company breakdown Archives | Steady Compounding

Understanding restaurant franchises – Domino’s Pizza

By Steady Compounder | October 25, 2020 | Comments 0 Comment

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:

The franchise model is able to scale rapidly, and
is capital-light.
~~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.

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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Initiated a position in Fastly

By Steady Compounder | August 21, 2020 | Comments 5 comments

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.

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

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.

What makes Mastercard a compounding machine?

By Steady Compounder | May 21, 2020 | Comments 0 Comment

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.

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.

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).

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.

You can also follow my Facebook page for updates here!

Investing in companies that will emerge stronger after Covid-19

By Steady Compounder | April 29, 2020 | Comments 2 comments

Since Covid-19 caused countries to go into shutdown, we have seen the conversation amongst investors shift abruptly from a company’s growth prospects to “How long can they survive without revenue coming in?“.

Many businesses have closed amidst this crisis. At the height of the pessimism during March 2020, many investors were shocked to discover the high cash burn-rate of many F&B companies. With no revenue, many restaurants and entertainment companies had to furlough, retrench employees in an attempt to preserve cash. Cash flow is the lifeblood of any company, and this crisis has placed many companies on the verge of going into insolvency.

We have no certainty as to when this pandemic will end, and predicting the end of the outbreak is beyond our control. That being said, investors looking to invest in industries caught directly in this crisis would have to ask this important question: are they able to raise capital?

How much can the company borrow? – Debt to EBITDA ratio

We can use the Debt to EBITDA ratio to estimate how much capital a company can raise. EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It is an estimate of the amount of cash inflow from business operations that the company could use to repay debt.

For simplicity purposes, a Debt to EBITDA ratio of 3 tells us that it would take 3 years for the company to repay its debt. Naturally, the lower the ratio, the better it is.

Generally, an investment-grade company would have a Debt to EBITDA ratio below 3. A ratio between 4 to 5 represents an elevated risk for rating agencies and creditors. Anything above 5 indicates significant financial difficulties and the strong likelihood that the company will be unable to borrow additional funds.

Debt to EBITDA	Risk Level
< 3	Low Risk
3 to 5	Elevated Risk
> 5	Unlikely to be able to borrow further

Debt to EBITA and Corresponding Risk Level

A company with a Debt to EBITDA ratio of 1, could easily double or triple the amount of debt by borrowing from the capital markets before it will hit the threshold of 3. Compared to a company with a ratio of 5, they are unlikely to be able to raise debt to tie through this crisis.

Using Starbucks (SBUX) as an example, the 5 years average EBITDA is approximately $5.8 billion. With its long-term debt at $11.1 billion, it gives SBUX a comfortable ratio of 1.9. Given this, SBUX could likely borrow an additional $6.3 billion before it hits the Debt to EBITDA ratio of 3.

Note: To adopt a more conservative approach, we could use Earnings before Interest, Tax, Depreciation, Amortization, and Rent (EBITDAR) if the company has lease agreements in place. Likewise, we will add the total operating lease to the debt figures as the company still have to pay for its rent during the shutdown. However, given today’s unique circumstances, we have seen many restaurants such as The Cheesecake Factory getting away with paying rent.

SBUX has also iterated in their latest conference call on 28 Apr 2020 that they remain committed to a leverage cap of 3 times rent-adjusted EBITDA.

How much more interest expense can they bear? – Interest Coverage Ratio

We would also need to look at the Interest Coverage Ratio. This measures the company’s ability to meet its interest obligations. A ratio for 8 indicates that the company is able to meet its interest payments 8 times over.

For this, we refer to the guidance provided by the rating agencies. Generally, anything above 3.5 would be considered safe. And anything below 1.5 would be considered extremely risky.

A company with an interest coverage ratio of 20 times would have greater capacity to incur interest expense. Compared to a company with a ratio of 1.5, creditors would be very concern on their ability to pay their interest obligations.

Continuing with the SBUX example, on average they made $4 billion in operating profits per year and incurred $300 million of interest expense in 2019. Giving them a cushy interest coverage ratio of 13.3x.

This means that they are able to pay their interest expense 13.3 times over, putting them in a comfortable position to raise additional capital.

Also, SBUX would be able to bear an additional interest expense of $200 million before their interest coverage ratio drop to 8x (which is still super cushy). Even if SBUX were to raise debt at 5%, it is able to borrow up to $4 billion dollars ($200 million divided by 5%).

At the height of the uncertainty, CEO Kevin Johnson stated that SBUX has a strong balance sheet. If required, the company has the ability to borrow an additional $3 billion very quickly. This is on top of the $2.5 billion in cash SBUX has in its bank. Thus, allaying fears that the company may face insolvency issues due to the shutdown.

In determining a company’s ability to raise capital, we will need to examine the debt to EBITDA ratio and the interest coverage ratio together. This will give us a rough idea of how much the company can borrow and at what interest rates.

Is the capital raised sufficient?

Lastly, we will need to determine if the capital raised is sufficient to last the company through this difficult moment. Sometimes the company will provide the burn-rate (e.g. how much cash each store burns per month) during earnings call and from there we can have a rough idea.

Otherwise, we can simply estimate the amount of cash required for the business to stay afloat. In this estimation, we can assume that the company will cut all non-essential expenses such as marketing, expansion plans, etc. The cost of goods sold will be reduced significantly due to the shutdown. We will also not include non-cash expenses such as depreciation, amortization, and stock-based compensation.

In the case of SBUX, the company has stated that it is burning $125 million of cash per week. The company expects the burn rate to decline as they open more stores from next week onwards. Given their capital of up to $6 billion, they are able to survive for 44 months, or 3.7 years in the worst-case scenario.

This puts SBUX in a comfortable position to go through this crisis. In fact, it will likely come out stronger as the company has the strength to expand into prime locations as weaker F&B establishment collapse during this crisis.

The company has also seen increasing traction in customers becoming Starbucks members and adopting digital payments. Customers who are members are more likely to be returning customers, as they enjoy the reward program Starbucks offer.

During the shutdown, 90-day active Starbucks Rewards members, increased to 19.4 million in the US, up 15% from a year ago. The membership card value has seen an increase from $1.2 billion to $1.4 billion. Effectively, the customers are providing a free loan to Starbucks.

To sum it up, Covid-19 is a black swan event and since then, many companies have raised capital by either borrowing or issuing shares. And as shareholders, we are the lowest in the pecking order when it comes to capital protection. To avoid severe dilution or total capital loss, I would prefer companies with a strong balance sheet, and the capability to raise cash in the debt market at favorable rates if necessary.

You can also follow my Facebook page for updates here!

How Ferrari delivered outsized returns for investors with its economic moat

By Steady Compounder | April 25, 2020 | Comments 2 comments

“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle,”
Warren E. Buffett

An economic moat is a term popularized by Warren Buffett, as he drew references to how business is like a castle, and having a strong moat is essential to deter invaders. Buffett invests in businesses that have a sustainable competitive advantage to protect themselves against competitors eyeing a slice of the market share.

Why should investors care about a company’s economic moat? The answer can be explained by the economic theory, mean reversion. Most of the time, investors & forecasters have a tendency to extrapolate the current trend. Companies that previously generated high growth are forecasted to continuously generate a high return and vice versa.

In reality, high returns will likely revert to the mean. Mean reversion is like gravity to returns on capital. An industry becomes attractive when incumbents generate high-returns on capital, enticing competitors to enter. New entrants will compete for market share, driving returns down for the incumbents.

Without a strong economic moat, high returns on capital would not be sustainable. Familiar examples that illustrate this trend in Singapore would be bubble tea, yogurt ice cream, poke/acai bowl, fried salted egg chips, etc.. you get the point. Without a moat, the success of these trendy concepts will attract competitors to pop up and reduce the incumbents’ profitability.

The outliers

That being said, there are companies that have defied mean reversion and continued to generate high returns on capital (in excess of 20%) for investors throughout the years. Some examples that spring to mind include Hermès, Costco, Facebook, Coca-Cola, and Illumina.

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Warren E. Buffett

A company’s moat is either expanding or declining, it never stays stagnant. As investors, it is our job to determine if the business has a sustainable moat and evaluate if management continues to invest in growing the moat. Popularized by Pat Dorsey, moats can be classified into the following categories: (1) Strong brands, (2) Patents or licenses, (3) Network effect, (4) Low-cost producer, and (5) High switching cost.

A strong brand name

“It’s not Christmas or New Year until you see Coca-Cola ads.” Or so the saying goes. Occupying a share of consumer minds is no easy feat. Brands such as Coca-Cola, Ferrari, Hermes, and Tiffany & Co brands have been extremely successful in occupying a share of our minds, allowing them to earn a much higher return than their competitors.

At the risk of this article becoming too long, we will discuss 1 of the 5 moats in this writing. Specifically, Ferarri (ticker: RACE) and how its strong branding has allowed investors to generate outsized returns over the years.

The birth of automobiles

Ever since the first introduction of cars in 1886, more than 2,000 carmakers have attempted to penetrate the market and most of them have ceased to exist. The automobile industry is notoriously competitive and capital intensive, companies often have to rely heavily on debt. Furthermore, it is also an extremely cyclical industry, where demand will taper off sharply (especially during times like these) as consumers will defer the decision to purchase a new vehicle when times are tough.

As a result, most carmakers have lumpy earnings and many generate negative Free Cash Flow (FCF). Making survival in this industry very challenging. As an example, General Motors (GM) generated a cumulative negative FCF of -$50.9 billion over the last 5 years. And they have made up for this shortfall by aggressively piling on debt to survive.

“What you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million now (the year 2001). So it’s easy to figure out the losers, the loser is the horse. But the winner is the auto overall. 2000 companies (carmakers) just about failed.“
Warren E. Buffett

The bright red car

Amidst the pack of car markers, Ferrari has the ability to charge astronomical prices for their vehicles. The power of the Ferrari brand is clearly evident here in Singapore. Despite our stringent speed limits and countless traffic lights, drivers still own Ferrari because the brand signifies wealth and affluence.

Ferrari’s moat allows it to earn outsized returns against other carmakers. The company has consistently commanded an average of 50% gross margins, while its competitors languish at an average of 15% gross margins.

In other words, the car which costs $50,000 to make can be sold at $100,000 for Ferrari. Its competitors, on the other hand, produce cars at the same cost of $50,000 but are only able to charge $59,000.

The fat margin leaves a lot of room for Ferrari to invest in widening its moat (e.g. invest in R&D and marketing) or to reward its shareholders.

Taking a look at their pricing power, Ferrari is able to command € 381,474 (SGD 588,000) per car on average. Competitors such as Ford and GM are only able to charge a fraction at $25,000 (SGD 35,600) and $16,000 (SGD 22,800) per car on average respectively.

During the 2008-09 global financial crisis, we saw the United States’ new car sales plummeted by 40%, sending GM and Chrysler into bankruptcy while Ford had to take a substantial loan from the government to stay afloat.

Car sales fell across the board for most carmakers, except for the company that made the bright red car. Despite the industry buckling down, Ferrari managed to see a 26% jump in the U.S. with its vehicles sold increasing to 6,587 in 2008, an increase of 122 from the previous year. And during 2019, it only saw a 1% decline in revenue.

The brand of Ferrari is so strong that its revenue growth continues to stay resilient through crises such as the 2008-09 financial crisis, Europe debt crisis, and trade war.

It targets the ultra-rich, and the company produces a limited number of cars each year. The long waiting list of up to 2 years, created a real sense of exclusivity for customers who can get hold of one. Even if customers have the cash to purchase a new vehicle, there is a limited quantity. This discourages those on the waiting list from withdrawing their orders even during bad times. And even if they do drop out, there is a long list of customers to take up their spot!

The moat surrounded Ferrari has proven to benefit investors immensely. Since its spin-off in 2016, it has delivered a CAGR of 37.3%, delivering a 400% return prior to Covid-19 within a short span of 4 years. Comparing this result with Ford, GM, or even the S&P 500, Ferrari has generated astounding returns for its investors.

To sum it up, having a strong brand that occupies a large share of consumer’s minds is a great moat, enabling companies to sustainably generate high returns on capital. As investors of quality compounders, we need to monitor if management is engaging in activities that widen the moat. Such as spending on marketing, increasing customers’ satisfaction, etc.

Facebook’s Incredible Business Model – Part II

By Steady Compounder | April 16, 2020 | Comments 0 Comment

In the second part of Facebook’s write-up, we will examine how its moat enables it to generate a high Return on Invested Capital (ROIC). We will also discuss its growth runway and what has changed for Facebook since the Cambridge Analytica incident.

A Compounding Machine

Facebook has consistently generated ROIC of ~30% on a before-tax basis. What this means is that every $100,000 invested in the business, it will give you $30,000 in operating income. Comparing this with buying a Condo for $1 million and it gives you $40,000 in operating income (rent less all expenses before tax), that would give you an ROIC of 4%.

There are many ways to calculate a company’s ROIC. Personally, I prefer Joel Greenblatt’s method of calculation. By using Earnings before Interest & Taxes (EBIT), it allows us to compare the true earning power of a company across time (different tax rates) and capital structure.

*Joel Greenblatt’s ROIC formula* from his book “The Magic Formula”

Interestingly, Facebook holds a lot of cash ($50 billion) in its Net Working Capital, indicative of its cash-generative capabilities. If we were to strip off that cash, its ROIC would go above 70% consistently for the past 5 years

A high ROIC is one factor that is important that I focus on when looking for quality companies. However, for it to be meaningful, a high ROIC must be accompanied by growth. The company must have sufficient opportunities to deploy capital at high rates for compounding to work its magic.

Can Facebook still grow?

Over the past 5 years, Facebook’s revenue growth per has averaged ~42%. It has since given guidance that growth would be expected to range around 20%, which is still an amazing feat given its size.

On a macro level, Facebook benefits from the tailwind of digital ad spending growth. Companies find that they are able to get a better bang for their buck by advertising on Facebook, compared to traditional media platforms such as newspapers and TV. Digital ad spending is now 53.6% of total ad market and it is expected to grow at an ~8% Compounded Annual Growth Rate (CAGR).

Facebook currently seized about 20% of the market share and that figure has been stable over the years. Apart from a growing pie, Facebook has room to seize market share from other players in the digital ad market as they roll out new features (e.g. Stories, Watch Party, Dating etc) which increases their competitive advantage.

Facebook, Google and Amazon’s % share of digital ad spending

Cambridge Analytica Scandal

In 2018, the company was fined $5 billion for the misuse of users information during the Cambridge Analytica scandal. But what has happened since? Since then, the management has aggressively increased spending on R&D by 75%, Marketing & Sales by 109% and General & Admin by a whopping 315%, a pace far greater than revenue growth 73% over the same period.

These numbers are attributed to Facebook’s efforts to hire a lot more staff & increase its investment in security. I take the management’s willingness to act and invest in the long run very positively.

Increased regulation may sometimes inadvertently strengthen a company’s position. Like in the case of Philip Morris (otherwise known for its product Marlboro cigarettes), the regulation in the cigarette industry effectively prevented competition from entering. This protected their profit margins and allowed them to consistently generate high returns for their investors.

Likewise for Facebook, increasing regulatory requirements for social media may increase the barrier of entry for new entrants. As regulators and users increasingly demand higher security features and greater oversight from the platform.

To sum it up

As the leader in social media with a strong network effect, Facebook has successfully navigated the pivotal changes from desktop to mobile, and from posts to stories.

Whether Facebook is able to compound wealth for investors would very much depend on whether it is able to continuously widen its moat, generate high ROIC and continue to grow.

Before we end off, this how profitable Facebook is compared to its FANG peers:

And this is because the content on its platform are free.

Facebook’s Incredible Business Model – Part I

By Steady Compounder | April 15, 2020 | Comments 0 Comment

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

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.

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.

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!