I’m launching a new, recurring series called: Competitive Strategy – Spotlight on Decisions that Strengthened Companies, No Matter the Industry. Why am I doing this? Frankly, I am tired of hearing “this is a good business” or “this is a bad business” with some blanket statements behind why. How many times have you heard why a certain company is a “good business”?
Leading national market share
Of course, saying a business has a “moat” doesn’t hurt
A company that has some of these features isn’t necessarily great. If you want to learn why (or disagree and would like to hear differing thoughts) stay tuned. I am actually launching the first in the series today – and what better way than to start with a company like Amazon.
A company’s competitive strategy outlines what decisions it will follow every day.
Where it will compete, what segments of the market it will target, where it will choose to scale, how it will use its balance sheet, and what will customers value?
These decisions can result the metrics I mentioned above, but the metrics themselves do not make the business good, or differentiated.
I will go through the competitive strategy of a wide array of companies. Decisions companies have made / are making to show how those decisions upgraded them from good to great.
I hope to surprise some folks by discussing names that are in “bad” or cyclical industries. Sometimes you can have a bad industry, but a great company within that industry – and sometimes the stars align for a great investment opportunity.
After writing a few of these, knowledge will build and I probably will refer back to previous posts for examples on different company tactics (e.g. hard to not say Amazon Prime is similar to the Costco Membership strategy)
Here is a preliminary timeline of companies and industries I will examine (subject to change). If there are any companies you’d like for me to add, reach out to me in the comments or on twitter and I’ll add it to the queue. Some names may jump to the top if there is enough demand.
As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2“, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures. I came to the conclusion that Amazon was preparing for a split up of the company and I would need to think of AWS valuation.
The split would be simple: take the traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.
For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources.
AWS allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.
This led me to ask myself:
What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
Is AWS actually a good business?
Would splitting the company make sense?
Is the AWS valuation not factored in to the stock price today?
I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:
Allow focus in areas of strength.
Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
Optimize capital allocation
AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
Better align incentives
Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
Wouldn’t it be better if your performance and the company’s performance were linked?
Note, AWS valuation being underappreciated is not really a core tenant here.
Is AWS a good business?
“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”
-Jeff Bezos, 2014 Letter to Shareholders
Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.
The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models. As an aside, what a beautiful competitive decision that was.
As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.
AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.
Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.
The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.
However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.
How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Jeff Bezos, 2016 Letter to Shareholders
In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.
But Microsoft ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns.
In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…
Lastly, its no secret that building data centers to support growth is capital intensive, and that will impact the AWS valuation (see financial table above).
They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.
Unfortunately, I DO think returns are going to come down materially over time. And that will hurt the AWS valuation.
The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.
Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage.
Think about commodity businesses that reports utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.
As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.
Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.
I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?
How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.
So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.
AWS Valution: Final Thoughts
Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases.
I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.
For the reasons stated above, I think this results in returns coming down over time. I still model goodreturns to be clear, but that the return on assets comes down meaningfully.
This may be hard to read, but I end up with an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.
However, AWS would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.
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.
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
I think Yum! China meets a lot of the criteria of a stock that will compound earnings for the next decade. I like it for 3 main reasons:
Long growth runway (China Tailwinds + Market is Not That Saturated + Upside from New Concepts)
Targeting 20,000 stores for core brands which is 2x the level today
High return on capital business, despite being mostly owned branches as opposed to franchise business model
Leader in Technology (core tenant as I think ROIC can go higher)
I know YUMC well from travelling to China. I actually did a college paper on my experience with different fast food brands in Asia; essentially which companies were succeeding with the new Chinese growth story and which weren’t.
YUMC was a leader at the time. Why? Because YUMC has been operating in Asia well ahead of its competitors (KFC first entered China in 1987, Pizza Hut in 1990) and frankly, they got it.
They got that you can’t take a US concept, plant it in China, and expect success. They got that the Chinese may have some similar tastes, but they didn’t grow up eating the same things as Americans. They also didn’t grow up, like I did, with a “Colonel” in a suit in charge of fried chicken chain and ask zero questions about that relationship.
So YUMC changed the items they serve for the local market. They did this well ahead of competitors. It’s been about 7 years since I’ve been to Asia, but I would say the other large chains were still trying to catch up to YUMC. That’s a general theme for this post and what we’ll get to later – innovation.
Invert the issue, too. Do you see many successful Chinese restaurant chains in the US? Not really. The ones you do see are highly Americanized / not Chinese food.
Here’s a snippet from their latest call. Do you think the menus are very similar to US? This is at a Pizza Hut for crying out loud.
For background, YUMC and YUM used to be combined, but YUMC was spun out in 2017. The rationale was that YUMC was more heavily owned restaurants, whereas YUM was mostly franchised. So YUM would become more asset light. At the same time, YUMC could dedicate more resources for growth. At the time of the spin, YUMC had 7,300 restaurants but it now has nearly 10,000. Mgmt says they feel 20,000 is a reasonable long-term target. (I also would mention the spin came around 3-4 years after the bird flu scare in Asia and perhaps YUM wanted to close that chapter / unknown future liability if supply chains get disrupted again).
Long-Runway for Growth
What is also interesting is that at Dec 2016, YUMC had ~7,300 KFC and Pizza Huts. Now, they have 9,000 and the balance (roughly 1,000 stores) are other concepts. These other concepts include Little Sheep (hot pot), COFFii & JOY (a coffee shop), East Dawning (Chinese food) and Taco Bell (theres only 7 Taco Bells in China – they need to ramp that up!).
They also just acquired Huang Ji Huang (a casual dining franchise in simmer pot) and partnered with Lavazza group in coffee (coffee is clearly growing in China – “In 2019, we sold 137 million cups of coffee at KFC, representing a 48% increase from 2018”).
So you’re not only buying a strong brand name of US companies operating in China, you have upside from new concepts. Each of these could probably support 500-1,000+ stores across China.
To put the store count of KFC and Pizza Hut into context, Starbucks has 4,100 stores in China at the end of FY2019. McDonald’s has 2,900 as of June 2020. YUMC is clearly dominant in China. That frankly means they have less of a runway in China with KFC and Pizza Hut, but I’m still optimistic on their other concepts, mentioned previously.
Restaurant chains have a low penetration rate in China, especially in lower-tier cities, with only approximately 332 chain restaurants per million people in 2019 compared to approximately 891 in the United States. While YUMC is “dominant” this indicates a substantial growth opportunity for restaurant chains in China.
Despite the pandemic, YUMC plans to continue ramping store count with a 800-850 target this year. They’ve averaged 2 days a day over the last few years. I’m not saying that will keep the same pace, but I am saying it doesn’t need to for an investor to benefit.
High ROIC Business
I’m very focused on unit economics for any business I study. The gold standard in this for me is Dollar Tree, which in their IPO docs in the 90s stated it cost them about $162k to set up a store and in year one they earned $162k in operating profit. So a 1 year payback period. For investors, understanding that they were earning such high returns + had a long growth runway in stores meant that signing up for the ride was a no brainer (in hindsight).
Now, I wasn’t around to catch Dollar Tree and it seems saturated today. But there are still opportunities. YUMC is targeting 20,000 stores for its core brands, which is double the current amount. Plus, they have a very good payback period.
This all jives with my estimates for returns on invested capital, as shown below (note 2020 is a bit weaker given COVID). As a shareholder, I’d prefer them plow that money back into the business if they can really earn these returns rather than give any back to me. I can’t earn 30-40% returns on my capital, but if you can, please take my money.
I also think YUMC can beat its historical returns for a few reasons (I think upwards of 50%).
The company is opening smaller concepts in tier 3-4 sized cities in China. In fact, 61% of KFC restaurants and 53% of PH restaurants opened in 1H20 were located in tier-3 & below cities as the cash payback levels are much faster.
Next is that the digital investments it has made will likely lead to higher turns. The restaurant business is all about maximizing turnover. A fine dining restaurant probably can only seat 2-3 sets of customers in any given night, which is why it needs to maximize $/table. Fast food reinvented that with the drive through. The next step is delivery which will further enhance the market YUMC can at any one point and further increase sales per store.
Quick aside here: Honestly, I think brands like YUMC should look at the Uber founder is up to because I think it could accelerate this journey. His idea is that take-out and delivery restaurants probably have too much square footage today (think about the local Chinese joint. People rarely sit inside, instead getting delivery or pickup). What if restaurants shared energy costs and a building and then delivery people went to one central location before they dispatched out to make deliveries. I think it makes a lot of sense, especially for a company like YUMC where a KFC, Pizza Hut, Taco Bell and all their other brands could sit under one roof and cross sell.
Investments in Technology
Now to the meat of the thesis. I’m not sure many other restaurant companies are so point blank about technology and innovation being the forefront of their mission statement. I think Domino’s is the main one that comes to mind, but here is YUMC’s:
Take a look at the slides below. These were items shared by YUMC in March 2019. Talk about being prepared for COVID. When thinking about brands that will come out even stronger from this pandemic, I think YUMC went in with a clear strategy and should come out the other side even better.
Personally, I think you want to invest in companies that come out of a crisis with more market share. What is really interesting is that YUMC’s app now has 268 million members and I thought this quote (and some of the following slides) was really interesting: “Member sales accounted for over 60% in the second quarter. While overall sales declined during the outbreak, our year-on-year member sales grew by double digits.”
Below are some quotes from the earnings calls. I’m not going to provide too much commentary because I think management explains it well (instead I’ll add emphasis).
The thing I would say is that they seem to be well ahead of US counterparts. I think Starbucks in the US gets a lot of credit for their app, but YUMC is clearly using the technology to offer targeted promotions to its members. It also has 10,000 corporate members, so again maximizing turnover, it can target lunches at offices for bulk discounts. Again, part of my thesis is improving economics at each store as well as a long re-investment runway.
“And guess what, we get our mobile ordering before Chinese New Year. We did not know the COVID-19 was coming. And then COVID-19 came, it became a very good platform for takeaway and mobile order. So our mobile order or digital order just increased significantly. And Pizza Hut alone, the digital order for Q2 is 61%. And that, compared to last year’s 29%, it almost doubled. So again, the business model transformed. And for Pizza Hut, when we add the takeaway business, which is very value driven, it’s very much incremental because it’s for 1 person, together with delivery, the non-dining business become more than 40% of our business. So we become less reliant on dine-in business. So that is an example of both short-term and long-term transformations.“
“And then I would like to mention the members. We have reached 268 million members. And the members are our digital assets to allow us cross-sell between the brands and between the business within the brands to increase frequency and cross-sell. As I mentioned in my presentation earlier, we saw the doubling of average revenue per active user, and that’s very exciting in the past years and for the coming few years.”
The interesting thing to me as well, to show how far ahead their thinking was, was they acquired a delivery platform called Daojia in early 2017. Now, the market moved to third-party aggregators, so that investment unfortunately didn’t pan out, but they now partner with the other aggregators. They actually acquired a small piece of Metuan which has been a good investment, but the point is clearly the business is being set up to win in the new environment.
“As early as 2010, we identified delivery as a significant growth driver and began to offer delivery services, first through our own delivery platform, and later, in 2015, also through partnering with third-party delivery aggregators to generate traffic. In 2019, we enjoyed one of the highest delivery sales contributions among restaurant chains in China, according to the F&S Report, with such sales accounting for 21% of total Company sales for the same year”
This wouldn’t be an interesting investment without some key concerns:
Pizza Hut in the US is suffering. What’s stopping that from happening in China?
Pizza Hut in the US is suffering from lack of investment and being set up as dine-in stores, whereas “DelCos” are now winning (delivery companies such as Dominos). This, coupled with a menu and offering that needs to be refreshed, is a concern for current operators in the US. The other main concern for Pizza Hut in the US is technology (seriously, the app is horrendous. It’s like a college intern built it).
It’s a different story in China. It seems to me that YUMC is learning from mistakes at YUM. I guess that’s the benefit of owning a large chunk of stores – you quickly can see an issue. If you don’t invest in the brand and turn things around, you’ll suffer much faster than a pure franchisor model.
Any concerns on backlash on the West now that the US and China seem to be in a new Cold War?
This is a hard risk to box. On one hand, I am concerned and think there could be some serious market volatility and even multi-year periods of where Chinese consumers may boycott western brands. A couple positives are that YUMC is basically a Chinese brand at this point (yes, they are American names, but it’s a Chinese company with a Chinese menu essentially…).
As someone reviewing the company, that was a bit frustrating to me as it is dilutive, but at the same time, its more capital to plow into the business. Perhaps they will even use it to slowly acquire US shares – I have no clue. The point is YUMC also has no debt at the moment, so likely could survive a drawdown period.
In the long run, if the tensions subside I think there is upside from optimizing YUMC’s capital structure.
If this is a serious threat to you, then I’d also say watch out owning SBUX and MCD as well as any other global brand.
I normally don’t build models that far out because its anyone’s guess as to what happens even in the next year. I did so for YUMC basically to sensitize different inputs. My main case assumes Pizza Huts aren’t a driver of any growth and instead growth comes from KFC and new franchise concepts. KFC improving profitability over time which is the main driver of results.
The reason why I really like the story is because there’s upside from factors outside of my model. Clearly, the company has expanded outside of US concepts. This could continue with more M&A or organic initiatives (think McDonald’s when they owned Chipotle, Panera, and oh yeah – they owned Redbox…).
At the same time, the financials may improve more than I expect for a host of reasons: Pizza Hut improving more than I expect, more franchise concepts vs. owned means lower asset intensity and higher FCF conversion, and better cost leverage from expanding to a company with 20,000 locations (I only model getting to 15,000).
I have the opportunity to again share the work from a friend & prior guest poster – the same author who imparted his views on cruise stocks in a prior post. This time, he’s back with some thought-provoking views on the hotel industry and the hotel stocks. Enjoy.
In #Is It time to Buy Cruise Stocks? Pt 2, we went into the heart of the Covid storm, and found that there may be solid upside if the risk sits well with you. For this article we’ll move to some of the “lighter” outer bands, as at least some portion of revenue stream continues for hotels, whereas cruise departures have been completely halted. Let’s start with some high-level thoughts on the industry, and then dig into some of the players.
If we break down hotel stays between business and pleasure, it seems reasonable to say that ~40% of booked hotel stays are business related. For the time being that implies a complete halt on 40% of hotels’ revenue. Assuming the other 60% of revenue is vacation related, it may be reasonable to assume ~50% of the vacation bucket is attributable to Loyalty Program members (see snipit from 2019 10-K below).
Digesting the above, it seems like (i) 40% of hotel revenues are completely compromised, and (ii) possibly another 30% is disrupted, as Loyalty Program members develop a lot of their status from business travel.
Enter Airbnb. Its presence represents an approximately decade long build of disruption to the hotel industry. In terms of annual revenue, it looks like Airbnb falls somewhere above HLT but less than MAR – it had approx. $1bn of revenue in Q4 19 (assume $4bn annually at this rate) – we can potentially get more details this year if they move ahead with IPO. Note that when considering HLT and MAR revenue, I’m excluding “Cost reimbursement revenue”, as there’s corresponding expense with this item (e.g. franchisor pays some expenses, and franchisee reimburses). Airbnb is a sizable force in the markets, but I’d also assume it does not have and cannot really get a share of business travel yet (easier from liability perspective to encourage employees to stay at big name hotels, rather than with miscellaneous landlords). What does this mean in Covid?
I’d guess Airbnb is benefiting from the suffering of hotels. Would you rather stay in an isolated mountain/lake house, or in a hotel resort teeming with tourists? Assuming you’re not a Covid denier, then probably the former.
While business travel should in theory return to the big-name hotels, this may not come for a longer time – why would a business risk Covid outbreaks for the sake of business travel? Seems unlikely unless business travel is essential to the functionality of the business. Further, a blow to business travel inevitably means some level of reduction to vacation stay for hotels.
Similar to analysis in Covid so far, showing e-commerce adoption has accelerated, it could be the same that Airbnb share has also accelerated (hence why they may be pushing for an IPO despite a terrible operating year…)
While hospitality may not be an awesome industry to be in at the moment, can we still find businesses that will persevere, and potentially emerge well once the dust settles? In exploring MAR and HLT below, we’ll discover that a sizable portion of their businesses come from franchisor/franchisee relationships. This leads to another question – is it better to be the franchisor or the franchisee? We can explore Park Hotels and Resorts Inc (PK) to get a flavor for the differences. Unlike the Cruise Pt 2 analysis, less of the below focuses on whether these companies have the liquidity to survive Covid – cash is still coming in the door, even if the demand recovery may not be as a resilient. It instead explores more of the pre-Covid operations for MAR and HLT, and thoughts on what that means going forward.
MAR and HLT
Historical revenue demonstrates a push to franchisor/manager business, rather than own and operate. Note that HLT spun off PK and Hilton Grand Vacations Inc (HGV) (owned hotel and timeshare businesses) at the very beginning of 2017, hence why you’ll see the change in revenue presentation and overall split.
My quick takeaways are:
Revenue per Available Room (“RevPar”), hotel room revenue divided by room nights available over the applicable period, has had immaterial changes for each company over the last six years, but MAR converts more $ per room then HLT.
MAR derives larger portions of its revenue from franchise/management fees than HLT. Given HLT’s spin offs of PK and HGV, it is clear the biggest players see more value in reducing the tangible assets on their books.
I’m not seeing crazy differences in the debt profile of the two. But compared to cruise lines, MAR and HLT are noticeably better capitalized and have generated sizable free cash flows compared to the debt on their books (15-20% each year). But MAR and HLT are noticeably more expensive – EV/EBITDA at 20x+, while cruises were closer to half that.
How well do MAR and HLT translate revenue into cash? #What Drives Stock Returns Over the Long Term? pointed out that growth in free cash flow per share often drives long term value. In looking over a 6 year horizon, the below free cash flow illustrations seem to speak to this point, with better overall performance from MAR.
In the above, I removed timing differences between reimbursement revenue and expenses; these items are supposed to offset one another over time, so it seems more appropriate to exclude noise from these pieces.
So, what does this mean going forward? MAR and HLT’s stock prices are down ~32% and ~18% since beginning of 2020. As you’d expect these entities faced losses, largely driven in Q2. However, there are still positive free cash flows, expectedly coming from changes in working capital accounts.
Looking at 2019 10-ks, debt maturities don’t become significant for HLT until 2024 (i.e. less than 40m), while MAR’s are more significant at ~1bn+ each year 2020-2022 (bigger red flag). The cash situation for these two feels better than what we saw in cruise stocks, but I think a significant con is that business travel may not come back for some time (i.e. until a vaccine is found)- I’d be more inclined to bet on cruise demand coming back faster than business need for travel lodging.
The Q2 MAR earnings call transcript may be worth a read. In that, they discuss cash burn with in a scenario where demand doesn’t pick up meaningfully from here. Running a quick liquidity analysis on MAR below, survival horizon for MAR seems around 3+ years.
If you’re quietly optimistic that Covid will be meaningfully resolved next year, then there may be potential upside in these stocks, but if you consider FCF yield then you’re probably disappointed at current stock prices. The 2019 FCF per share were $5.57 and $4.76 for MAR and HLT; if we want a 10% FCF yield that implies stock prices slightly above and below $50, but meanwhile the stock prices are around $100 and $90. Additionally, it’s probably going to take some time for FCF per share to come close to the 2019 levels. Not attractive points from a cashflow perspective.
Let’s explore a player on the ownership side of the house to see if that noticeably changes what we’re seeing.
As noted above, PK was spun off of HLT back at very beginning of 2017. As expected in looking at end of 2019 vs Q2 2020, there’s more debt on books to generate cash on hand, and unlike the above franchisors, the costs associated with maintenance and operations of the hotel real estate is entirely reflected on PK’s income statement. The stock price has declined ~62% since beginning of year (significantly more than MAR and HLT), with its discontinuation of dividend payments back in May further crushing investor sentiment. See below for some quick snipits comparing PK’s 2020 financials to 2019.
Reductions in PP&E, wipe out of goodwill, increase in cash with corresponding increase in debt – all things I’d expect to see in this Covid environment.
The income statement data isn’t any better.
Free cash flows are also already negative – noticeably worse cash situation than MAR and HLT, as those companies have still been able to stay free cash flow positive in 2020 thus far.
PK is a Real Estate Investment Trust (“REIT”) for US tax purposes, meaning there are requirements from the IRS that need to be met for the entity to preserve flow through status (i.e. no entity level income tax for federal tax purposes). These requirements include and are not limited to distributing the majority of taxable income to shareholders (REITs often distribute all of taxable income anyway), holding a certain % of assets in real estate, and ensuring the majority of income is derived from passive real estate sources (see Section 856 of the US tax code for additional details). Hotel REITs include additional complexity, as most hotel REIT structures involve (1) creation of a Taxable REIT Subsidiary (“TRS”) where hotel operations occur, and (2) a lease agreement between TRS and REIT whereby REIT owns the assets and TRS makes payments to REIT for use. The nature of this arrangement is intended to mirror a typical real estate arrangement. Hotel REIT players try to maximize REIT income by ensuring the lease agreement strips most of the kosher earnings out of TRS.
My concern here is more a generally pessimistic view of the recoverability of REITs post recession. Distribution requirements make it hard for a REIT to hold on to cash; there is a concept known as “consent dividends”, whereby REIT shareholders may agree to recognize a deemed dividend in their income without cash actually moving outside the REIT, with this fulfilling the REIT’s distribution requirement. But this obviously does not apply in a public REIT context.
Furthermore, REIT investors are mostly concerned with annual yields generated by investment, making cash collection more impractical. While REITs are able to generate net operating losses (“NOLs”) to the extent that they have taxable losses, NOL usage is done on a “post-dividend basis”, making it tough to monetize them since REITs typically distribute out most of their taxable income.
While I think the above points make it hard for REITs to come back after a downturn, I can see a potential opportunity for prospective Buyers (e.g. Blackstone, Brookfield, etc) with cash on hand to buy real estate at a heavy discount (see WSJ article Public Real-Estate Companies Are the New Way to Buy Distress for example). In looking at PK, I tried to compare the net asset value to market capitalization to assess how discounted PK is currently trading. Below I’m assuming that the FMV of land and buildings/improvements is equal to original cost (likely conservative since most of the real estate was acquired back in late 2007).
I’m estimating market cap at ~2bn and net asset value at ~4.7bn; these quick estimates at least directionally tell me that prospective buyers could likely get a pretty sweet discount if they tried to buy the assets.
That said, I think that you can probably find this trend and opportunity across non-hotel REITs as well, and therefore would be more inclined to pass on buying PK.
Thank you again for this great guest post. My main takeaways from this are:
Cruise lines over hotel operators might be better risk/reward, as at least with cruise lines there are signs that demand is still strong once ships can take-off (so becomes just a liquidity consideration in the near term, which you can bracket)
Not getting paid much for the franchisors. The franchisors, MAR and HLT, are historically good businesses. Asset light and generating strong FCF, but at the end of the day, revenues / performance are going to be tied to how the hotels are doing. Its going to be hard for them to just sit and generate FCF when their franchisee base is struggling. With the stocks currently trading at ~20x peak FCF (2019 levels), it doesn’t feel like you are getting paid for any downside risk (e.g. do the franchisees want forgivable loans or some re-cut of the franchisee agreements to survive)
Airbnb wildcard. Airbnb has been a concern to the industry for years, but frankly the impact hasn’t been too noticeable yet (e.g. hotel revenues continued to march up despite Airbnb’s new presence). However, that may change in the future….
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:
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.
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.
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.