With a sagging stock price and disappointing underlying performance, I wanted to share my thoughts with B&G foods management (particularly CEO Ken Romanzi) on how to create the most shareholder value from here. Here is the play by play:
IPO Green Giant as a separate company
Use the capital from the Green Giant IPO / Spin to delever Core B&G
Cut the aggregate dividend, focus on share repurchases & M&A with more flexibility
Here is the open letter. Note I haven’t actually sent this to them, but it is my view on what should be done. Hopefully they consider some of these items.
As you can see in the chart below, B&G’s stock price performance has been abysmal. Investors are concerned over the mature brands in your portfolio, the changing landscape within grocery stores, and that your leverage will prevent you from being flexible. I do believe your portfolio has strong characteristics and like so many other things, investors are likely overestimating how fast these changes will occur and underestimating the power of your business (both its cash value and brand value of Green Giant).
But at the end of the day, you are getting no credit. You are definitely not getting credit for the value of Green Giant and the turn-around story the team commenced. Green Giant was acquired at the end of 2015… but your share price has suffered meaningfully since then.
I personally believe Green Giant has tremendous platform value and would be more appropriately valued as a separate company. Once separated, I think both Green Giant and the legacy business would be much better served and have more appropriate capital structures that would allow growth. I therefore recommend the following “game plan” for the team:
Spin-out / IPO / float Green Giant as a separate company
Distribute capital back to B&G, which will be used to delever the core business
Cut the aggregate dividend, focus on share repurchases or accretive M&A when appropriate
Spin-out / IPO / float Green Giant as a separate company
There is no doubt in my mind that the acquisition of Green Giant has been a success, despite some pressure on the shelf-stable side of the business. With the growth of the frozen category, you have created a formidable opponent to Birds Eye. As summarized in the table below, the aggregate Green Giant business has grown despite significant pressure in shelf-stable and I think 2020 is set up well with cauliflower crust pizza, vegetable hash browns, and veggie gnocchi launches. There will also be further growth as grocery stores expand the freezer aisles at the expense of the center aisles.
As of right now, you are getting no credit for this brand.
Let’s look at a group of comps that also include mature businesses, some of which are experiencing low-to-no growth. When compared to B&G – they trade well above. The reason B&G trades so low is that the “core” or legacy business drags everything else down because it is mature and under pressure. Also, people view the dividend at risk so they might as well get out now. Lastly, leverage of B&G is well above its peers. As discussed further in this note, each of these concerns could be assuaged by spinning out Green Giant.
The names that are growing should trade at a premium. Based on this, I think Green Giant should be worth at least 12-13x, which seems reasonable given the trends in frozen vegetables, consumer demand, and the ability to add more to the business from a platform perspective. Offsetting it will be its “shelf stable” Green Giant business, but that could serve as a source of cash to help fund the growth of the freezer business. At the end of the day, if Kellogg and General Mills (which face secular demand pressure in cereal), then so should Green Giant (again perhaps a premium given the growth story). Bob Evans was acquired by post for 15.4x or 12.5x post-synergies. The play there was a pure-play refrigerated sides, frozen food, and breakfast sausage business. I think this is an excellent comp for Green Giant and shows other avenues it could expand into.
Here is my breakdown of the current B&G enterprise value (TEV). Note, I’m using an estimate for net debt based on the company’s refinancing that occurred in October (post quarter-end):
If we assume Green Giant grows top line 3% next year and assume 19% EBITDA margins, that implies we are getting the rest of the business for ~8.0x.
Why does a spin make sense?
First, you should get better value for Green Giant. As shown in the comps, Green Giant seems cheap. Second, you should get more value for the cash flow. B&G currently trades at a 12% dividend yield. The market is clearly implying the dividend will be cut. And as I will say later, you might as well cut it and buyback stock if you’re not getting credit for it. This leads me to the second part of the recommendation:
Use the capital from the Green Giant IPO / Spin to delever Core B&G
First, we should look at a reasonable capitalization for Green Giant. I think given the growth of the business, its strong brand, and opportunity for further product tack-ons, plus where the comps trade – I think 13x is reasonable. The company could raise 4.5x of leverage (which would only be 35% of TEV) and the balance would be an equity raise.
Does this make sense? Well comparing it to what the company would do in FCF, it foots to a 6% FCF yield to equity- which seems fair.
More importantly, I’ve provided a summary of what we think the impact on the legacy B&G business and capital structure would be:
So first, this would reduce leverage at core B&G considerably. Second, if the stock still traded at 8.0x EBITDA then that foots to ~$930MM market cap.
If we generate $109MM of FCF on this new EBITDA number, that would foot to a 12% FCF yield… If your cost of equity is 9%, then a 12% FCF yield essentially implies a 3% decline in perpetuity. That could be reasonable, but if you (as management) think that is unreasonable you could deploy cash to buyback stock. At the end of the day, the point is that you will be more flexible. You could use cash the way you see fit – buybacks, dividends, pay down debt.
A 6.3x business that is struggling organically is much more risky to investors than one that is 3.5x that can be stabilized and generates gobs of cash. That is why you are getting no credit for the dividend today. Hopefully this analysis gives you some sense on how the two businesses when separated could be significantly de-risked and also provide breathing room to grow.
This leads me to the next recommendation…
Cut the aggregate dividend, focus on share repurchases & M&A with more flexibility
The problem with dividends is that they are viewed as sacrosanct. If you cut the dividend, you’re stock will get punished. However, a dividend policy established many years ago may not be right for this environment. I think Green Giant should almost pay no dividend. Instead focusing on M&A that may enhance its portfolio or opportunistically repurchase shares. Invest for growth.
The legacy B&G could pay a large dividend to entice yield-hungry buyers (e.g. 4-5% yield), but also have flexibility for share buybacks or M&A. You cannot honestly tell me you do not wish the dividend quantum was lower right now so you could repurchase shares or have more flexibility for M&A today. Again, give yourself the capital allocation flexibility – buybacks, M&A, dividends, pay down debt. Put the power back in your hands.
I’ve been studying Bill Ackman’s portfolio and strong performance so far in 2019 and it seems the hedge fund manager is getting back to his roots. Gone are the shorts in Herbalife and aggressive long in Valeant, and instead he has waved in a new era of “high-quality, simple, predictable, free-cash-flow-generative businesses with formidable barriers to entry.” As shown in the slide below, it seems as if Ackman is positioning himself towards high-quality blue chip names. And not pictured, he added Berkshire Hathaway to the mix and existed UTX and ADP.
As a quick aside, this strategy is puzzling to me. For a hedge fund manager to be buying huge, blue chip stocks… it just seems odd. Perhaps it is due to his view on the business cycle and these investments, with good balance sheets, will perform fine in good or bad economic times. However, they also are now mostly consumer discretionary businesses. Maybe he is bullish on the consumer 10 years into an expansion? Odd indeed.
In this post, I am going to examine Lowe’s which Ackman’s fund, Pershing Square, now has a ~$1bn investment. This is an age old question. We have two companies in a big industry. Everyone knows their names… why and how do you pick one over the other?
Ackman’s thesis seems to rest on Lowe’s “closing the gap” with Home Depot. Ackman even says Marvin Ellison, the Lowe’s CEO announced in May 2018 who is an ex-Home Depot executive, was his top pick for the CEO job.
As such, I will be examining Lowe’s in comparison with Home Depot and also determining if there are any structural differences between the two companies. In essence, I will see if Ackman’s thesis has merit. I hope to finally tie that into valuation. Because so much of this report will be comparing the two building product juggernauts, this might as well be viewed as a report on both Home Depot and Lowe’s.
Lowe’s history dates back to the early 1920’s when it opened its first hardware store in North Wilkesboro, North Carolina. In anticipation of dramatic increase in construction following WWII, Jim Lowe (the son of the original founder) and his partner Carl Buchan began focusing on hardware and building materials. Following some years’ operating together, the two disagreed on focus and Jim Lowe split with his partner to focus on grocery (and started Lows Foods grocery chain) while Buchan operated Lowe’s.
The company expanded in the Southeast. After Buchan died in the early 60’s, his executive team took the company public with 21 stores.
In the 1980s, the company suffered against Home Depot and the big-box retail concept. Home Depot was formed in just the late 1970s and early 80s with the home-improvement superstore concept. Their first stores were built in spaces leased from JC Penney in Atlanta and began branching out in the southeast US. By 1989, Home Depot surpassed Lowe’s in annual sales.
Lowe’s resisted this big-box format, mainly arguing that Lowe’s served smaller, rural communities where a big box chain doesn’t make much sense. However, it eventually did succumb to pressures. Today, Lowe’s has ~2,000 stores and ~209 million square feet of store space and does ~$72BN in sales. Home Depot, in contrast, has 2,289 stores, ~240 million square feet, and ~$110BN in sales. More on these comparisons later.
Lowe’s and Home Depot operate in what is estimated to be a $900BN market. With $72BN in sales, this means Lowe’s has less than 8% market share while Home Depot has ~12%.
However, I will say it is unclear to me what this market size estimate includes. Obviously, the housing market is huge and the market that Home Depot and Lowe’s serve must be big given the size of their respective sales ($180BN combined). But if they’re including everything within home improvement, the addressable market is likely much smaller for the duo. They will never truly displace the lumber yard. Nor should they. That is a low margin, commodity business. Home Depot in the past as alluded the market is more like $600BN, which makes more sense to me.
The customer base is split in DIY (do it yourself) and DIFM (do it for me) customers as well as professional contractor customers. I think we can all understand the DIY / DIFM customers well. These people are doing repairs on their home and come into Home Depot or Lowe’s for a certain tool, toilet, door, window, flooring, etc. Lowe’s and Home Depot serve as a one-stop shop for them.
Contractors on the other hand are a bit different. This is the segment Lowe’s is now aggressively targeting. As noted at Lowe’s investor day in 2018,
“[Our] final focus area will be intensifying customer engagement. At the core of this objective is winning the Pro. We have a tremendous opportunity to grow this portion of our business. This is a customer that is very important because the typical Pro spends 5x as much as the average DIY customer.”
We will discuss this in more detail later on, but I can see the challenge of this sector of the market. Time is money for a Pro and when they need something, they need to go to one place. That is why specific building supply stores and distributors exist. Not necessarily for one stop shop of everything (cabinets and windows in the same purchase), but more like, “You need plumbing products for that job? Head to Ferguson. Need HVAC products? Head to Watsco.” There are also showrooms around the country to sell tile, flooring and cabinets specifically for the pro channel. For example, Fastenal, Grainger, Ferguson, HD Supply, Watsco each have a niche they are targeting in the Pro segment.
It makes sense why Home Depot and Lowe’s would target this customer. If a pro stops in to buy one product and then decides to throw a hammer, some fasteners, adhesives, and paper towels in the cart as well, that is all upside to Lowe’s.
Comparison – How do Lowe’s and Home Depot Stack up?
Now that we’re starting to get into their differences, I’d like to provide a simple breakdown first of Lowe’s and Home Depot’s stats. I think this is where it becomes clear that their performance differential is stark, despite seemingly similar store count.
Clearly, Home Depot has similar store count, but is much more productive. Home Depot has 14% more stores, but 50% higher sales, 140% higher EBITDA, and incredible return metrics on invested capital, despite spending about 2x as much per store.
What about like-for-like sales comparisons?
As shown below, Lowe’s was performing well against Home Depot up until the financial crisis. Since that time, Home Depot has been eating Lowe’s lunch.
This is more clearly seen by looking at the two-year stack (that is, comparing the last two years sales growth rate together). Coming out of the crisis, Home Depot took a strong lead and has since maintained it.
If we look at the drivers of Lowe’s sales since 2010, we can see in the chart below that in the past few years, most of the growth has come from larger average ticket sizes, while transaction growth (or volume) stalled.
At the same time, Home Depot has had a good mix of volume and pricing gains. To me, it looks as if share shift is clearly demonstrated in the last two years, where Home Depot is reporting stronger transaction growth to Lowe’s negative comps.
Rationale for the Underperformance?
Lowe’s called out some of the reasons for under performance here:
“We took a hard look at the current state of our stores. We saw that customers were very excited to come to Lowe’s. And therefore, our traffic growth was quite strong. However, frequent out of stocks led to poor conversion, lower transaction growth and a frustrated, disappointed customer. We have terrific associates who know this business well and give their all each and every day to find solutions for our customers. But we also saw that we made it difficult for those associates to do their job. Lack of process, procedures and clear direction made their work inefficient. Complex, outdated point-of-sale systems require too much time and training to navigate, leaving our dedicated associates scrambling and long lines of customers waiting. In effect, the staffing models placed too many hours in associate and tasking activities and not enough in selling activities.
In addition, the company called out the lack of focus on the Pro.
“We had also fallen out of step with the Pro. They had been a lack of focus on the depth of inventory, the right pricing and the products that they expect. In fact, we lost some critical brands years ago because there was a focus on margin rate rather than the understanding and responding to the comprehensive needs of that important customer. We also found that our online assortment was lacking with a significant SKU deficit versus the competition.”
Home Depot has had much more success with Pros recently vs. Lowe’s. On Home Depot’s Q2’18 call, they stated that Pro penetration is ~45%, while Lowe’s stated it is ~20-25%.
Why does the Pro matter? Home Depot stated in 2019 that they were going to dispell a myth: the Pro is not higher margin than DIY. The margin mix of products is similar. However, they spend much more when in the store. Home Depot also stated that “the Pro represents nearly 40% of sales but only 4% of customers.” Therefore, you have more inventory turns in the big box store and you are much more productive.
I think another reason why Lowe’s stores lag Home Depot’s and lag in serving Pros is geography. Lowe’s stores lag in the high density population areas, which are Pro heavy. Instead, I think they have more locations in more “rural” areas which is heavy DIY. Household incomes of these denser population areas are also higher on average, which means they have more to reinvest in their homes and renovate.
Why did Lowe’s outperform pre-crisis? I think Lowe’s stores where in areas which were likely impacted by the real estate bubble. As the bubble grew, the city sprawl grew as well and the values of homes on the outskirts of town also witnessed strong growth (at the time). This translated into higher sales for Lowe’s at the time. When the bubble popped, these areas were more heavily impacted.
This is speculation on my part, but let’s compare some stores in areas. Note: this is completely anecdotal, but what I am trying to gauge is Home Depot’s density in city centers (where population is theoretically higher) compared to Lowe’s. I also pulled up some smaller cities to compare store count. It’s one thing if you have the same store count, but it is another if one competitor has 10 locations in Houston and another has none there, but does 10 in Des Moines. With a big box store you want to be serving as many people as possible in a day.
Below is Boston. You can see some Lowe’s stores are peppered outside of the city, but no real ones serving the actual city. Contrast that with Home Depot on the right – more stores dead inside the population zone.
The next is Houston. This time, Home Depot has many more stores serving the 4th largest city in the US, both inside and outside.
Next is Oklahoma City. Home Depot and Lowe’s looked roughly well matched. However, Lowe’s has 11 locations there, including one outside of town. Home Depot has 9. Does it make sense for Lowe’s to have the same number of locations in Oklahoma City as it does in Houston, when Houston has 4x the population?
Next is Indianapolis. To me, it is the same story as Oklahoma City. You can argue now that Lowe’s will be better positioned as these other, smaller regions grow, but it is questionable how they’ve allocated capital in the past at least (we can open a store in Houston, or one in Indianapolis – which do you pick?).
Ok last one to test the bubble thesis. South Florida was blasted by the housing bubble due to very high speculation activity in these areas. Let’s check out the store count:
Are the differences structural?
I think the differences in margin are not structural. However, I do think that turning a ship with nearly $80BN in sales is not easy and will not happen quickly. There may be taste changes that Lowe’s will have to overcome (didn’t have the product before, why should the Pro trust you now) and the investments may take some years to play out.
So what is Lowe’s doing to close the gap?
Clearly, it seems Lowe’s knows it needs to target the Pro. After an internal review, they discovered that there was inadequate coverage of Pro by their staff. The staff was busy with documentation work during peak hours and missed serving Pro staff. Time is money.
It does seem simple on paper: if they can be price competitive, have the right brands and quantities, and be consistent with service, I think that will help close the gap.
Again, however, I think this can only improve so much due to geographic differences.
On the profitability side, the company said that its payroll systems are antiquated and not prepped for changes in demand by department. Outside of COGS, store payroll is the company’s largest expense and they definitely spend more than Home Depot does on a per store basis (see EBITDA margin difference in table at beginning of this post). At the same time, they will be adding sales staff to support the Pro segment. The company’s goal is for the savings from one to fund the other.
They also noted they will focus more on “high velocity” SKUs in stock. Historically, they focused more on inventory dollar position versus inventory turns. If you are turning your inventory quickly – you are making more money. This seems like retailing 101 so hopefully is a quick fix.
As shown below, Lowe’s thinks it can improve sales per sq ft by ~10% over 2018 levels (and 8% over LTM Q1’19). By having better SG&A leverage, they think this will translate into 12% operating margins, or ~300bps higher than today and ROIC will improve dramatically.
In addition, Lowe’s is expanding its leverage target from 2.25x to 2.75x EBITDAR in order to free up cash flow for the equity.
This all seems to be a tough and a bit of a stretch. While $370 / sq ft is still behind HD, I try to detail my view on earnings if this were all to happen. I can see how you would get 110bps of margin expansion all being equal, but the company is also talking about investing in additional supplies, new technology, additional sales staff… all to support the Pro and help close the gap. That will cost something and doesn’t appear reflected in their goals.
However, as I look at consensus estimates, this isn’t totally priced in either. Street estimates show EBITDA margins expanding to 12.2% from 10.6% by 2021, so still high but not giving full credit. There is some doubt in the numbers which is good. It still seems rather optimistic to me, however.
Is it reflected in the valuation?
If I pull a list of comps for Lowe’s, I of course need to look at Home Depot, but I also need to show other defensible retail. I view the Home Depot and Lowe’s duopoly as similar to the auto repair stores. The customer service and experience drives customers back to their stores and there is some moat that Amazon will have trouble crossing. That said, if you don’t have the part in auto retailing, you lose the sale. Seems rather analogous to our discussion here.
Dollar Tree and Dollar General also remind me of HD and Lowe’s. Two formidable competitors that serve a niche part of the market. Finally, I also think Walmart, TJX, Ross Stores and Target need to be included as they are retailers known for their powerhouse supply chains and ability to survive in a tough retail environment.
In each case, Lowe’s screens as pretty cheap. But given what we know, would you buy Home Depot vs. Lowe’s?
Unfortunately, it is too simplistic to just compare multiple of earnings or EBITDA. We have to also take into account ROIC. Lowe’s is currently around a 12% ROIC while Home Depot is ~25%. If we were to run a DCF on these two companies and assumed they grew at the same rate and had similar WACCs, the one with the higher ROIC would clearly receive the higher multiple. Here is a brief summary with made up numbers:
Now compare to company 2…
If you then factor in that Home Depot has been crushing Lowe’s in growth, you have the formula for a much higher multiple that is warranted. Lowe’s is just trying to close the gap, but during this time, Home Depot won’t be standing still. It could reinvest more in new projects that extend its runway.
In sum, I think that Lowe’s has a formidable competitor. While I like that they realize they were asleep at the wheel and have a former HD exec running the ship now, I am a bit afraid that HD will still be pulling away while Lowe’s is trying to catch up. I want to root for the underdog, but I’d probably put my money on HD outperforming Lowe’s.
Announced on July 9th, Blackstone will be selling up to 17.7MM shares of CorePoint. That represents ~30% of the outstanding shares of CPLG. Should investors be concerned or even follow Blackstone with the sale?
I think its best to put some historical context behind this: How did Blackstone end up with the shares?
Blackstone acquired La Quinta in the beginning of 2006 for $3.4BN. I won’t call that the tippy top of the market, but it is pretty close. And since that time, large hotel chains have consolidated and gained more power (e.g. Starwood & Marriott). AirBNB has also emerged on the seen. The point is that not only did Blackstone acquire at a bad time from a market valuation perspective, the hotel industry has undergone some significant changes that crimped middle tier hotel chains like La Quinta.
So Blackstone has owned La Quinta for 13.5 years, when the average private equity life of a fund is around 5 years. That means its investors in that fund have to file k-1’s for an investment made that long ago. In addition, every day that passes drags down the IRR of the fund.
Blackstone also likes to own the franchisor, not the franchisee, because they collect management fees and generate a lot of cash. For example, Blackstone bought Hilton, they recently bought SERVPRO, and even formed a franchise roll up for the hospitality sector. The operators / franchisee has to manage the operate the business which is obviously tougher.
Given my fundamental view of the company, I’m not that concerned. If another shareholder wants to sell at 50% book value due to misaligned incentives (i.e. they need to get out), I am fine to scoop up the shares at a discount.
I do expect the shares to be under pressure soon. The stock is at $12 at the time of writing this, so it is quite possible we see a much lower valuation with 30% of the stock coming for sale.
To say Bayer’s acquisition of Monsanto has not gone smoothly would be a significant understatement. Since Bayer closed the deal, lawsuits regard Monsanto’s “Roundup” have started to gain traction which has lead to the market trying to “price in” Bayer’s glyphosate liability.
Roundup’s main active ingredient is glyphosate, an herbicide first registered for use in the US in 1974. Glyphosate is a non-selective herbicide, meaning it will kill most plants. This is great for killing weeds, but you also don’t want to kill the plant you are growing.
Enter Roundup Ready – genetically modified crops such as soybeans and corn that are resistant to glyphosate and therefore will not die when you spray glyphosate over top. Kills the weeds, not your lawn.
As you can imagine, this was a huge boon to farming crops in monoculture. And as such, the use of glyphosate has proliferated. Here is a chart below of the pounds applied annually, sourced from the EPA. The herbicide represented 56% of total herbicide usage according to the EPA.
Considering glyphosate is the world’s most widely used weed killer, we should all be pretty worried if it does indeed cause cancer. That is the question for the Roundup lawsuits set to go to trial in the US. It is estimated that there will be at least 13,000 lawsuits.
So far, Bayer’s ability to fight these lawsuits has been abysmal. A California man was awarded $289MM in August 2018 after a state court found Roundup caused his cancer (this was later reduced to $78MM and is on appeal). A couple was also awarded $2 BILLION in punitive damages, on the jury finding that Roundup was responsible for their cancers (though the expectation is this will be reduced dramatically).
What is most surprising to me is that glyphosate is one of the most studied chemicals in the world. And nearly all determine that glyphosate is safe. Here are a few snippets:
The study that has gained a lot of traction is from the the International Agency for Research on Cancer. They issued a rating for glyphosate that gained a lot of media attention because IARC classified glyphosate as a “probable carcinogen.” Read the IARC report.
However, what gets much less attention is that IARC’s findings were challenged by other organizations around the world as inconsistent with other scientific assessments conducted by scientists from countries worldwide who are responsible for ensuring public safety.
In total, more than 100 countries have approved glyphosate for use. A few of those publications can be found here:
What is amazing about these jury cases is that a jury can now decide something gave you cancer… hmmm.
How much is the market pricing in for Bayer’s glyphosate liability? One way we can estimate this is by looking at Bayer’s price performance since the first trial compared to the broader market, in this case using the German DAX.
By taking the difference between performance, we can get a rough proxy of what the market is pricing for a liability:
By this analysis, the market is pricing in $40BN liability for Bayer…
Another way to look at it would be the difference in multiple. I would normally argue Bayer is worth more than the broader market (given its healthcare assets + crop protection), but assuming they should trade-in line, we can take the difference in multiple today and see what the market is pricing in.
Therefore, this albeit crude analysis points to the market pricing in a $30-$40BN liability for Bayer. Is this reasonable?
Perhaps if you think every case will go through and get huge settlements, but that’s not typically how it works.
Let’s take a look at other class action lawsuits. In some cases, these were clearly drugs / chemicals that caused issues in humans and weren’t defensible by science like glyphosate is. The claimants range from ~3,000 to 27,000 and the settlement per case was $0.18MM to $0.37MM.
So what does a $30BN-$40BN mean for Bayer? Based on the sensitivity table below, the market is pricing >25,000 claimants and a settlement of $1MM a piece. This seems extreme, especially when the other cases settled in total for a max of $5BN. If you think Bayer will eventually $5BN to settle all these claims, you could then argue it is mis-priced to the tune of $25-$35BN.
A larger question with the stock is if glyphosate is determined to cause cancer, is the entire $68BN acquisition of Monsanto impaired? This would likely mean that you can no longer use GMO plants and spray glyphosate like you used to, so Monsanto’s seeds business would also deteriorate in addition to its glyphosate sales.
I also don’t think this is likely, especially in the face of how much we use glyphosate and how much we need GMO to feed the planet.
I’ll try to help provide some insights into the businesses and “what you need to believe” to invest in these companies. The bull case for Uber and Lyft is that “transportation-as-a-service” or “TaaS” is a new market. While Uber and Lyft are fiercely competitive today, and unprofitable, the market is really 2 players (in the US) and that should ease over time (“think of the great duopoly’s of Visa and Mastercard” the bulls will tell you).
So let’s rehash the investment case:
“TaaS” is a large market and growing
Upside possible from the “end” of car ownership (and entry of autonomous cars)
These are “platform businesses” that can leverage their user base to expand into adjacent markets (UberFreight, UberEats, third-party delivery, scooters, bikes etc.)
Only two players today. Now that they are public, competitive behavior should cool as the CEOs will be beholden to new investors
I struggle with the last point for several reasons. Uber and Lyft are not actually the only two players – taxi’s do still exist. While you may not take one every time to the airport, they wait for you when you arrive in a new city as the marginal provider of transportation. When the Uber wait is too long or there is surge pricing, yellow cab is still there… My point is that pricing for Uber and Lyft can only go so high. And who knows if the companies that have succeeded in China and elsewhere are waiting in the wings to enter the US market (and drive down prices).
If Uber and Lyft can’t raise the the price of your ride, maybe they take more of the driver’s fare. That’s possible, but they also have to incentize the drivers to drive and beat the hell out of their car. As I calculated in my post on what driver’s might make, it is a decent wage, but if you squeeze that too much, they just won’t drive anymore.
DoI think Uber is the Facebook of transportation? No. Facebook increased the return on investment for all advertisers and increased the total pie. Uber drove down the price of taxi medallions because it added significant supply to the market (everyone can now be a driver) and drove down prices.
The other bull case is that Uber or Lyft win the race to autonomy. The reason why this would be so important to the stocks is that autonomy is viewed as a winner-take-all business (think google maps – do you really need another provider?).
There again, I struggle. Calling the winner in autonomy is anyone’s guess. Why would I bet on Uber or Lyft winning vs. Google? I can’t, I can only speculate. And to speculate, I would have to bet that others are not pricing it into the stock. Google spends over $1bn on Waymo a year. I have no insight into this market
Next, to the notion of Uber reducing car ownership. There have been anecdotes of people forgoing car ownership, but that doesn’t seem to be impacting car purchases yet. Car sales, measured by units, are at all-time highs. It’s slowing, but its because we are selling nearly 17MM cars per year and have been for ~5 years.
Prices too have marched up since the Great Recession. In December 2018, the average price paid for a car was $37.5k, up from $30K in 2013. If Uber and Lyft are having an impact, it is hard to decipher this from the data.
Indeed, while Uber is growing bookings significantly and reported revenue, their growth rates have slowed dramatically. As shown below, Q1’19 adj. rideshare revenue growth is only +9%.
That is materially different than the +21% for the reported bookings. This is revenue that is adjusted to reflect driver earnings as well as incentive comp. An example is provided below:
As you can see, the driver pay and incentives matter materially here. “Excess” incentives are defined as “payments, including incentives but excluding Driver Referrals, to a Driver that exceed the cumulative revenue that we recognize from a Driver with no future guarantee of additional revenue.”
Is this number improving for the Company? Hmmm…
Granted, this does include incentives for UberEats and Rideshare incentives are expected to improve for Q1’18 compared Q1’19, but hard to see that the conditions overall are less competitive.
As an aside, I recently had an Uber driver tell me he was going to buy the Uber IPO (he admitted he didn’t study it much, just knew they were growing). That actually could be an interesting employment hedge… if the drivers are hurting, Uber may be doing well – and vice versa!
There are two players so we should compare what they look like. For starters, Uber is much bigger than Lyft and is global. How has that scale played out on the financials? Still a bit too early to see benefits. It’s clear you can see Uber expanding into other markets, while Lyft is focused on the core.
Clearly, they both burn cash. This actually surprised me a bit. Before the financials were released, I would have viewed the companies as platforms and apps, or asset-light businesses, whereas all the asset-heavy stuff is left to the drivers. Similar to AirBNB, where the homeowner faces the cost of serving the guest and the platform just takes a fee.
Clearly, that is not the case. They spend a lot on data centers and other infrastructure (more on cash flow at the bottom of this post)
We should compare and contrast the two players as well (feel free to add anything in the comments):
Pros of Uber:
– ride sharing is 5x the size of Lyft.
More diverse business with options – UberEats, UberFreight, autonomous… with the added
scale. You could argue Lyft is also entering these, but Uber appears to have
Valuation seems less demanding – basing that only on Lyft’s valuation and other
Cons of Uber:
Clearly losing share to Lyft
Operates in highly competitive markets – as if ride sharing wasn’t competitive enough, Uber
got into UberEats (a zero barrier to entry business, but I get why they did it),
and freight brokerage
Pros of Lyft:
– nothing other than “transportation-as-a-service”. There is some support of companies
that focus on one goal tend to execute on that rather than be stretched in all
Increasing Share – overthe past 2 years,
Lyft’s share has grown from 22% to 39%, taking advantage of Uber’s PR mishaps
while also being competitive
More Upside in Core Market – Similar to the bullet above, if Lyft continues to
take share, it seems clear that it will be at the expense of Uber. Given Lyft is
1/5 the size of Uber, there is plenty of share to give
Cons of Lyft:
Smaller company / less scale
No “other bets”
– Similar to google’s “other bets” segment, Uber benefits from its core
delivery business, cross-synergies with UberEats, and other bets. Lyft has autonomous capability, but its anyone’s
guess on who wins the war here.
Perhaps Uber should trade at a significant premium to Lyft due to scale, global presence, and “Amazon” view of transportation. Jeff Bezos wanted the everything store, Uber will be the transportation store. Conquer all, forget profits in the near term, it is all about the next 10+ years…
At $45/share, that means Uber is valued at $82.4BN while Lyft is valued at $15.7BN at $55/share. That places them both at exactly 7.3x 2018 sales…
I will be passing on both. I just don’t see this as a great market and I think it will be forever competitive. It seems like a race to the bottom for both attempts to gain and retain riders and drivers. Yet, there is nothing binding one to either. Therefore, I don’t see much pricing power here, as noted above.
Interesting Insurance Dynamic Not Discussed Often
One last thing — as I was building the cash flow statement for these companies, I noticed working capital changes were an inflow of cash, largely due to changes in an insurance reserve.
At first, it seems that Uber and Lyft are negative working capital businesses (i.e. the more sales grow, they actually get cash in the door like an insurance company that they can reinvest). That could possibly be a great thing. Lo and behold, I learned Lyft and Uber actually have self-insurance.
In other words, when a driver
accepts a rider on Lyft, up until the ride is finished, Lyft is responsible for
insuring the trip. This is a huge cost.
In fact, cost of revenue is
really made up of two main items: Insurance costs and payment processing
charges. Payment processing is the merchant fees that credit cards charge. Insurance
costs include estimated losses and allocated lost adjustment expense on claims
that occurred in the quarter. It also includes changes to the insurance
reserves. These latter two items make up the bulk of COGS.
Lyft says in its S-1 that, “By
leveraging our data and technology, we are seeking to reduce cycle times,
improve settlement results, provide a better user experience, drive down our
cost of claims and have fewer accidents by drivers on our platform.”
Clearly, this would be great. But insurance is also one of the items that can be gamed in the future. By reserving less, Lyft and Uber and report higher earnings. This often happens in good times for banks, where they reserve less for bad loans to boots EPS until a recession hits and they realize they didn’t reserve enough.
Analysts typically are wrong in their expectations, but this could be something where they are especially wrong. If analysts think they can leverage COGS more than reality, the forward estimates people are baking in could be too high.