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.
SAAS stocks are all the rage. While the S&P500 is up ~12.5% at the time of writing, the Tech-Software ETF is up 41%. Over the past 4 years, the gap is +215% for Software and +88% for the S&P.
It makes some sense. These are companies that have long runways of growth, are FCF generative (if you count stock-based comp as an addback, but point is they tend to be people-heavy, but asset lite), and a good portion of them are really sticky businesses through the subscription model.
A sticky business is important. Imagine you’re a business owner trying to prepare shifts for your employees. You don’t know if a customer will come into your store or if you’ll be bombarded that day. If you are bombarded, you might lose sales because you don’t have enough staff. Recurring revenue companies can plan much more effectively and align costs with revenues appropriately.
I’ve outlined this before, but the subscription models also tend to spend a lot of money on just acquiring the customer. So the first year, the business isn’t that profitable, but on renewal it is highly profitable.
Also think about this dynamic in COVID-19 impacted world. Economies were literally locking down. I was running scenarios on companies that I’ve never had to do before – “how would these businesses look with ZERO revenue for the next 3 months.” If you’re in a business where you are mission critical to the customer and get paid a small monthly fee for that service, then you weren’t sweating it as much.
Therefore, I think there was a changing of the guard this year. Well, maybe it actually happened in the 2015/2016 recession scare. (The latter would make more sense because that’s when we saw the atmospheric launch of FANG and SAAS.)
Investors had long been valuing recession proof businesses at much higher multiples than more cyclical peers. Think Utilities, Consumer Staples, large Healthcare companies. I think following the great financial crisis (the GFC), it had a big psychological impact on investors – “try not to own things that can get crushed like that again.” And therefore, the discount rate on these cash flows went lower (due to perceived lower risk).
SAAS combines those attractive characteristics with ultra growth. But the subscription really made it easy to count on what was going to be in the bank account. So low discount rate + hypergrowth = highly valued.
Secret Subscription Models
Something I’ve been thinking about the past few years is “secret SAAS” or really, “secret subscription” businesses. These have very similar characteristics to SAAS, but aren’t in software.
Some of these companies have highly recurring revenue, but may not have a monthly subscription. Some of these names are also dominant and will own their category, but it might be niche and many people just don’t know about them.
The only thing missing from my list is the hypergrowth. But you also aren’t paying 10-100x sales for any of them…
Perhaps I’ll do a post on each of these, but please feel free to reach out, comment below and comment on Twitter (@DollarDiligent) names you think should be added to the list.
Secret Subscription Business Models (no particular order):
Flavor and Fragrance Names such as Sensient Technologies and International Flavor & Fragrances
I really like names that are critical to an end product’s use, but are a very low cost input. This typically translates into limited switching and little pushback from some price increases
Flavors & Fragrance names provide the products that impart taste, texture, or smell to consumer end products.
These are mission critical. They also are sold into pretty recurring end market – food and fragrance.
WR GraceAre you a refiner that wants to upgrade that barrel of oil into higher value products like gasoline or jet fuel? Well – you need a catalyst. The catalyst creates a chemical reaction to start the process. This is also true in creating plastics.
Unfortunately for you, refiner, you can only get this catalyst from 3-4 companies. But they are very high touch, high R&D businesses and the cost of the catalyst is very little compared to the cost of a refinery.
Beacon Roofing and Carlisle Roofing segmentThere is a large installed base of roofs. And many were put in place 15+ years ago. As they age, the roof needs to be replaced.
No matter what the economy looks like, if the roof is leaking, it needs to be replaced ASAP.
This leads to very high recurring revenue (albeit storms can make some years lumpy)
Moody’s / S&P Global / MSCINeed to refi your bond? S&P and Moody’s are the gatekeepers. Need to access the ratings? If you want to access detailed reports, investors need to pay a fee. In a large market, this adds up to highly recurring revenue (in addition to other platform services the companies offer, such as Platts and Cap IQ)
For MSCI and S&P – Having managers benchmark to your indices provides a highly recurring fee each year. Changing your benchmark tends to be a “no no” and the more recognized the benchmark company, the more circuitous it is
Apollo and Blackstone and other asset managers.
Earn management fees on a large, mostly locked up capital. Sure, there are incentive fees that may not be highly recurring, but the bulk is actually just management fees
Franchisors – many come to mind like Domino’s, Planet Fitness, McDonald’s etc. These names take little capital to run themselves and earn recurring royalty fees from the franchisees
Google is shifting its Photos storage business to a paid model. Clearly, Google is trying to capture more of that sweet, sweet cloud storage money. And kudos to them for playing the long game. I know I have a lot of photos stored with them plus about a million unread emails…
Now that they have a bunch of users hooked on keeping photos they’ll never print out, they know they can charge a token amount and not have much churn.
But this tweet really caught my eye….
Google earned $11.2 billion in profits last quarter and uses all your uploaded photos to train its ML algorithms, which offers it other enormous competitive benefits https://t.co/LsCrZ1gT92
Essentially, Google Photos will scan pictures and identify objects. Apple Photos does this as well on the paid model. For example, I recently needed my license plate number on my car, but didn’t want to go outside and look at it. So I went on my phone searched “White SUV” in my Apple Photos and it popped up. Bam – I got my license plate number without leaving the house.
While that was nice, this feature is much more valuable to Google which makes most of its money from business advertisements.
Let me paint a picture: If Google’s algorithm gets really good at identifying objects in pictures, it could add new “billboards” onto our photos. Let’s say you’re walking by a piece of furniture you like, snag a picture as a reminder for later because it would look great in your living room. Now, an icon pops up of where you could buy something similar from Google Shopping.
That’s clearly Pinterest’s bread and butter and I think what Pinterest investors are banking on. My wife recently was looking for wallpaper and was frustrated that Pinterest couldn’t just link her directly to something very similar to what she was looking at for sale. So it appears to me Google is slowly but surely moving that direction. And Google is a pretty strong competitor, especially in search algorithms…
News of a Pfizer vaccine has sent COVID-impacted names soaring. However, some areas still look very cheap, particularly in the movie theater space. National Cinemedia is a decent bet and could possibly be a multi-bagger. There’s obviously a ton of risk – this is almost a microcap stock right now – so do your own homework please!
Let’s start with what I am not doing: I’m not looking at stock charts and saying, “well in January, it was $x and now its at $y, so it has a lot of upside if it just goes back to $x”.
The problem with that is that a lot of names have issued a lot of debt and or equity. For example, American Airlines just announced it was going to issue $500MM of stock. They’ve also issued a ton of debt to pad liquidity. Based on Bloomberg, the current EV is around $39.5BN compared to $41.9BN at the end of 2019… yet the stock has been cut in half. The value is being transferred to debt holders.
In fact, following yesterday’s move, a lot of center-of-the-storm names don’t have nearly the upside I would want for the uncertainty. And this includes some movie theater chains that were too levered and entered this crisis in too fragile of a position (looking at you AMC… AMC’s 1L term loans and bonds are well below par, implying that the company will still need to restructure).
But National Cinemedia does have the upside. And I don’t think they’ll need to restructure at all.
Why National Cinemedia? Several Reasons:
Solid balance sheet means it can wait this pandemic out
“Asset Lite” business limits cash burn now, also means cash turns back on quickly as movies come back
Confident that movie theaters aren’t dead and that the notion that “PVOD” or prime video on demand taking share of traditional theaters is overblown
Movie slate was deferred in 2020, but makes 2021-2022 likely a blockbuster year
Solid Balance Sheet & Asset Lite: National Cinemedia is an advertising business. They typically run the ads that you see 30 minutes before a movie run by national accounts. They don’t actually own any theaters, so the business model is very asset lite. The downside is that if the theaters aren’t open, there aren’t going to be people paying for ads!
The other issue right now is that we are in a limbo with new movies. The studios have a huge production slate they want to release (see more later below), but they want there to be fans in the stands, if you will. In sum, the theaters can be open, but if there are no films, the theaters might as well be shut to National Cinemedia.
However, National Cinemedia has $217MM of cash on the balance sheet. At its current monthly cash burn rate of $11MM in October 2020, it can last ~1.5 more years in essentially hibernation mode. Management seems confident enough that they continue to pay a dividend of $0.28/share, or ~8.5% yield based on today’s price.
Confident in Theaters Coming Back: There seems to be this feeling that Netflix killed the theater. Wrong.
Look at box office sales over time:
You need to remember that because you may not go to the theaters, doesn’t mean others don’t. And the core group of movie theater attenders area die hard group. I hate to bring it up, but people still went back to the movies following the Aurora, Colorado movie theater mass shooting. If they still go back after that, I am confident they will go back now. There have been no COVID-19 outbreaks linked to movie theaters yet.
APAC is the leading indicator – already snapped back:
PVOD (Premium Video on Demand) is not a solution right now:
Here’s Disney on the matter:
“So we’ve got a pretty robust slate. And once again, we hope that the theaters are open. A lot of our films are films that the people who choose to go to movie theaters, the experience is very different than what they would have at home.So when you look at our box-office numbers over the last couple of years, we have — we drive a lot of people into theaters to see the Disney films. These tent-pole films become kind of part of zeitgeist of culture, whether it’s Marvel, whether it’s Black Panther that was a couple of years ago, but these are movies that people like to see in theaters and talk to their friends about. So once again, we hope the theaters stay healthy and can rebound from this COVID world we’re living in now.”
What about Mulan? That was released on PVOD? Well, it wasn’t Disney’s first choice and it largely was not a success. Disney had said in the past as well that it would not have been released this way if it weren’t for Theaters being closed:
“Well that — it has had some, but that was not the primary reason that we chose to release it this way. We chose to release it this way because the release date — as some people who were following just what was going on with theaters not opening and just shift, shift, shift, we had moved the release date several times. And we believe that, that movie — given that there’s so little new content out, that the movie was done and we wanted to get it out in the public domain. And so we chose to do it this way because we believed that it was the best way to get to the most people for them to enjoy it.”
Here is Bob Iger on whether Disney+ will be the new way to release movies. He says this because he knows that Movie Theaters still generate the bulk of a film’s profits:
“The theatrical window is working for this company. And we have no plans to adjust it for our business. Your comment about how those companies are faring on the market, I think, maybe is a reflection of how the other movie companies are positioning their films and their business. We’re not the only movie company. We had the biggest box office, but we’re not the only movie company. And I suspect that it’s not due to us or either a lack of conviction on our part or any suspicion that we might be — that we might not beat on the truth. But we’re not — it’s working for us. And we have no plans in the foreseeable future to change it and that”
Now there is news that MGM wants to sell its latest James Bond movie. Apple and Netflix reportedly offered a couple hundred million dollars and MGM wanted $600MM. The PVOD offer likely would’ve led to a big loss. It had a $300MM budget plus they had already spent tens of millions on marketing. And another problem – Daniel Craig and others own backend rights to the film based on how it does. This would’ve added to the cost of the film before MGM made any money.
I am not concerned about theaters living or dying. I think they will be around for many, many years to come.
My base case for NCMI is to generate ~$109MM of FCF before working capital changes, but if I am wrong, I still think there is a ton of upside on the stock. As shown below, my discounted EBITDA shows ~18-19% FCF yield plus they will have roughly half their market cap in cash by the time they reach these numbers (currently have about 85% of market cap in cash).
In short, I think NCMI can double from here, maybe more. There is a huge film slate just waiting to come out, so I think the vaccine news is actually game changing:
Obviously there are some risks. This company is tiny and while it may not have significant maturities until June 2023, its customers do. This can be complicated. You see, NCMI was founded as a JV between AMC, Regal, and Cinemark. They are the company’s largest customers, but also because it is a JV, they also own ~60% of the company.
AMC is the theater chain I am most concerned about filing for bankruptcy. AMC could reject its contract with NCMI in bankruptcy. However, this would be messy as it would create a giant unsecured claim and NCMI might end up with a huge chunk of AMC equity. I think AMC would avoid this situation and likely just re-instate the contract, but it is something I am monitoring. AMC doing an out of court restructuring would be the best outcome here.
A lot of people know Visa and Mastercard, but they don’t know how the business actually works. Simply put: card networks act as the toll booth connecting the “issuing bank” with the “acquiring bank” and they take a fee as the transaction goes across. The “issuing bank” is the bank that issued the credit card. The acquiring bank is the bank of the merchant. Ryan Reeves has great commentary on this network, which I found in a tweet of his. He also has a blog post on it where he explains it well:
The company where you put your money, called a bank, gives you a piece of plastic, called a credit card, that signals you will pay for something later. When you buy coffee from Starbucks using your piece of plastic, your bank sends the $4 to Starbucks, instead of you paying. But before Starbucks gets the money, two things need to happen.
Your bank has already made a promise with another company called a card network whose job it is to act like a toll booth between two banks. The most popular card networks are Visa and Mastercard. These card networks make promises with other banks called merchant banks, who hold money for the stores where we buy stuff. So the money from your bank first goes to through the card network and then to the merchant bank and finally to Starbucks, each company taking a little bit of money along the way for their services. And then the final piece, at the end of every month, you pay back your bank for the money they sent to Starbucks. And that’s how credit works!
Here’s a diagram from Plaid as well as their explanation:
Card networks—for simplicity in this explanation, let’s say Visa—receive fees from the issuing and acquiring financial institutions. Visa makes money by collecting a small percentage (0.13 percent as of early 2015) of total transaction volume, rather than by charging a fee on each transaction. But it also sets and doles out the rest of the fee paid by the merchant to the other players. While this percentage may seem nominal, billions of transactions processed each year (with minimal overhead) add up to a very profitable industry.
What’s more, a network like Visa’s entrenched partnerships and critical technologies create high barriers to entry for new players. Established card networks also have low marginal costs to continue operating, making them attractive business models.
So Plaid touches on a few things here: High barriers to entry, toll booth business, low marginal costs. This translates to really high margins and super high FCF. And since payment transactions are growing quickly (ex-COVID), the company is able to leverage those costs and expand margins. For example, look at both revenue growth and margin expansion. Most companies I follow don’t even have 50% gross margins…
People often look at the current market structure and think, “This will clearly be disrupted. It is too complicated.” Card networks work because they have high degrees of trust and a large network, which makes their usage more attractive. Take American Express on the other hand which actually has a different model. Have you seen many merchants say they don’t accept American Express? Amex “consolidate functions of the merchant bank, card issuer, and card network by personally extending credit and cards, and minimizing parties involved.” However, their fees are too high for the merchant and AmEx gives a lot back to the consumer.
Square also differs somewhat, too. Instead, they aggregate the merchant transactions and pass of the processing to Chase. You will always hear about one of these names (Square, Stripe, Apple Pay, etc) are “disrupting payments.” In reality, they are all still passing through the card network monopoly.
So why is there an opportunity now? Well, COVID-19 has caused investors to reset the bar lower this year. Sales were down 14% in Q3’20, but Op Income down 20% (due to fixed costs). You can’t have a dramatic recession and expect spending to be up. That obviously will have a direct impact on Mastercard. But that makes Mastercard interesting because its a very strong business, but also a recovery play. Indeed, there may even be higher tailwinds on the way out – think of less use of physical cash.
And the long-term growth story is still intact. Look at how much in transaction volume is still down via cash and check.
Is Mastercard Cheap? I think so. But you say – Mastercard trades at 45x 2020 EPS?? And 34x ’21. That is not cheap.
First of all, is Mastercard an above-average business? Yes. Is its long-term growth rate above the market? Yes. It should trade at a premium.
Second, Mastercard trades at ~3% FCF yield, but also it can grow FCF/share at a 10%+ CAGR for the next 10 years. This would be half the rate of the past 14 years. I think growth will continue from continued market gains (remember, pre-COVID, the company was growing top-line in the high teens and bottom line even faster due to operating leverage. This will continue at a high rate in a post-COVID world). That points to at least a low double-digit IRR for the stock. I would also point you to my post on how Growth can help pay for a lot of sins…
I’m not going to publish my whole model here, but I encourage you to check your models for this. This is the beginning FCF yield + what I expect FCF to compound out. It is interesting how it almost matches up perfectly with the IRR of the investment:
There are still capital structure benefits that could come. As I talked about in my MSCI post, MSCI is leveraging its cash flow and returning significant cash to shareholders. Mastercard is roughly net debt zero. If they had 2.0x of leverage, that would be an incremental $18-$20 billion available for shareholders, which would obviously boost returns. I also think they’d be comfortably investment grade at that level as well.
Ladder Capital stock is a high conviction name for me. It is one where I see little downside and significant upside and also a situation where you are paid to wait (~10.8% dividend). Lastly, I can’t say enough how high I hold management (which also owns ~10-11% of the equity).
Ladder Capital is a mortgage REIT. Unlike typical REITs that specialize in the actual real estate, mortgage REITs specialize in… you guessed it… the mortgages that secure property.
Mortgage REITs have sold off significantly as the market becomes more concerned with commercial real estate. Several mortgage REITs used significant repo financing coming into the COVID crisis, so when there was a disruption in the mortgage market and all securities were crashing, several seemed unable to meet their margin calls…
That did not really impact LADR. In fact, management issued an unsecured corporate bond in 2019 to reduce reliance on repo funding… very timely. Did I mention management is A+ quality?
I tend to think of LADR as an investment company. We want them to make high earning, good risk/reward assets and we understand that they will use leverage in normal course of business. “Do what you think will make money, just don’t blow yourself up.” It’s clear to me they realize all of this.
LADR trades at a steep discount to book. In a hypothetical scenario, we need to ask ourselves that if we foreclosed on LADR, would we get book value or not. What price could we liquidate the assets for in an orderly liquidation. If we can get book value, the stock has 65%+ upside.
See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)
My goal of this post is to show you that you can bank on book value here. And that because of the short duration of the assets, we know cash will be coming back in the door soon. As a friend put it, soon a large majority of Ladder’s book will actually be post-COVID loans…
Here is my thesis:
Ladder’s book is high quality; Stock at ~60% of GAAP book value, 52% when incorporating appreciation of real estate
Book consists of transitional first lien mortgages (which I’ll define later), but also investment grade CMBS, small amount of conduit loans, and they also have a portfolio of triple-net leased properties and other CRE that they own outright.
~93% of their market cap in unrestricted cash; Or 14% of assets
43% of asset base is unencumbered, 74% of which is either cash or first mortgages. This means the company has significant borrowing capacity as well (which is important, as LADR is like a bank – you want them to take $1 and make $2 or $3 of loans with it).
Mgmt is top notch and has history of deploying capital attractively. Dare I say, the Warren Buffett of mortgage REITs (patient, cash not burning hole in pocket)
Buying back both bonds and stock – both at discounts to par / book value
Cash is both a downside backstop, but opportunity as they deploy into distressed sectors
Let’s Break Down Ladder’s Book: Here I will detail the bulk of Ladder’s assets. Note, this is just the bulk. They also have a small amount of conduit loans (which means they make loans which will soon be bundled and sold into CMBS).
Transitional Mortgages(43% of Assets, 53% of Equity): These are loans to commercial properties undergoing a… transition. LADR has a first lien on the property, while the borrower uses the capital to bridge it through renovations, repositioning of the asset, lease-ups, etc.
While COVID has created “income uncertainty” for a host of real estate assets, these transitional properties are inherently not generating much income at the time of the loan! And here’s some commentary on that from Management’s Q2 call:
[Our transitional loans] are close to stabilization and require minimal capital improvements. Our balance sheet loans have a weighted average seasoning of 18 months, which is a little over 15 months remaining to initial maturity and 27 months remaining to final maturity. Further reflective of the lightly transitional nature of our portfolio, we have less than $150 million of future funding obligations over the next 12 months and less than $250 million in total, all of which we can comfortably meet with current cash on hand. The majority of these future funding obligations are conditional and are subject to the achievement of predetermined good news events like tenant improvements and leasing commissions due upon the signing of new leases that enhance the cash flow and value of the underlying collateral. We continue to have limited exposure to hotel and retail loans, which comprise only 14% and 8% of our balance sheet loan portfolio, respectively. Currently, almost half of our loan portfolio remains fully unencumbered, and our exposure to mark-to-market financing on hotel and retail loans is just 1% of our total debt outstanding.
As such, they typically are low duration (<2 years), lower LTV (67%), and as mentioned – 1st lien on the property. In a sense, the property value would have to be marked down 33% for Ladder to begin taking a loss. Here’s a comment from the Q1 call on the borrower – you have to think they’ll want to preserve that equity value if they can and have a long-term view:
These same loans currently have a 1.26x DSCR with in-place reserves. The significant third-party equity our borrowers have in these loans provides strong motivation for them to protect their assets and provides the company with a substantial protective equity cushion. Like all prudent lenders, we’ll be very focused on asset management to protect and enhance the value of our loans
Here is more commentary on the assets performance and the short duration:
The property types are highly varied too. In other words, it’s probably a good thing it’s not all Hotels right now. But even so, they have significant cushion above the loan value.
Let’s say you don’t like this situation. Well think about this: We are buying LADR today below book value. Therefore, you could look at as us buying 1L mortgages on a look-through basis of ~40 cents on the dollar (i.e. 60% of Book value * 67% LTV). Do you think a 60% haircut is coming across the board?
Securities(23% of Assets, 8% of Equity): These are primarily AAA-rated real estate CMBS that has very short duration (2.1 years as of 9/30/2020) and significant subordination (i.e. it would take a lot of losses for the AAA tranche to lose money). In fact, even at the height of COVID where gold, treasuries, investment grade corporate credit were all tanking, the company was able to sell assets at 96 cents on the dollar. This speaks not only to the quality of the loans, but also liquidity.
As I think about this portfolio and the low duration, you should think of it this way: in 2 years, if the company did not re-deploy this capital, they’d have ~$1.45BN on loans that would pay off. They do have ~$1BN of leverage against them, so you’d have $383MM of equity back in cash. Keep this in mind for later.
Commercial Real Estate (16% of assets, 6% of equity though the assets are carried at historical cost, so there is significant unrealized gains not captured by GAAP)
Net Leased Commercial Real Estate (~65% of CRE): Ladder outright owns triple net leased properties, where the primary tenants are Dollar General, BJ’s, Walgreens and Bank of America.
Diversified CRE (~35% of CRE): these are other properties Ladder owns across office buildings, student housing and multifamily.
Now that I’ve discussed the book, it’s important to quickly discuss how they capitalize themselves. Again, very limited repo facilities and that source of funding continues to decline.
Note the unsecured corporate bonds. This brings me to one of my investment points: Ladder issued these opportunistically and has since been able to repurchase them at a discount to par. Ladder has repurchased $175MM of bonds.
At the time of writing, their 2027 4.25% unsecured notes trade at ~86 cents on the dollar. Every dollar used to repurchase these notes at a discount builds equity value on the balance sheet. There’s also the added benefit of decreased interest, which is a drag when they have so much cash.
As an example, let’s say we had a company with $200MM of assets ($100MM of which is cash), $100MM of debt, which would imply $100MM of equity. Using $25MM of cash to pay down $25MM of debt at par would not build book value on the balance sheet. However, if you paid down debt at a discount, it would.
Here’s that illustration shown below. Notice you actually build incremental equity. Given financials typically trade on a P/BV, I feel like this topic is warranted.
But obviously more importantly, it’s an attractive return of capital to shareholders if you think the stock is worth at or above book value. However, management may have opportunities to deploy this in attractive assets, noted below in the management section.
Adding up the pieces:
I wanted to do a build up of “what you need to believe” here. Maybe you don’t like the assets, even though I personally view them as very low risk. Well, the securities portfolio itself is worth $3/share. That’s very liquid and something you can take home in a few years if they decided not to reinvest the proceeds. We could get those assets tomorrow.
I also started with the corporate debt, subtracted cash, and looked at the equity value after paying that all back against the balance sheet loans (the transitional mortgages). I didn’t assume this debt was retired at a discount at all.
As we discussed, the transitional mortgages are low LTV properties and worth ~$6 share. You could haircut this by 40%, add in the securities portfolio and everything else is free.
Next you have the real estate assets, worth $1.8 share on the books. Fine, don’t give credit to the unrealized value here (another $1.8), but the company did sell 3 properties in Q3’20 for a gain relative to BV.
Our downside is very well protected. Given the short tenor of the loans, we will either see Ladder receive cash or take-over properties and sell above the loan amount (which they did with a hotel in the quarter, one of a few assets in trouble per mgmt).
Often, the missed piece of any thesis is management. Boy, all I can say is go read their calls. These are truly savvy investors, which is what you want in an mREIT.
Here are some examples of great quotes from mgmt:
From the Q2 Call – I get Buffett vibes:
My instincts are telling me that it might be better to actually be the borrower in a market like this as opposed to be a lender. Occasionally, we’ve talked about that on some of our calls. Conduit lending is back in a very soft kind of way. And a lot of cleanup from inventory that was sitting on the shelf is getting done. But I would say the typical conduit loan today that’s getting written is a 3.5% to 4% 10-year instrument at 50% LTV.
I think if we begin to deploy capital, and I think we will, we’ll probably be a borrower of funds like that because I think we can find some attractive situations where, perhaps, somebody has to sell something. And in addition to that, I would say that a stretched senior used to be, if a guy bought a property for $100 million, he could borrow $75 million. I think $100 million purchase today, you can probably borrow about $60 million. And so a stretched senior now goes from maybe 60% to 70%, 75%, and I think that is a sweet spot for risk/reward right now on the debt side.
If you remember, in 2008, when we opened, we had quite a few mezzanine loans in our position because we felt that the capital markets were very fearful and maybe too fearful. And so then once we got to around 2012 or ’13, we stopped writing mezzanine loans because we felt at that point, markets were priced right. And then around 2016, we felt that mezzanine money was too cheap. So I would imagine it will feel and smell like equity in some cases, or at least in some scenario where somebody is forced to transact.
And another from Q3’20 from Pamela McMormack, the other Co-Founder
I’ve been with Brian, forgot, I’m turning 50, I think, since I was 30. And so I’m a little bit of the cycle in that regard. But what I’ll say is, I remember, when we opened the doors in 2008 with the private equity guys, and they were begging us to make loans, make loans, make loans. And we were sitting on a lot of cash, we had raised over $611 million back without placement agent in 2008. And Brian was very patient, had a set up to become a (inaudible) borrower. We’re buying securities, and they said they don’t pay people to invest in securities.
And we were very patient about making loans until we felt like the market was right. We’re not incapable, we’re not afraid. We are intentionally and purposely waiting for what we think is a better risk-adjusted return.
There in lies WHY they have so much cash right now. Unfortunately, COVID is not going away tomorrow and there will be some desperation out there. I like this management team’s ability to take care of it.
Here is LADR’s ROE over the years. Not too shabby! I’d add this to the rationale that the company should trade at at least 1x BV (this ROE excludes gains on sale).