Tag: Company Analysis

Why I Own Disney Shares

Why I Own Disney Shares

“It’s not share of market. It’s share of mind that counts.”

Warren Buffett

The happiest place on earth. It is near impossible to replicate Disney’s share of mind even if you have all the money in the world.

The Disney name is well-known to billions of people. It has a meaning, an emotion perhaps, attached to it globally.

It is hard to find another brand that is unanimously known as the happiest place on earth.

With Disney+, it is now able to ship this happiness at an unprecedented scale.

Creating movies profitably

In Berkshire’s 1996 annual general meeting, Buffett explained why Disney makes money for shareholders. Unlike many other movie companies.

Most movie companies are able to make a lot of money. But they make a lot of money for everybody else (e.g. acting cast, directors, etc) except for the shareholders.

Buffett shares, “The nice thing about the mouse (Mickey) is that he doesn’t have an agent… He is not there renegotiating (his salary).. every week or every month and saying, “Just look at how much more famous I’ve become in China.””

From 2006 to 2019, Disney made 44 films. Each film brought in an average of…

$850 million!

Pricing power

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

Warren Buffett

For Disney, let’s take a look at their pricing power pre-COVID19.

Like clockwork, Disney theme parks, hotels, and cruise has been able to raise prices at approximately 5% per year.

Taken from Disney’s 2019 Annual Report

Coming off a low base, Disney+ is set to raise its price from $6.99 to $7.99 after just 1 year since launch. In sales, it is always easier to sell an incremental dollar than the first dollar.

The oil field that keeps gushing

Disney’s intellectual property (IP) is like an oil field that doesn’t dry up. We have seen the remakes of Beauty and The Beast, The Lion King, Aladdin, and many more.

Furthermore, IP created generates value beyond the box office. Box office hits will be translated into merchandise which ranges from toothbrushes to quilts, figurines, watches, legos, and more.

A quick search for Elsa will show you an endless array of products that could bring a smile to your daughter’s face.

Buy her a counterfeit Elsa and you will see her smile melt faster than Olaf.

Getting swindled on eBay over COUNTERFEIT Frozen dolls!!

The oil field doesn’t end here. The benefits will trickle to its theme parks, resorts, vacation, and cruise packages.


“Disney is an amazing example of autocatalysis… They had all those movies in the can. They owned the copyright. And just as Coke could prosper when refrigeration came, when the videocassette was invented, Disney didn’t have to invent anything or do anything except take the thing out of the can and stick it on the cassette.”

Charlie Munger

With Disney+, the value of all the past IPs can be unlocked at scale. As Netflix’s and Spotify’s subscription-based business model suggests, monthly subscription fees are very sticky. Providing upfront, recurring revenue for Disney.

This is different from the traditional way of spending hundreds of millions of dollars upfront (e.g. Frozen costs $150 million). Locking up tons of working capital before the movie is released, reducing the amount of free cash flow for shareholders, or to grow its IP by producing more movies.

Depending on whether the movie becomes a hit, Disney would have difficulty estimating how much cash flow will be coming in. Which leads to difficulty in budgeting for new projects.

This is all about to change with Disney+.

In its investors day on Dec 2020, Disney exceeded 137 million in paid subscriptions across its Direct-to-Consumer (DTC) services. Smashing all of its earlier estimates.

Disney+ alone produced 86.8 million subscribers, with the rest coming from Hulu, ESPN+, etc.

To put it in context, it took Disney approximately 1 year to achieve what Netflix did in 10 years in subscribers count.

Disney+ estimates have been revised from 60 million to 90 million to 230 million to 260 million subscribers by 2024.

Netflix currently generates approximately $10USD per subscriber monthly. Applying that to Disney+, this will bring in $2.3 billion to $2.6 billion in upfront recurring revenue monthly, or $27.6 billion to $31.2 billion annually.

Data is the new gold

With Disney+, imagine all the data the company will be able to collect. It will have deep insight into how Disney fans interact with its content. Increasing its revenue per Disney fan.

Oh, your son watched Iron Man for the third time in the past 2 months, here’s an ad on how he could look like Iron Man!

Ride of a Lifetime

With Robert Iger’s 15 years at the helm, he has done some massive transformation for Disney.

In his book Ride of a Lifetime, Iger started making several gutsy moves once he took over. Taking over Pixar for $6.3 billion, bringing the world of Toy Story, The Incredibles, and Monsters Inc into Disney.

The acquisition of Pixar brought in Steve Jobs to Disney’s board of directors. Prior to the acquisition, Disney’s animation business had been struggling.

Disney then went on to acquire Marvel for $4.2 billion in 2009 with Avengers: Endgame raking in $2.8 billion in global gross box office receipts.

What seemed like expensive acquisitions turned out to be great deals.

After owning the world’s most valuable superhero property, Disney followed up by acquiring Lucasfilm (Starwars, Indiana Jones, etc) for $4.1 billion in 2012.

And of course, the biggest acquisition of the Twenty-First Century Fox which closed in Mar 2019. Which ended up costing $71.3 billion by flooding their balance sheet with debt.

All these moves required Iger to do a lot of convincing to the board of directors. But Iger understood that Disney’s moat is with its IP and he has executed beautifully. Churning out blockbusters after blockbusters.

After his 15 years of service, Iger has set Disney up nicely for its big move into streaming—Disney+.

Disney’s legacy business

Disney media networks segment comprise of cable networks and broadcasting. It currently contributes approximately 25% of the operating income for Disney.

Operating margins for this segment has been declining over the years due to cord-cutting.

Streaming companies (Youtube, Netflix, and IGTV) are eating up traditional TV’s market share (eyeball time). Much like what blogs, Facebook, and Google did to traditional newspaper advertising revenue.

With this as the backdrop, Disney+ seems to make sense from a long-term perspective.

In the short term, Disney is likely to face some pressure from this segment as it keeps its best content for Disney+. But it will benefit from its streaming business tailwind in the longer term.

This is similar to Adobe’s playbook when they first transit into a subscription model. Revenue would be impacted in the short-term as they cannibalize their existing business. In the long-term, the predictable upfront recurring cash flow will greatly benefit the company.


It is hard to find another brand that invokes a positive emotion and create blockbuster hits after hits. With Disney+ coming up huge amongst consumers, Disney stands to benefit hugely from introducing streaming into its ecosystem—upfront predictable cash flow, monetizing past content, data, and increased revenue per Disney fan.

Disclaimer: This is not a recommendation to buy or to sell securities. Please conduct your own due diligence or consult your advisor. I merely write to improve my investment and thought process.

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Why Did Bill Ackman Buy Into Hilton?

Why Did Bill Ackman Buy Into Hilton?

Hilton first got my attention earlier this year when Ackman doubled down. This was after his incredible timing (both with buying and selling) with his hedge, profiting over $2b (on a $27m premium) during the sharp drawdown in March.

I follow Ackman’s 13F closely because of his investment philosophy—simple, predictable business, cash generative, with a moat and is able to grow profitably.

Bill Ackman’s interview

Simple businesses with not a lot of moving parts are my favorite.

The truth about hotels

Because of its cyclical nature, a traditional hotel company’s earnings are extremely lumpy. When times are good, the tourism sector or business travel would boom. Driving up the Revenue Per Available Room (RevPAR) during good times.

On the other hand, when times are bad, RevPAR will fall thrdoough the floor. During recessions or pandemics, demand for travel dries up along with their earnings.

And to grow, hotels need a huge upfront capital locked in for building up extra units. Taking up huge loans during good times for expansion and then struggle with paying back the debt during downtimes.

With huge capital requirements, the normalized return on invested capital (ROIC) would inevitably be dragged down. And we know that when ROIC is lower than COC, any efforts to expand will reduce shareholder returns.

So this begs the question—why would Ackman be interested in Hilton?

Hilton’s business model

The cat is out of the bag. Similar to Domino’s, Hilton runs a capital-light franchise business model. Approximately 95% of Hilton’s operating income comes from collecting management and franchise fees.

The bulk of Hilton’s properties are on the franchise model. With 942,307 rooms on the franchise model compared with 20,557 rooms on the ownership model.

Over the decade, Hilton has been able to grow fees at 11% CAGR. From $814m in 2009 to $2,272m in 2019. This is vastly different from the lumpy revenues shown by most hoteliers.

They are able to grow at a meaningful pace despite being in a traditionally capital-intensive business because they are using other people’s money to grow!

I mean, take a look at their growth plan which requires $50.25b in investments. Only $0.25b is coming from Hilton!

The rest of the expansion plan (i.e. $50b) will be funded by third parties—their franchisees.

Management fees collected are typically a function of monthly gross revenue and an incentive management fee, which is a percentage of the hotel’s operating profits.

On top of the management fees, each franchisee will have to pay a one-off application fee and a recurring royalty based on the monthly room and F&B revenue.

Furthermore, like Domino’s, franchisees are the ones paying for most of the marketing and all other expenses.

Hilton Honors

Similar to Starbucks, Hilton is one of the first in its industry to introduce a loyalty program. In fact, they have been the first in a number of initiatives:

Taken from Hilton’s 2019 annual report

Having a loyalty programme encourage repeat purchases, turn first-time buyers into brand advocates, and allows the company to have data on consumer spending habits.

In fact, research has shown that repeat customers spend 67% more than first-time customers.

Here is what Hilton has to say about their Hilton Honors:

Being a Hilton Honors member has many benefits. This is reflected in their ability to drive membership numbers at a 16% Compound Annual Growth Rate (CAGR). From 36m members to 110m members from 2012 to 2020.

Apart from being able to offer end-to-end experiences to their guests, Hilton is now able to collect a ton of data on their guests. Allowing them to further refine their guests’ experiences.

Hilton Honors App functions

Ackman’s Thesis and COVID-19

You can find Ackman’s pitch on Hilton below:

And here is what he has to say about COVID-19’s impact on Hilton:

What is unclear is COVID-19’s long-term impact on business travel. Ackman believes that business travel will resume in phases. While Zoom is able to replace the routine meetings, it is hard to imagine that it can replace networking or sales pitch altogether.

Vacation travel is bound to recover and is likely to return with a vengeance. Furthermore, this pandemic is likely to strengthen big players who are in a better position to navigate and survive this crisis.

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Initiated a position in Fastly

Initiated a position in Fastly

Initiated a stake in Fastly recently to make myself follow through on deep diving into this company.

So what piqued my interest with Fastly?

They reported a strong set of Q2 results, with revenue rising 61.7% y-o-y. It was also the first time their EPS became positive, at $0.02 per share. Yet its share price took a hit and declined 33%. Largely due to Donald Trump threatening to ban Tik Tok, which accounts for 12% of Fastly’s revenue.

Even if Tik Tok were to be banned, I see this as a temporary blip to Fastly’s prospect. Fastly mainly serve enterprise clients. Many of the leading digital companies chose Fastly’s edge computing capabilities due to its capabilities, speed and reliability.

Source: Fastly’s presentation

It is worth noting that they have recently bagged Amazon and Shopify as their clients. With both of them enjoying the tailwind of e-commerce acceleration due to COVID-19, Fastly would stand to benefit as well.

Without further ado, and without being overly technical, let’s jump into what Fastly does!

What problems does Fastly address?

Traditionally, when we listen to music on Spotify or stream videos on Netflix, our request would first travel all the way back to the data center (or the cloud). It would be processed at the cloud before the content (along with recommendations for our next song or show) is delivered back to our devices.

This would usually not be a problem. But with increasing devices and applications moving to the cloud, shared bandwidth becomes a problem.

And this is what happens:

Netflix Loading GIF - Netflix Loading Buffering - Discover & Share ...

I hope you did not stare at the above gif for too long. I’m just trying to illustrate that high data usage (i.e. increased load) would increase the latency (i.e. response time).

And we know how detrimental this would be for user’s digital experience.

To give an idea of how much data is running on our networks:

Given how much data is running through our networks, the huge load and distance between user and cloud data centers are bound to increase latency.

Any lag would be detrimental to time-sensitive operations such as self-driving cars, smart hospitals, etc (and of course also to us streaming on Spotify and Netflix).

This is where Fastly’s edge computing capabilities comes in — to solve the latency issue. By bringing data processing closer to the edge of the network where the raw data is generated.

Edge computing sits closer to the users. For a Netflix user in New York, rather than having the request traveling to a remote data center (e.g. AWS data center), getting processed together with millions of other users’ requests. It gets processed at an edge computing server locally, referred to as Points of Presence (PoPs), which is closer to the user.

Apart from ensuring a fast and smooth streaming, edge computing is smart and is able to ensure that the right type of content is served each time by allowing for more on-device computing and analytics. The cloud is able to do these as well. But with millions of requests going to the cloud at the same time will drastically increase latency.

By being strategically distributed in city hubs, edge computing reduces latency by reducing the distance traveled and by distributing the load each server has to process.

Edge computing also helps reduces cost as cloud (e.g. AWS and Azure) is on a pay as you use model. By using edge computing, it helps reduces cloud usage and thus bring down costs.

An example would be the use of security cameras that automatically uploads the videos onto the cloud. Edge computing is smart, users can program it to upload only videos with moving motions onto the cloud for further processing. As opposed to uploading the entire 4k video onto the cloud.

Hence, Fastly essentially solves 2 problems — reducing latency and bringing down costs for its customers.

Developers focused

For enterprise software providers, winning over developers’ hearts is critical.

With a developer-focused usage-based sales model, companies like Datadog, Twilio, and Fastly empower the developers, who are the closest to the products being built to make the purchasing decision.

Fastly is developer-centric with a strong appeal to the developer community because of their advantages in performance, security and programmability.

This is opposed to the traditional model where a single buyer sign a huge contract on behalf of the entire company. An individual developer can proceed to Fastly’s website, register and starting building on their new idea in less than 30 minutes.

Large and growing TAM

Source: Fastly presentation

According to research firms, MarketsandMarkets and IDC, content delivery network (CDN) & Streaming and App Services & Security at the Edge are estimated to be a $35.4 billion by 2022 and is expected to continue growing at a high clip.

Fastly’s trailing-twelve-month (TTM) revenue is currently $845 million. They are in a good position to continue eating up market share as they continue to innovate and rapidly roll out new product offerings in edge computing.

Metrics to keep an eye on

Revenue: As with any growth companies trading at high valuations, it is important that they are able to sustain a high growth rate. Due to their strong Q2 revenue growth of 61.7% y-o-y, management has guided for Q3 revenue growth of 49.6% y-o-y.

Dollar-Based Net Expansion Rate (DBNER): This represents how much existing customers spent today compared to previous years. With a focus on large companies as opposed to their competitors (e.g. Cloudflare who focuses on SMBs), customer curation allowed Fastly to achieve the best-in-class DBNER.

DBNER was up 133% in Q1 and 132% in Q2, meaning their customers increased their spending by by 33% and 32% respectively y-o-y. As a rule-of-thumb, anything above 120% is excellent.

Number of customers & average spend per customer: We want to see that Fastly is able to keep grabbing market share. Total customers count increased to 1,951 in Q2, representing a 20% annualized growth.

Enterprise customers increased to 304 in Q2, from 262 the previous year. Enterprise customers are defined as accounts which spend in excess of $100,000 over the year.

Average enterprise customer spend grew 29%, from $556,000 in Q2 2019 to $716,000 in Q2 2020.

Gross margin: Gross margin was 56.7% in Q1 2020 and jumped to 61.7%. Management attributed this to improved efficiency in the operating model. As they continue to introduce high-margin products and scale, management expects gross margins to improve to 70%.

Why companies are investing heavily in Cloud

Ultimately, it boils down to its value proposition — creating a win-win situation for all parties. The opportunities here are huge due to the cost savings and increased capabilities it can provide.

Final words

Fastly is still a young company at its early innings with its moat still being developed. Compared to my other investments which form the core of my portfolio, Fastly is expected to experience higher volatility (which is not necessarily a bad thing).

Traditional metrics such as P/E ratio would not work for reasons covered in my previous posts. You may check them out below:

In my future posts, I will be covering Fastly’s risk, management, competitors, and valuation. Subscribe to the newsletter to follow along!

So far I have been able to publish at least 1 article per week and hopefully that has been value-adding to you!

I aim to publish 2 articles over the next month to spend more time catching up my backlog of reading and to do a deep-dive into other companies that have piqued my interests.

Disclaimer: This is not a recommendation to buy or to sell securities. Please conduct your own due diligence or consult your advisor. I merely write to improve my investment and thought process.

How to filter for high-quality compounders?

How to filter for high-quality compounders?

A high-quality compounder is a business that is highly profitable, has a strong competitive advantage (i.e. moat) and the ability grow (i.e. huge total addressable market). Companies such as Ferrari, Mastercard, Facebook, Berkshire, Amazon, Monster and Starbucks are great examples.

A key characteristic of a high-quality compounder is a high Return on Invested Capital (ROIC). The problem is that ROIC is a function of operating income and invested capital. For example, many high-growth companies spend heavily on marketing and R&D. Filtering by ROIC may cause you to miss many high-quality compounders.

A great solution to overcome this is to use the gross profitability as a first-level filter instead of ROIC. Professor Novy-Marx defines gross profitability as revenues minus cost of goods sold, measured against the book value of total assets. In other words, it measures the amount of gross profit a company generates for every dollar of assets.

Reasons gross profitability is a great filter

Gross profitability is highly persistent in both the short and long term. This allows investors to make a reasonable estimate of future profitability based on historical records. Research shows that businesses with higher gross profitability generally deliver better total shareholder returns.

Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more ‘polluted’ profitability measures become. Gross profitability doesn’t ‘penalize’ companies for investing heavily in growth.

Many of the investments (largely marketing and R&D) that companies make for their long-term future growth can cause short-term hits to reported operating income.

A good gross profitability benchmark

So what is a good benchmark for gross profitability?

In Novy-Marx paper, gross profitability of 33% or higher is considered attractive. A look at Amazon’s gross profitability shows that it surpassed this level easily.

It is also worth noting that in Novy-Marx back-testing, a dollar invested in the market between 1973 to 2011 grew to over $80. While the same dollar invested in businesses that have high gross profitability (i.e. above 33%) grew to $572 in the same period.

Similar results were shown in a more recent study conducted in 2018 here. By investing in companies with high gross profitability of over 20%, it would produce returns in excess when compared to the overall market.


The gross profitability ratio is a great way to do a first-level filter. With growing revenue and gross profitability of over 20%, it is a great indication that the company could be a high-quality compounder which warrants further investigation.

In our future article, we will discuss in detail the issues with ROIC and how we may adjust the reported earnings figure to use this metric.

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Amazon and the problem with reported earnings

Amazon and the problem with reported earnings

Amazon share price has recently broke $3,000 per share and is currently trading at a lofty P/E of 147x. In fact, the company often trades above 80x P/E. Merely looking at the earnings would deter most value investors from owning Amazon.

Building on our income statement series on gross profit margins and marketing expenses, Amazon is the poster boy for not giving a hoot about reported earnings. Here is what Bezos have to say:

Bezos has an incessant focus on the Amazon’s long term prospect. He emphasized a high return on invested capital (ROIC) by reinvesting relentlessly to become the market leader. He understands that for growth to deliver long-term value, the ROIC must be sustainably high.

Amazon build up its moat by spending aggressively on research and development (R&D). R&D expenses include developing new products and infrastructure to enhance customer experience and improve process efficiency:

Looking beyond reported earnings

When we look at Amazon’s operating income, it looks rather mediocre. In 2014, the company made a meager $178 million in operating income on the back of $88 billion in sales. Giving it a razor-thin operating margin of 0.2%.

Adding R&D expenses into operating income would paint a drastically different story. In 2014, Amazon spent $9.2 billion on R&D. Adjusting for R&D expenses would give the company an operating margin of 10.6%.

This is a consistent trend for Amazon over the years. On the surface, the operating margin continued to linger below 6% even in recent years. Adjusting for R&D expenses, we can observe that the margin has actually exploded upwards to 18%.

This is largely due to higher margins segment third-party seller services (3P) and Amazon Web Services (AWS) operating segment rapid growth. This is the result of their aggressive investments in R&D earlier.

Capacity to suffer

The “capacity to suffer” is key because often the initial spending to build on these great brands in new markets has no initial return. Many companies will try to invest smoothly over time with no burden on currently reported net income, but the problem is that when you are trying to invest in a new market, smooth investment spending really doesn’t give you enough power to make an impression. You end up letting in a lot of competition that will drive down future margins. 

Tom Russo, Gardner Russo & Gardner

Capacity to suffer” is a term coined by Tom Russo and its a key trait I look for in companies. Companies that have the capabilities to look beyond short-term Wall Street expectations. Family controlled businesses or founders who have a majority of the voting rights are a commonplace to look for such businesses.

Amazon could have appeared very profitable if it wanted to. By pulling the plug on R&D expenses which drove growth and strengthened the company’s moat. But that’s not how Bezos does things. It always boils down to achieving growth and sustaining a high ROIC.

Here is my favorite statement from Bezos this year:

The problem with GAAP earnings

For digital companies, its economic engine is built on the back of R&D, brands (i.e. marketing efforts), customer relationships, software, and human capital. These intangible investments are akin to the traditional industrial company’s hard asset investments – factories, buildings, and machinery.

For the traditional hard asset investments, expenses are recognized over its useful life. A machinery that cost $10,000 would reduce the current year’s earnings by $1,000. This expense recognized over its useful life of 10 years. Recognizing that wear and tear reduces the value of these assets over time.

However, for the digital company, investment in its economic engine is not capitalized as assets. Instead, they are treated as expenses and charged in entirety towards the current year’s earnings. Despite intangible investments generally having multi-year benefits, or in certain cases, enhance in value over time.

When a firm engages in R&D, marketing, software development, or training employees, it must charge these long-term value-creating expenditures the same way it recognizes general expenses such as office space rents in the current year period.

In short, there is a mismatch between the value delivered and the timing of recognizing the expenses. Also, these intangible benefits are not recognized as assets on the balance sheet.

Take Amazon for example, its value increases as it onboard more sellers, which in turn attracts more customers as it offers a great range of products and vice versa. Its value growth is driven by the network in place, not by increments of operating costs.

Hence, the most important thing for digital companies is to invest aggressively in its early years to achieve market dominance and command a “winner-take-all” profit structure.

Here is a short excerpt from Marcelo Lima’s 2Q 2018 letter to Heller House fund clients:

“Winner-take-all” structure

Since 1996, Amazon has grown revenue at a 50% compounded annual growth rate (CAGR). Even at its current size, adjusted operating income (excluding R&D expenses) grew at 28% CAGR for the past 5 years.

The eventual profitability is a result of continuous investment into the company’s economic engine to achieve market dominance in e-commerce and cloud (i.e. AWS).

For SaaS companies, many have spent years and tons of capital growing despite producing meager accounting profits or are running losses. They are profitable though, when evaluated in terms of unit economics, and when they stop investing every dollar generated into further growth (i.e. once market dominance is achieved). A good example would be Adobe.

In our next article, we will discuss how to analyze SaaS companies unit economics by looking at two important metrics – Customer Lifetime Value (LTV) and Customer Acquisition Cost (CAC).

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Where the key value driver of a company is in intangible investments, investors need to look beyond reported earnings. Especially for innovative companies in their early stage as they invest heavily in growth. Compressing their earnings and balance sheet assets.

Figuring out a company’s intrinsic value with PE ratio

Figuring out a company’s intrinsic value with PE ratio

The price-earnings (P/E) multiple is one of the most popular tools which analysts use to value stocks. A company trading at 10x P/E implies that for every $1 in net income generated investors are willing to pay $10 or a 10% earnings yield.

Despite its popularity, it remains one of the most misused misunderstood metric. A share valued at 30x P/E might not be expensive relative to another stock trading at 15x PE. Likewise, a share trading at lower P/E today, when compared to its 10-year median P/E, does not imply that it is a bargain.

To apply this tool, we must first deconstruct the P/E ratio to better understand what goes in. The P/E ratio is a short-cut to arrive at the Discount Cash Flow valuation. The most sensible way to determine the worth of a business is to estimate the cash flows a business will generate for its owners over time, and then discount these cash flows back to their present value.

Hence, to figure out the intrinsic value we need to ask ourselves these questions:

  1. How much free cash flow (FCF) will the business generate over its lifetime for shareholders?
  2. Can the business grow?
  3. What is the discount rate (i.e. required rate of return/cost of capital)?

In this post, we are going to focus on the relationship between – (1) the amount of cash flow the business generates and (2) its ability to grow this future stream of cash flow.

This brings us to the next question, Why is the cash flow available to shareholders different across companies? Two companies with the same amount of revenue and net income may well generate different levels of cash flow for shareholders.

This is because different companies require different amounts of reinvestment in their business for growth. The more a company needs to reinvest to achieve growth, the less the company retains for shareholders. And this variation is largely driven by the differences in the return on invested capital (ROIC) achieved.

ROIC’s impact on FCF & Growth

Consider two companies, Company A and Company B both generate $1 of earnings per share. Both companies aim to grow their earnings by 10% next year. It would require the companies to reinvest their earnings for expansion.

The key is understanding how much capital is required for each company to achieve a growth of 10% in earnings?

Suppose Company A is able to generate 60% ROIC (similar to a business like Mastercard). This means that every $1 invested in the business, results in a 60% growth in earnings. For it to grow its earnings by 10%, Company A would only need to reinvest 16.7% of this year’s profit. Since a 60% return on 16.7% of current earnings will create a 10% increase in profit. This means that Company A is able to distribute 83.3% of current year’s earnings, or 83.3 cents of the $1 in earnings back to shareholders, through dividends, share buybacks, or by reducing its debt.

On the other hand, Company B is only able to generate 12% ROIC (similar to the S&P 500’s average). To grow its earnings by 10%, it would need to reinvest 83.3% of its earnings. Since a 12% return on 83.3% of current earnings will create 10% more profit. This leaves only 16.7 cents of the $1 in earnings for Company B’s shareholders.

Here we can see that Company A’s ROIC is 5 times greater than Company B’s. To achieve the same growth of 10%, Company B needs to reinvest 5 times its earnings compared to Company A.

Essentially, this shows us that not every dollar of earnings is worth the same amount. Although both companies have the same earnings per share of $1 and generate 10% growth, they require different reinvestment rates. Thus, it boils down to the ROIC that a company is able to generate.

All else constant, a company with a higher ROIC should command a higher P/E multiple and vice versa. A company trading at 30x P/E and another company trading at 12x P/E could both be fair value.

We need to dig deeper into its ROIC and evaluate its sustainability.

Why growth may destroy value

Not all growth is good for shareholders. For growth to generate value for shareholders, its ROIC must be greater than its cost of capital.

The S&P 500 index has returned an average of approximately 10% since inception. Hence, we can consider using 10% as the cost of capital. When deciding whether or not to grow, management should evaluate whether the ROIC from reinvesting earnings could exceed 10%.

If ROIC is 8%, reinvesting for growth would reduce value for investors. Companies should choose to distribute out all its earnings to shareholders as the returns from reinvesting earnings fails to exceed the cost of capital of 10%.

The best way to think about this is to imagine a company borrowing at 10% interest rate and investing for 8% returns. Every dollar borrowed to invest for growth would result in a -2% returns for shareholders. While the cost of equity capital isn’t an interest expense, it is an opportunity cost for investors.

It is important to be aware of this. Even if companies have the same earnings per share and the same growth rate does not mean that they are worth the same P/E multiple. Because ROIC makes a huge difference to whether growth adds value, or destroys value.

How to think about the P/E ratio

In assessing the worth of a company using the P/E ratio, we must first consider whether the company is able to generate ROIC in excess of the cost of capital and growth second. Growth only creates value if the investments generate a return in excess of cost of capital.

For example, here is a quick and dirty way to evaluate Apple’s P/E ratio:

Apple’s Stock Price Chart

It has traded at P/E of below 10x two times over the past decade (points A and B). This is way below Apple’s average P/E ratio. Mr Market was essentially saying that Apple is unable to maintain its ROIC and was unlikely to grow further.

When compared with the broad market’s valuation (S&P 500). Apple was also below the market’s valuation P/E ratio of 17x during point A and 21x during point B. Mr Market was telling us that Apple’s ROIC and growth will be lower compared to the average American company.

Investors should then evaluate if the current P/E underestimates Apple’s ROIC and growth going forward.

In hindsight, Apple continued to generate a high ROIC of approximately 30% and grew its EPS at a CAGR of 11.13%. A rate far above the S&P 500’s ROIC of 12% but lower than Apple’s historical average ROIC of 40%. Apple should rightfully have suffered a P/E contraction. But Mr. Market over discounted Apple with its P/E collapsing below the average S&P 500 companies’ P/E multiple.

Mr. Market eventually corrected Apple’s P/E multiple. Investors who have been right on evaluating its ROIC and growth, and bought Apple when it was trading at P/E multiple of ~10x would generate handsome returns of approximately 600% in 7 years and more than 300% in 4 years if they bought in at points A and B respectively.

Apple’s Stock Price Chart

For more information on understanding P/E ratios, readers may check out the white papers published by Epoch Investment Partners and Michael Mauboussin.

I also wish to share that I’m currently reading the updated version of the book Joys of Compounding by Gautam Baid. This book is highly recommended, and it is incredibly helpful in improving my thoughts about personal finance, investing, and life in general.

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What makes Mastercard a compounding machine?

What makes Mastercard a compounding machine?

Investors who held Mastercard for the past 10 years, have been rewarded handsomely with a 27.4% returns compounded annually. A $10,000 investment would have returned approximately $113,000 over this period. In this article, we will discuss why Mastercard’s wide moat has allowed it to reinvest its earnings at high returns.

In this post we will discuss Mastercard’s business model, reasons for their high margin, and why Mastercard will likely continue to grow and compound returns for its shareholders.

How Mastercard makes money

Mastercard does not see itself as a credit card company. Rather it sees itself as a technology company in the payment industry.

Taken from Mastercard’s 10K

Mastercard & Visa are commonly known as a tollbooth business. Before we begin, it is important to know who are the players in this space:

  • Account holder (That’s you and me)
  • Issuer’s Bank (Our bank)
  • Core Network (This is where Mastercard & Visa comes in)
  • Merchant (The store you buy your product from)
  • Acquirer’s Bank (The merchant’s bank)
Mastercard’s Business Model (Taken from Mastercard’s 10K)

Simply put, the role of Mastercard is to be the bridge between our bank and the merchant’s bank. While doing that, they collect a small fee of approximately 0.25% on the transaction. For example, when you buy your iPhone for $2,000, Mastercard will make $5 from the transaction.

The beauty of Mastercard business model is that it does not assume credit risk nor does it have to deal with end-users like us. It merely sits as a connecting network for the banks and collects a small fee.

Taken from Mastercard’s 10K

The company makes the bulk of its revenue by mainly charging a small percentage of the transaction and a fixed fee per transaction.

Some of the key metrics investors should track to measure if Mastercard’s business performance and moat would be:

  • Gross Dollar Volume (GDV) – How much we as consumers spend using a Mastercard in total.
  • Cross-border volume growth – The increase in consumers spending overseas.
  • Switched transactions – Number of transactions processed.
  • Number of cards issued
  • (Rebates + incentives)/Revenue – This is the amount Mastercard spends to attract financial institutions to carry its brand. An increasing ratio may mean the industry is getting competitive.

Rational competition

Industries that are dominated by a few key players (duopolies or oligopolies) often act like monopolies. Tacit collusion is normal and competition is rational, as industry players raise prices in tandem and compete for the share of the market. This “cooperative behaviour” allows companies to generate sustained high returns on capital.

“A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and noncomplex rules of engagement is the perfect setting for companies to engage in cooperative behavior…and it is for this reason that the really juicy investment returns are to be found in industries which are evolving to this state.”

Marathon Asset Management

As a connecting network, Mastercard is effectively a duopoly with Visa. We can see that Mastercard has been able to hold their fees steady over the years as we can see from the crude take-rate (obtained by Revenue/GDV).

Mastercard’s Rising Take-rate

And this has translated into fantastic margins for Mastercard. Their gross margins are 100% as there are no variable costs associated with every transaction. With GDV and revenue growing at a fast clip as shown in the table above, Mastercard is able to spend its gross profits on marketing, R&D and the likes to expand its moat.

Their operating margins have consistently been above ~50% for the past decade. Except for its closest competitor Visa, there probably isn’t another company that is able to consistently generate such high operating margins.

Network effect

When it comes to an economic moat, there may be none stronger than a network effect once it has been set in motion. The idea is simple, as more customers carry a Mastercard, more merchants would accept Mastercard, which would then drive even more customers to own a Mastercard.

Over the years, we have seen this played out beautiful as the number of cards issued and merchants on-boarding grow. At of 2019, there’s approximately 2.2 billion Mastercard issued around the world.

Compounding machine

The characteristics of a compounding machine are: (1) Ability to generate high returns on capital in cash; and a (2) Long runway for growth. Let’s see how Mastercard fare in this aspect.

(1) Ability to generate High ROIC in cash

Over the past 5 years, Mastercard’s Return On Invested Capital (ROIC) has an average of approximately 60%. To put this in perspective, the average ROIC of the S&P500 companies hovers between 9% to 13%. As a quick rule of thumb, we typically want to look for at least a sustainable 20% ROIC.

Having a ROIC of 60% means that every dollar of retained earnings will generate an additional $0.60 of earnings.

Over a 5 year period, the company’s cash conversion is also above 100%. This means that every dollar in earnings translates to more than a dollar in cash.

Over the last 3 years, the company generated $20.1 billion of operating cash flow. And returned $18.4 billion to shareholders through share buybacks and dividends.

Mastercard is able to do so because it is a capital-light business that doesn’t require huge investments; freeing up plenty of cash for shareholders’ benefit.

(2) Long Runway for Growth due to Cashless trend

Without room to grow, a high return on invested capital alone would not generate wealth for investors. So let’s take a look at what makes Mastercard a compelling investment.

The company processed a gross dollar volume of $6.5 trillion in 2019, which seems already immense. However, the Total Addressable Market (TAM) size for payments is $235 trillion! And cash payment still accounts for 85% of transactions. The trend of moving towards a cashless society remains a powerful propeller for Mastercard’s growth.

This is especially so when an estimated $68 trillion of total payment (~30%) is still made in cash & check. In light of COVID-19, it will likely accelerate the trend of declining cash usage and hasten the change in consumer behavior towards cashless transactions.

In Mastercard’s latest research, contactless payment grew twice as fast as cash payment as consumers are concern about the spread of germs. Likewise, with social distancing in place, many are turning towards e-commerce for their shopping needs. This could potentially be a long-term consumer behavioral change in Mastercard’s favor.

Risk: Fast-changing landscape

The payment industry is a fast-changing one. In recent years with online transactions accelerating, we have seen the growth of payment aggregators such as Adyen and Stripe. And even more recently, we have seen Square threatening to take over the offline transactions. These payment aggregators threaten to take over the acquirers slice of the pie.

However, they are still reliant on payment networks and their technology is built on top of Visa’s and Mastercard’s technology. The real threat would come if Stripe venture into personal banking solutions and achieve huge success. Imagine using Stripe to store your savings and to process your online transactions, skipping the card network altogether.

That would be similar to what Alipay and Wechat Pay has achieved in China, with so many users on their network they are able to bypass the card networks altogether.

This still seems quite far-fetch for the players outside of China. And would likely trigger anti-trust lawsuits if a player becomes as dominant as Alipay or WeChat Pay. To achieve this dominance and bypass the card networks, everyone must be using Stripe’s credit card and bank account.

All-in-all, Mastercard is a company with a fantastic moat and a capital-light business. Though the fintech and payment industry is a fast-evolving one, understanding the dynamics would allow us to observe that these card networks are likely to retain its dominance for years to come.

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My key takeaway from Berkshire’s AGM 2020

My key takeaway from Berkshire’s AGM 2020

Warren Buffett started the Annual General Meeting (AGM) with a seemingly bullish stance, diving into America’s history and how it always emerged stronger. Despite painting a rosy image, it is important to observe his actions. Key decisions such as the sale of airline stocks, the lack of new investments and share repurchases indicated a much more bearish sentiment.

But in any event, the range of probabilities on health narrowed down somewhat, I would say the range, the probabilities, or possibilities, and on the economic side are still extraordinarily wide. We do not know exactly what happens when you voluntarily shut down a substantial portion of your society.

Warren E. Buffett

As the meeting unfolded, we were once again reminded of the Oracle’s ability to think in probabilities and the importance of taking action when circumstances change.

The ability to change your mind

When the facts change, I change my mind. What do you do, Sir?

John Maynard Keynes

Selling off the entire position in airlines

In late 2016, Buffett revealed a surprise bet on the airline industry and took stakes in four major airlines – American Airlines, United Continental Holdings, Delta Airlines, and Southwest Airlines. In 2020, the stocks were down 63%, 70%, 59%, and 46% respectively.

Sale of Airline Shares

His decision to sell highlights his ability to change his mind when new facts present itself and not let ego stand in the way. This was my biggest takeaway as its a tough pill to swallow when my investment thesis doesn’t pan out the way I expected it to.

In Buffett’s own words “The airline business, and I may be wrong and I hope I’m wrong, but I think it changed in a very major way.” Similar to Singapore Airlines, these four airlines were each going to borrow an average of at least $10 to $12 billion each.

These debt obligations will severely impact shareholders’ returns over a prolonged period. And there was the possibility of the airlines having to issue shares at a cheap valuation to raise capital.

Furthermore, the demand for travelling remains uncertain 2 to 3 years from now. Passenger miles may not return to 2019 levels and airlines will not be profitable if passenger load falls below 70-80%. Buffett was concerned about the oversupply of aeroplanes as a result of COVID-19.

There could be many reasons he felt that there’s potentially a structural shift happening. My guess is that business travel which accounts for the highest margins (i.e. first class and business class passengers) would significantly reduce as companies undergo rapid digitalization during this period. Meetings and deals could be executed online as opposed to having an executive flying several hours and spending a day or two away from home.

Lack of share repurchases

In 2019, Berkshire repurchased approximately $5 billion worth of shares during 2019. From their annual report, we could see that the company repurchase class B shares between $204.07 to $221.67 range.

Excerpt taken from 2019 Annual Report

When the class B shares plunged to $162 per share, many investors including myself expected Buffett to massively repurchase shares as it was significantly below what he would consider to be undervalued back in 2019.

I was surprised when the total shares repurchased was only $1.7 billion in the first quarter of 2020. With Buffett ceasing shares repurchase in its entirety as the market went on a free fall.

Excerpt taken from Q1’2020 10Q

Once again, Buffett showed that when facts change, we have to adjust accordingly and not be anchored by our previous purchase price/ experience. He explained that Berkshire shares are not worth as much and it is not as compelling now to repurchase shares. Buffett was also honest and upfront that partly it was due to his mistake in purchasing the airlines.

He would much prefer to preserve the option value of money and share repurchases must only be done when current share prices are at a significant discount to intrinsic value to benefit existing shareholders.

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