebook probably has one of the best business models in the world. Even before it went public, the company grew its revenue by 57% and had 36% operating margins. Its business model is similar to a traditional media company, with advertising revenue as the key driver. Facebook has the largest readership base in the world (2.5 billion people) and to top it off, the readers are the ones providing the content for free.

What does Facebook Owns?

Facebook properties consist of 5 products. Most of us are familiar with them and would use 4 out of 5 products on its properties – Facebook, Instagram, Messenger and Whatsapp.

Among all the properties Facebook owns, the company’s 2 main revenue drivers are Instagram (acquired at a bargain price of $1 billion) and Facebook. Facebook’s priority is to continuously invest in these social media platforms.

Messenger and WhatsApp (acquired for $16 billion) are mainly for messaging and are more difficult to monetize. Especially for WhatsApp when they are trying to brand it as less intrusive with its encryption capabilities. However, it does make the platform ‘stickier’. The more functions your users rely on your platform for, the more engagement you will receive, and revenue will follow. Facebook currently has plans to integrate Messenger, WhatsApp and Instagram to increase its platform’s ‘stickiness’.

Oculus was acquired back in 2014 for $2 billion because Zuckerberg believes that Virtual Reality (VR) would be the next major computing platform. Though its success has yet to bear fruits in terms of widespread adoption, Zuckerberg believes that VR could be the next big revolution. It is comforting to know that the management is on its toes preparing for the next big wave. This parallels their massive pivot in strategy during 2011 as users shifted their preferences from surfing Facebook on desktop to smartphone devices browsing.

Network Effect – Exactly how many people are on Facebook?

Across the globe, Facebook splits its business into four geographies:

  • Rest of World
  • Asia-Pacific
  • Europe
  • US & Canada
Taken from Facebook Q4 2019 Results

With a rising MAU, the company now has approximately 2.5 billion active users on its platform. To put Facebook’s incredible reach in perspective, the world’s population is 7.8 billion, of which 4.6 billion have access to the internet. Due to censorship, let’s remove China’s population of 1.4 billion from the 4.6 billion pool of internet users. That would leave us with 3.2 billion people who could be users of Facebook.

This means that Facebook has captured 78% market share of its total possible users. Think about the amount of data they could collect on its users based on sign up details, photos, likes, friends, and when you log in to other platforms using your Facebook account (e.g. Spotify). It is no wonder their targeted advertisements generate much better returns for their advertisers.

Taken from Facebook Q4 2019 Results

And about 66% of its users check their App at least once a day.

Facebook properties have huge network effects, and the great thing about networks is that as the user numbers grow, their moat widens exponentially as it grows. The size of the platform acts like a magnet for both users and businesses to join. It is able to retain users because that is where all our friends are and likewise, it is difficult for businesses to leave because that is where all its customers are.

How valuable are you to Facebook?

Out of the 2.5 billion users, only 10% are from US and Canada, yet they generate close to 50% of Facebook’s revenue.

Taken from Facebook Q4 2019 Results

From here, we can see that US & Canada’s ARPU is at least 4x the worldwide average.

This leaves a lot of potential for revenue growth from its market outside of the US & Canada. The reasons Facebook gets a higher revenue from US & Canada are largely due to:

  • Price increases, this is likely attributed to the purchasing power of consumers. The recent article by WSJ suggested that ad rates may have fallen by 25% in Mar 2020 due to COVID-19 induced economic downturn, even though usage has increased by 50%.
  • The number of ads shown, mature markets tend to have a higher ad load.
  • Higher engagement, US & Canada users are more likely to share, like and comment. We can expect to see this increase as Facebook rolls out more features such as Live Stream, Watch Party, etc.
  • More ads clicked, with more targeted ads leads to more clicks and higher cost per click.

Interestingly, we can see that we as Singapore users “brought in” at least USD12.63 worth of revenue for the platform in 2019 and this figure is expected to grow over time.

In my next article, I will further discuss Facebook’s profitability, growth potential and the challenges it faces, including regulatory concerns surrounding the Cambridge Analytica incident. Stay tuned for Part two!

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Thomas Chua