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 is a business that has been impacted both by a commodity downturn and COVID (hit occupancy).
With where things are, I think their earnings should improve over time
I also think the US will likely improve as we still are underinvesting back in O&G and E&Ps are only disciplined for so long…. but that’s just upside
I think where commodity prices are at this point will also mean producers will eventually be willing to commit to new projects and that will drive demand for CVEO’s lodging and hospitality services.
CVEO’s balance sheet is in great shape, limited BK risk, and generating solid FCF
However! You don’t need to bank on much. You just need to think things won’t get too worse given the company generates good FCF. And there was evidence things would at least level out.
I was pleased to see CVEO report Q2’21 EBITDA in-line with estimates ($32MM), generated good FCF again (~$14MM) which all went to pay down debt. The company is 2.0x levered now.
How are things moving from a trajectory standpoint? Sorry I’m ripping a bunch of comments from the call:
We are encouraged by the decline in COVID-19 cases in Canada and hope this trend allows our customers to continue to normalized operations.
The British Columbia health order, which temporarily limited occupancy at all industrial projects in the province, including our Sitka lodge, was lifted late in the second quarter. Now that, that order has been lifted, we have seen an uplift in occupancy as our customer works to catch up on their project time line. These expectations are in line with the EBITDA guidance that we are maintaining from the last quarter. Yes, we’ve seen much better turnaround activity.
Second quarter was in line with expectations despite the fact that we had one customer push some of their activity from Q2 to Q3. But it appears that that activity will come through. But turnaround activity in Canada is clearly much improved year-over-year.
For the full year, we’re still expecting Canadian billed rooms to be approximately 2.3 million billed rooms, a little over that compared to 2.1 million billed rooms last year. That improvement is both operational as well as better turnaround activity over year. Going into the third quarter, we’ve seen better occupancy for most of the second quarter, we averaged about 5,000 Canadian guests a day, and now we’re averaging a little bit over 6,000. So things are improving, but certainly not to where we were pre-pandemic.
In Australia, we anticipate that the prolonged travel restrictions related to the COVID-19 pandemic will continue to pressure our performance in the region with increased labor costs anticipated to be a factor that we can continue to — that will continue to impact our margins.
The outlook for metallurgical coal markets in Australia for 2021 has continued to be impacted by the Chinese trade policy. So increased interest in Australian met coal outside of China has built some of the negative impacts.
We expect a supportive commodity price environment to remain for the rest of the year with met coal currently trading above $200 per ton. The met coal prices are at much healthier levels than we had last provided revenue and EBITDA guidance.
We have chosen not to increase our expectations for the back half of the year for the Australian segment. Our customers continue to be hesitant to increase activity in light of the lingering China-Australia trade dispute.
Our current guidance does not assume a material improvement or degradation in the Australian-Chinese trade dispute, nor does it assume a material improvement or degradation in labor costs.
It seems like they are being very conservative with Australia assumptions. Perhaps 2022 will be better…
Importantly, they increased the FCF guide again… now $68MM at mid-point. So even though shares have moved up, we’re still talking about a 22% FCF yield on CVEO stock.
I kind of hate it when people say, “look I get the pitch, but what is the catalyst??”
You can imagine a scenario where the company has basically no debt and if the FCF yield is still this high… well, companies have a way of solving that problem. That is the catalyst.
Here’s what they said on the call about a buyback – quite a change in tune from just all debt reduction commentary:
Stephen Michael FerazaniSidoti & Company, LLC – Research Analyst
Great. Great. If I could just get one more in. You noted lower CapEx now expected. You’re down to 2x leverage, sounds like reasonable free cash flow this year. Any other thoughts on uses of cash given that leverage is probably down to an area you’re comfortable with?
Bradley J. DodsonCiveo Corporation – CEO, President & Director
It’s getting there. I think for our business, our target is to get to 1.5x levered. That being said, to your point, capital allocation decisions, have a little bit more freedom now and we will be assessing whether or not a share repurchase program is prudent, but that is on the to-do list for Q3.
I just really like the right tail on CVEO stock… I certainly make no bets on where commodities will go. But I am at least aware of where they are and where we likely are in the cycle (we’ve had a good 5 years of a downturn, now things have turned up). The stock is a 22% yield on pretty conservative numbers with the US also not contributing at all.
Lastly, you’ll recall part of the thesis was about a “forced seller.” I felt like his indiscriminate selling was pushing the stock down despite positive trajectory in the business. Isn’t it funny how his last reported sale was April 9th and now CVEO stock is moving higher?
Reading Time: 2minutesMasco stock continues to reflect too much cautiousness. Should this company traded at such a discount to the market?
As a reminder, Masco owns Behr paint (exclusive to Home Depot) as well as other brands like Kilz. The company reported Q2’21 numbers, which were good and raised guidance, but the stock hasn’t reacted as much as I’d hope.
Q2’21 EPS was $1.14 vs. consensus $1.03 and they raised EPS to $3.70 vs. consensus at $3.63
That’s a “modest raise” so why was I expecting a stronger reaction? I got the sense that Masco stock was becoming a consensus short. This stems from the company’s exposure to DIY vs. DIFM (do it for me). Sherwin is a play on DIFM whereas Masco stock is DIY.
Masco’s paint did decline 5% on a +8% comp, so things are normalizing.
But not all Masco does though. Masco is the owner of Delta, the faucet and plumbing brand and that’s ~60% of LTM sales. This fact is often overlooked in my view and its easy to relegate Masco just to “Behr paint.” Plumbing sales were +53% and +31% on a two-year stack.
Masco stock currently trades at 10.5x 2022 EBITDA and 15x EPS. However, they are currently doing about $850MM in FCF and they have $750MM in cash and nothing drawn on a $1BN revolver (so plenty of liquidity).
At the current market cap of $15BN, they could easily buy back 10% of the stock over the next 12-18 months. They repurchased $875MM in the TTM, so its not crazy to think they keep on plugging away at this. This very much reminds me of my Autozone call…
Also, its important to remember from a valuation standpoint, Masco’s ROIC is insane. Take a look:
Reading Time: 6minutesAs everyone I am sure is aware, container shipping rates right now are astronomical. The re-opening of the economy and associated supply-chain bottlenecks has created a situation where people will pay up just to make sure their items are actually on that boat!
This has caused blow-out earnings for the shipping lines. Maersk reported a 166% increase in EBITDA for Q1’21 for example.
However, I don’t think this is sustainable and no one else does, probably. Shipping is also a fraught industry to invest in – when times are good, capacity is brought online. These ships are long-lived assets so when times aren’t good, the supply is still there.
There’s alternative however, with a much stronger industry structure, ROEs, cash flow, on and on. That is container leasing. Triton is the largest player in the space after it merged with TAL in 2016.
I like Triton stock because:
Leader in the market – scale in the leasing industry matters and drives much higher margins + lower cost of capital
Fundamentals are in terrific shape
They are signing long leases at high rates – abnormally long and abnormally high – which will give strong visibility into cash flows for foreseeable future
Can flex capex spend with the market – has a history of shutting of capex and buying back stock + dividend
Triton stock trades for ~6x ’21 EPS, 1.3x ’21 BV – historically generated mid-teens+ ROE in normal times. This should improve
The business historically went something like this:
Triton buys containers and places them on lease with shipping companies.
Historically, these would be 5 year leases. However, with limited technological obsolescence (just renting a steel box in most cases), the age of the asset didn’t really matter. So they can pretty quickly re-lease the box, but the lease rate may change
The assets (boxes) last about 15-20 years with pretty minimal maintenance. Maybe slightly more for a refrigerated box, called a reefer (yes the actually name), but the lease rates would also be higher. So historically there’d be 3+ leases involved
End of life – they sell the box for some residual value, which also helps recoup part of their investment. It used to be they buy a box for $2,000-$2,500 and could sell it for ~$1,000. Right now, they can sell the used box for about $1,500, which is pretty nice.
Why do shipping companies lease instead of owning their own containers? It outsources capex in an already capex-heavy industry. It’s off balance sheet financing for them. The shipping lines do still own their own containers (about half of the market), but that’s been trending down pretty consistently over time. It just makes more sense for them to focus on shipping and flex leases up and down with the market.
I don’t think I need to dwell on why fundamentals are good right now or why buying Triton stock at 6x earnings is optically cheap. I’m going to focus on the lease rates and new longer duration contracts being signed right now.
If you are worried about the current conditions being unsustainable, long, contracted lease rates help that. As shown below, Triton is trying to tell investors that not only is it leasing more containers than basically ever…. putting assets to work… the lease durations are now approaching 12-13 years.
If you like SaaS, you’ll *love* container leasing companies.
We’ll have to think about these rolling off in 2031-2033, but meanwhile, the company will be earning above average ROEs.
Here is a chart from their Q1 basically showing lease rates are 1.6x the general average. You can see there was a dip in 2019, but the company pulled back – the size of the bubble indicates how many containers were put on lease (so very few). In a sense, Triton is an asset manager just like a Blackstone – you kind of need to trust that they will be deploying capital when times are good and pulling back when times are bad.
What could go wrong?
I should mention what could go wrong. We have seen this situation before – following the GFC, world trade snapped back and lease rates surged. Unfortunately, they all basically expired in 2015/2016. This was also when we were in a quasi-industrial recession. This was also when steel prices were in the gutter, which makes up most of the price of a box and makes it tough to sell used boxes at a fair price. Hanjin, a major shipping line, also effectively liquidated (in a BK case, most of the time a shipping line will just keep its assets rolling in a Ch. 11 because its a critical asset to operating – Hanjin just disappeared.)
In many ways, 2015/2016 was worse that the GFC. I mean, it actually was worse. The GFC wasn’t actually that bad because global trade remained pretty steady.
Even with a trade war, it’s hard to knock off the secular trend of the western countries importing from Asia. If it isn’t from China, it is from Malaysia, Vietnam, and so on.
Did I strike to buy Triton stock in 2015-2016?? No. I was gun shy as I’ve been following the industry for quite some time and they never seemed to generate real FCF (CFO-Capex). It was an asset gathering game.
But then in 2019-2020, when the market wasn’t particularly great, they actually proved they could shut-off capex. They starting generating a ton of FCF and showing signs to shareholders that they care about the stock (they issued a pref as well to help fund buybacks)
Another sign they care about capital allocation is this fantastic sources and potential uses of cash in their deck:
Basically they are telling you they could buy back 12% of the stock in one year. Share count is down about 15% in 2.5 years, but now I think they’ll be deploying cash into higher ROE opportunities, which is fine by me.
One thing I should mention is typically Triton finances itself through the ABS market. They get 80-85% LTV against the asset value for very long duration. Happy to answer any questions on this, but I’m not too concerned with the ABS market financing.
Triton issued $2.3 billion of ABS notes during the third quarter at an average interest rate of 2.2%. Most of the proceeds were used to prepay $1.8 billion of higher cost notes, which is expected to reduce interest expense by more than $25 million over the next year
They are also diversifying financing – so they just issued an IG secured bond and have talked about moving up to IG ratings. If their cost of capital goes even lower, I it will be great for the business in the long run.
Last thing I’ll say is basically Triton is covered by one company. You’d think modeling it would be easy enough, but we are talking about hundreds of thousands of containers, utilization can change, etc etc. However, I think EPS estimates are probably still too low in the long-run. It’s been that way in the short-run, so far, but we shall see. It’s hard for sell side to model operating leverage + high lease rates + deploying cash into such a significant amount of assets.
Reading Time: < 1minuteI was just talking to a friend about how NWHM stock was way too cheap again. If you took cash on hand + real estate inventories – LT debt, that would be $185MM of value vs. $85MM market cap. So I’ve been adding to the position.
Well fortunately, Apollo is acquiring the company for $9/share, or an 85% premium to the latest close. Not too shabby!
Reading Time: < 1minuteHFRO has had a nice bounce since my recent post and is +8% since I wrote about it. I think it still has upside from here, but if I’m honest, it depends to some degree on “known unknowns” and discount narrowing, which is always a tough story with no catalyst.
Full disclosure, this shift comes after talking to MDC of Clark Street Value. His posts on NHF were excellent and after he joined a Twitter Space I started, I though NHF was the better opportunity. Highly recommend you follow his blog if you’re not already.
HFRO is still fine! But NHF on the other hand:
Trades at a larger discount (~32% vs. 22% at HFRO). However, the Terrestar position is at 9%, which I had concerns about, so its close.
Has a better catalyst to close the discount: its converting to a REIT which will trade on FFO most likely and multiples are typically pretty high in REIT space. Therefore the chance the discount narrows is descent even ex-Terrestar whereas at best I was thinking HFRO would still trade at 85% of NAV.