Category: Columns

MSCI Reminds Me Why I am a Long-term Bull on SAAS Stocks $MSCI $IGV $DBX $NOW

I’m taking a look at MSCI stock. It’s an interesting one and pretty easy to understand. The bulk of the business is a subscription revenue tied to the indices MSCI  creates. These indices are then used by asset managers for their benchmarks. It’s kind of funny how similar it seems to a SAAS stock.

MSCI’s business is growing well (though not gangbusters) which you can see below and ~97% of it is tied to recurring subscriptions. The thing that sticks out to me is the EBITDA margins!  In total, the company has ~55% EBITDA margins. If you were to just take the Index business they have, that segment is >70% EBITDA margins.

Given capex is so low, this results in a ton of FCF. MSCI can’t really invest it all back into the business, so they pay a reasonable dividend and do share repurchases. They also have levered the balance sheet ~3.5x to juice returns, which makes since on a highly recurring business.

The table below shows how much in share repurchases + dividends MSCI has done. I also put the market cap at the end of the year for context. Obviously, buying MSCI would’ve been a great call back in 2015. But also just look at how much capital has been returned. It’s around $4BN and if you bought at the end of 2015, that’d be nearly ~60% of your capital back. 

Why does that make me bullish on SAAS stocks?

For one, its still early days. And as these names get scale on their costs, I think they too will be generating a significant amount of FCF (some already do, but I think it will be higher).

Some names will eventually reach a “maturity” point. Take Dropbox for example, which I did a post on recently. Arguably, they are reaching maturity and their margins are exceptional, as is the FCF.

If you made it to the end of my Dropbox post, you would’ve seen some analysis I did for long-term margin potential which I’ll repost here (saved you a click). This is a template I typically use to evaluate SAAS names. In some cases, like for ServiceNow, I arrive at “mature” operating margins of near 50%. The main reason is that the typical first sign up is actually negative margin, but the following renewal is very high margin (i.e. lots of costs in to win your business, then I just need to keep you).

Fast forward ten years: Some SAAS stocks will still be plowing every dollar back into the business. Some will still be very nascent and growing quickly, but not have much earnings. Some SAAS stocks will be more mature, be willing to take on debt like MSCI, and will likely gobble up shares and pay dividends.

Remember when Apple shifted to this strategy after generating so much cash? That makes me excited.

 

Canada Goose: It’s Still Early Days $GOOS

This will be a brief post, but I think Canada Goose is a fantastic luxury brand. Someone buying GOOS stock today is still coming in very early in its life cycle.

A quick digression first: What makes LVMH so great? It’s composed of premium, luxury brands that we all know. Louis Vuitton, Moët, and Hennessy are products that elicit a good feeling whenever you buy them, even if you know the price is a little wild. For some of their consumers, they don’t even look at the price.

I think it’s obvious why LVMH tried to acquire Tiffany then. It exhibits the same characteristics. But alas, the Tiffany’s deal has seemingly failed (for now). Tiffany has high mall / retail exposure and weddings this year are clearly being pushed. I’m sure LVMH is still interested in owning Tiffany’s, just at a lower price.

But as I mentioned in a post on what drives long-term shareholder returns, these brands are able to increase price ahead of inflation, which drives great top line performance and even better bottom line performance. It’s no wonder that these companies have compounded at such high rates (LVMH especially).

But brands are tough. You have to make a feel on how powerful the brand is. Do I think YETI has a strong brand? Yes. But maybe just for now… People may not think it’s very cool or iconic to have that brand of $300 cooler in 5 years from now. Its possible. I do, in fact, have a YETI koozie.

Investing in brands is hard. Picking winners and losers in not easy. Some people though GoPro had a good brand that would protect it in the harsh hardware world. Blackberry was also a ubiquitous brand, but then another brand came along that is more ubiquitous. Victoria Secret seems to be losing share, Lululemon seems to be gaining share…

I could go on, but the point is understand those risks. I just think Canada Goose is different. Footnote, I don’t have one of these jackets despite living in an area that gets very cold. I view it like a Ferrari of jackets.

Here’s another anecdote, one of my close friends shared that she had an early version of the Canada Goose jacket. She held on to that jacket for probably 4-5 years and then sold it online for nearly what she paid for it. That is amazing brand power.

I think the GOOS stock is worth a bet for several reasons (please do not miss the DTC bullet near the end):

  • Best in class brand
  • Long-term optionality to expand outside of just outdoor jackets
    • GOOS did $400MM of sales in FY2017 which has doubled in LTM June 30 2020. It’s still early days.
    • Right now, the bulk of sales comes from selling $1,000+ intense weather jackets. They could easily leverage the brand into other weather gear
  • Still very early days (opening up 4 retail stores in China)
    • Right now, the company mainly sells through wholesale distribution (i.e. Canada Goose jackets in other peoples stores), but they have launched their own stores
    • Right now they just operate 20 stores themselves, but as they grow and expand the brand, it’s possible to see the number of stores increase by a few multiples of the current amount.
  • I’m writing this in COVID-19, a global pandemic that has caused a steep rise in unemployment. However, the cohort of people who are buying Canada Goose are likely the same cohort that has seen very limited employment impacts this year.
    • LVMH, for example, saw sales +4% in 2008 and roughly flat in 2009 in what was close to a Great Depression
    • GOOS sales will be down this year (consensus has down ~20%), but as the pandemic subsides I think they will still be here and be back on track. If anything, consensus probably underestimates mix shift and underestimates new launches from the company.
  • This winter could surprise to the upside
    • Yes, if everyone is still working from home, it’s less about buying that jacket to show off. However, if everyone is still at home, they’ll pay whatever it takes to keep being able to take long strolls.
  • This could accelerate direct-to-consumer conversion
    • “Today’s reality has reinforced long-standing pillars of Canada Goose’s DTC strategy: globally scalable in-house e-Commerce and omni-channel innovation. With digital adoption rising rapidly, the Company has increased and accelerated investments in these areas going into the Fall / Winter season. This includes the launch of mobile omni-channel capabilities in U.S. stores, following a successful pilot in Canada, and a cross-border solution to expand international access.”
    • DTC represent 55% of revenue today. However, it has an operating margin of 47%. If mix shift goes more and more towards DTC, that would be very positive for the company (total operating margins are around 20% on a normalized basis).
    • For example of how this could impact the company, GOOS did $193MM of EBIT for the 12 months ending 3/30/2020 on $958MM of sales (20% margin). If the company grows to $1.2BN of sales and 65% of that is DTC at 47% operating margin, they would produce around $365MM of operating income from just DTC, or about double the TOTAL EBIT they do today

Why Hasn’t Autozone Stock Re-rated with Other Pandemic Winners? $AZO #COVID19

I just did a post where I evaluated my holdings of Apple following its recent surge, which looks to be a quite big move for the US’s largest public company. One thing I didn’t really discuss in that post was that Apple may have re-rated recently due to perception of it being a pandemic winner. If your sales have held in well this year, or even increased, you are viewed as either defensive or on a continued growth trek. In turn, your stock has rocketed up.

Here’s a list of stocks that I would say fall into that category. I can’t include them all, but you get the point:

FB Chart

FB data by YCharts

The S&P total return is ~5.5% at this point in the year.  Home Depot is doing well because housing is holding in well, and the pandemic is causing people to reinvest in their homes. Same store sales were up ~24%+! No wonder Home Depot has surged.

The same is true for other retailers, such as Target or Wal-mart, which despite possibly missing the back-to-school shopping season (which is big bucks) they are reporting some of the best comps in years.

So let me take off some of the true high fliers and compare Autozone stock and other auto part retailers to these names.
FB Chart

FB data by YCharts

If you’re having trouble finding the auto retailers on this busy chart – they’re all at the bottom!

This is odd to me. O’Reilly reported +16% SSS comps for Q2 and a 57% increase in net income. Advance Autoparts has a different fiscal period, but they reported 58% increase in EPS on a 7.5% SSS comp.

Why is that? There are several reasons.

  1. In recessions, people keep their car longer and do more work themselves. See my post on AutoZone for some discussion on their comps after the 2008 financial crisis.
  2. After reaching about 7 years in age, cars tend to need more work. The average age of a car in the car parc today is around 12 years
  3. Retailers focused on cleaning products and other pandemic needs consumers would need and auto parts took the back seat. It’s likely that the pure-plays auto stores picked up share

So I fully expect Autozone’s sales to benefit when they report at the end of September. And if this current crisis persists, then their increased comps will likely persist as well.

I’ve been watching street estimates for Autozone. They still sit around pre-pandemic levels. My guess is AZO handily beats these estimates, though admittedly there are some tough comps (believe there were additional selling days in the prior year).

Look, I’m a long term holder at the end of the day and I wouldn’t recommend trading around a  quarter. All I’m saying is you have (i) a high ROIC business that (ii) historically has returned every dollar of FCF to shareholders that (iii) is probably benefiting in COVID where (iv) estimates might be too low. I like the set up.

Should you hold Apple stock here? $AAPL

I’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.

One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.

Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.

Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.

If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at  the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.

In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare.  One reason why active management is so hard.

Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.


Ok, back to my view on Apple’s valuation. What do we need to believe here?

First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.

So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?

Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.

Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.

I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.

Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.


Of course, there are some other drivers for Apple recently.

The core driver for Apple here has to be the upgrade “super cycle.”

    • If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
    • To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
    • That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
    • The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
    • Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
    • ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.

Apple’s bundling could create a “services” powerhouse

    • First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
    • Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
    • Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
    • These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
    • Apple next launched “bundling” most recently and this could be a game changer.
    • Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
    • Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
    • Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
    • Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.

Bundle services… Bundle hardware

    • What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
    • Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
    • Then they push the software bundle. Rinse and repeat.

Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.

Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.

What Drives Stock Returns Over the Long Term? $AMZN $MSFT $KO $COST $ROL

We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.

 As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.

The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.

A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements.  One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).

In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.

I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).