Tag: fundamental analysis

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.

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.

Analyzing the gross profit margin

Analyzing the gross profit margin

Reading the financial statements is important to understanding businesses. For beginners, it may be daunting at first. I will try my best to make it come alive with case studies!

For this post, we will focus on the top 3 lines – Revenue, Cost of goods, and Gross profit. Now, imagine you are running a lemonade stall:

  • Revenue is the total sales made from selling those lemonades.

    Revenue = Price per glass x Number of glasses sold

  • Cost of goods is the cost of the ingredients and labor costs for making that lemonade. It would include the cost of lemons, water, ice, and syrup. If you hired someone, their wages would be included here too!

  • Gross profit is simply the difference between revenue and cost of goods. If you made $100 from selling lemonades and it cost you $40 for the ingredients, your gross profit is $60!

    Gross profit = Revenue – Cost of goods

Gross profit margin

You’ll frequently see the term Gross Profit Margin (GPM). Which is simply gross profit/revenue x 100%.

It signifies pricing power. The higher it is, the more pricing power you have. In our lemonade example, our GPM is 60%. Which means we make our lemonade for $0.40 and sell them for $1.

It could also reflect cost structure and production efficiency. As companies scale, they may have more bargaining power over their suppliers and demand lower prices (e.g. Walmart & Costco).

Low margins doesn’t mean its bad

Costco is one of America’s largest retail chains and its mission statement is “To continually provide our members with quality goods and services at the lowest possible prices.”

And we can see this being echoed in their annual report as well. They outline their strategy as follow:

Does Costco walk the talk? Let’s take a look at their income statement. Their gross profit margin is only 11%. This means that when you bulk purchase toilet rolls at $15, it cost the company $13.35.

How do they fare when compared to Walmart? Did they fulfill their mission – to provide the lowest possible price? As we can see, Walmart’s gross profit margin is at 24%. The same toilet roll that cost you $15 at Costco, would cost you $17.57 at Walmart!

What about Target? Their gross profit margins are at a staggering 28%. Meaning the toilet roll would cost $18.54!

By studying the gross profit margin, we can see that Costco is truly the “pricing authority” in retailing. Which explains their success, in winning over customers and delivering returns for shareholders (20% CAGR) over the past 10 years. Who wouldn’t want to get the best prices?

Importantly, we can see that low gross profit margins doesn’t mean it is a bad business. For Costco, low prices are their competitive advantage. They pass all the cost savings to consumers. What matters is the consistency of the margins. If it declines, we will need to investigate and understand if its pricing power is being eroded.

This brings us to our next case study on Victoria Secret, also known as L Brands.

Declining margins almost always spells trouble

Victoria Secret used to be regarded as a premium brand. Since the late 1990s, Victoria’s Secret has been one of the best-known and most talked-about brands in the country.

Robert Cialdini aptly points out, a higher price truly can influence us psychologically into perceiving the product as more valuable. For premium brands such as Victoria Secret, Louis Vuitton, and Hermès, prices send a strong signal of value in the products.

For a business whose competitive advantage lies in its brand, the gross profit margin tells us whether its pricing power is intact. And here we can see that Victoria Secret heavily discount its products. In an attempt to clear its inventory. The gross profit margin declined rapidly from 43% to 34.5%.

The company’s competitive advantage (moat) has since been breached. A tarnished brand is difficult to rebuild. Its share price has seen shrunk from $74 to $15, an 80% decline.

Other times, a declining margin may suggest that the company is a price-taker. As the cost of goods increases, the company is unable to raise the prices and pass down the additional costs to consumers.

Making sense of revenue

The revenue is one of the most helpful figures in evaluating management’s growth plans. In the business section, management will inform you of information such as the number of stores and average square feet. As Ulta Beauty did.

Ulta has a total of 12,540,000 (10,000 sq feet x 1,254 stores). And they made $7.4b in revenue as stated in their 2019 annual report. That comes up to $590 per square feet made per year!

Measure this figure against past years. If revenue made per square feet has been rising, great! It means the company has more room for growth. If its declining, it may suggest that the company has over expanded.

I would also do this for premium brands. To measure if they are diluting the brand by lowering prices. For Ferrari, I would take revenue divided by the number of cars sold. If the average revenue per car is going down, that may be a red flag!

Growing gross profit per customer

Companies that are able to keep growing its gross profit per customer often signals a high-quality company. To achieve this, the company must have recurring revenue and the ability to scale (i.e. grow).

SaaS companies such as Adobe and Autodesk have been able to raise prices by delivering additional features to their software without a corresponding rise in the cost of goods. And the revenue is extremely sticky as consumers pay subscription fees to enjoy the functionalities.

For consumer staples, Starbucks has been able to enjoy this with its premium brand. They have been able to raise prices at a faster clip than the cost of goods. The revenue is stickier than other restaurants as coffee is a staple for some and often consumed daily. Starbucks has also been able to improve consumer loyalty with its membership program.

Steady Compounding Updates

Do let me know if this has been helpful or if there are any other topics you are interested in by commenting below!

The next section on understanding income statement would be on operating income. Where we will take into account other expenses such as depreciation, amortization, rental, marketing, and more!

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