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.
Reading Time: < 1minuteI had the pleasure of joining my good friend, Ben, on his podcast. This was the third time I’ve joined him, but this conversation spanned such a wide array of topics that my head was spinning with where I want to research new opportunities. It just shows how good of a host he is, being able to navigate the conversation through these topics.
Please check out the link below for more info and find the podcast here:
Reading Time: 4minutesToday will be a quick idea on Civeo. The bottom line is that CVEO stock trades at ~25% FCF yield, is only ~2.5x levered, and there is a “forced” seller I think is driving down the stock.
Ok – “forced” seller is kinda click bait. The company completed an acquisition a few years ago, giving the seller some stock as consideration. That seller is now blasting out nearly every day, which I get into below.
Civeo provides hospitality services to commodity industries. So think about remote locations where companies are mining precious metals and pumping oil and gas, Civeo provides lodging, food service, and housekeeping for those companies.
Commodity prices generally have been completely bombed for several years now, particularly where the company participates. This includes oil, liquified natural gas, met coal (the coal used to make steel), and iron ore, though demand has still been OK (as I noted in this oil post). The nature of the business also means they typically are in highly commodity driven areas – Australia (given their met coal and other metals help serve the China / Asia demand), Canada (oil sands) and the US E&Ps.
As you can see, the stock has not performed too well in this environment.
The company currently operates around 28 lodges covering 30,000 rooms. They also own a fleet of modular assets that are typically used for short-term stays in the US and Canada.
ANYWAY – if you were to look at the company’s insider transactions, it would look UGLY. The Torgerson’s have sold 3% of CVEO stock (almost $7MM) in near-daily blocks since August 2020.
That is until you realize the Torgerson family were the sellers of a company Civeo bought, Noralta Lodge, for $165MM. Of the total purchase price, $69MM was issued in equity to the holders of Noralta.
This was a little over 3 years ago at this point, so no surprise following a COVID scare + some time since you’ve sold your business that’d you would just want to move on.
The Torgersons still own 11% of the company, so there is a long way to go, but I can’t call the end of this technical factor.
Nearly 25% FCF Yield
The seller is obviously not selling because the value of the CVEO stock looks too rich.
On the latest call, Civeo management guided to $55MM of FCF. This compares to a market cap of ~$230MM. Previously, the company used FCF to delever (after levering up for Noralta), but now that it is at 2.5x, there is a bit more flexibility. As I’ve talked about, I like these busted balance sheet names as they start to improve, but are still in the penalty box of equity holders.
When a stock trades at 25% FCF yield, the market is saying there is high bankruptcy risk. I don’t think that’s the case here. The term loan and revolver mature in 2023 and they generate plenty of FCF to keep lenders happy.
Fortunately, the COVID snapback has caused commodities to rip. If they stay elevated, who knows, but I think it will at least help the company extend contracts on existing lodging facilities and maybe sign some new ones (that will also help any concerns with credit facilities, but again – I’m not concerned there).
Back to the FCF yield guidance – there should be pretty good visibility. You have a set number of rooms available on site, you talk to your customers about need and what they are planning for the year, and you have a general gauge of commodities (are they up or down, is demand up or down) so you can try to win more business. This makes me believe FCF guide is a decent one to bank on.
Last thing I’ll say, the past 3 years the company actually generated $63MM of FCF on average. There was some working capital movements there, but it doesn’t seem unreasonable at all to me.
M&A Target (Seriously)
Using “M&A target” as an investment thesis is weak… yet here we are.
Typically its weak because its like, yeah sure… in SOME scenarios, this COULD get acquired (especially in a deal hungry private equity market), but any time I hear that, it doesn’t come to fruition.
In this case, Target Hospitality received a buyout offer from TDR Capital. Now, it was apparently a really cheap price of $1.50 and now Target Hospitality is trading at $3.40. Target Hospitality currently trades at 7.25x ’21 EBITDA vs. 6.0x for CVEO. HOWEVER, Target is also pretty levered still at 5x EBITDA vs. 2.5x for CVEO. Their cash flow has also been much less consistent.
I also think the capital markets are supportive and perhaps this company would be better suited as a private company, rather than a $230MM public company. Just saying.
Reading Time: 4minutesReal estate prices are booming right now. Supply is tight and competition for investment properties tend to also overlap with first time home buyers. To me, the math doesn’t add up as much as it used to, even with low rates to finance the properties.
The funny thing about super low interest rates is at a certain point, you start to not discriminate between a low rate and a no rate. I know it sounds crazy, but for example, a treasury bond with a 0.5% yield starts to be pretty close to just a zero coupon bond.
It’s happened to me psychologically – I can tell.
I’ve looked at some rental properties recently, I have a long time horizon, and so I think “well, as long as the income covers my mortgage at the minimum, that’s all I need – I’ll generate a levered return to real estate prices.”
This is dangerous because unexpected capital expenditures, occupancies, etc. can knock off your cash flow assumptions.
I own several rental properties today. While I can sell them and generate profits, I’ll either be taxed (and greatly reduce those profits) or I’ll 1031 like-kind exchange into rental properties that are also expensive. Not really a “win.” It’s one expensive home for another expensive home.
So back to low rate vs. no rate: if I’m comparing rental property where competition is very high due to tight supply… I started to think to myself:
Why not just buy land where I think housing developments are moving?
“Skate to where the puck is going.”
Can you 1031 rental property for land?
Actually the rules are pretty broad. You can exchange commercial for residential. Single-family residential for apartments. Farmland for other real estate. What matters is each is real estate used for investment purposes on either side.
How does is work?
I decided to walk through a hypothetical situation where you bought $650k of rental properties 10 years ago, which are now worth $1.06MM. As shown below, if you sell you’ll either take $387k after taxes or $580k that you can reinvest in real estate.
Is a 1031 Worth It?
Clearly, it seems like if you can sensibly reinvest in real estate, it might be worth it to avoid the taxes and continue to compound capital. Alternatively, if you’re comfortable with your cash flow covering your debt, you could do a cash out refi which I previously discussed. Or, you just keep the property.
But I’m exploring hypotheticals here.
Look at the tables again and you can see one labeled “acres purchased.” I did a quick check for land for sale on outskirts of areas I currently invest in, but places where I am reasonably confident growth is moving and the land would be reasonable to develop.
You may know of cheaper land and I definitely saw some expensive land and as of right now, that was a reasonable median. So I could buy nearly 80 acres for around $12,500 an acre and use all that cash.
A note on these assumptions: I’m not being scientific. I think some of this hypothetical lot could trade for 25k an acre in 10 years, or double the price. That’s mainly because (i) some of the lots that are currently butting up against the “next” housing area are selling for that, so in 10 years if you picked the right spot, I’m OK with that assumption (ii) home price appreciation will make it easier for a developer to capture that price, and (iii) we have a shortage right now. I think it will take a reasonable amount of time to rectify that shortage (although affordability may hit demand as well).
Mortgage Boot Kills the Fun
In a 1031 like-kind exchange, there’s the concept of “mortgage boot” which basically means you need to reinvest the cash flow from the gain + take an equal sized mortgage. Or cough up more equity of equal size to the mortgage. You may have noticed in the table I included a mortgage. Ideally, you could just take the gain with no mortgage for the next property and no additional cash, but that’s not the way it works.
The IRRs without mortgageboot are shown below. Not too bad – all you owe are the taxes along the way!
IRR with mortgage boot shows the drag on cash flow may be too much for people. This also doesn’t include the principal payment on the mortgage (I assumed a 10-year mortgage, which would be $52.5k in total payments – not fun).
I like my cash flows to go the other way…
There is one other upside, and I’ve heard a few stories of this, is you buy the land and are able to sell the timber immediately which basically covers your cost. This is treated like a farmland, so there are some specific taxes you have to work through, but that would be an ideal scenario.
Then you own the land and have most of your basis out. Unfortunately right now, with lumber prices through the roof, you probably won’t recognize that value or the person selling the land would have already cleared it for themselves.
Bottom Line: I don’t think switching from a low-cash flow property to negative cash flow property makes much sense.
Reading Time: 2minutesWhen you think about all the articles being written about shortages and fears of inflation, it seems like the US economy is doing very well. You can’t really have those things without consumer demand. Indeed, some are calling for GDP growth of 8% in 2021 and a big increase in inflation.
I’m a little cautious on the GDP growth in 2021 causing sustained inflation (mainly because its high growth lapping a year that was beaten down) (as I previously wrote about). Let’s not confuse a one-time increase in prices with inflation…
But I also get pretty cautious when everything I read is all the same – “a boom is here.”
One piece of data that gets thrown around is ISM Manufacturing PMIs. The latest reading was 64.7%! It’s well above pre-COVID levels.
A Manufacturing PMI® above 43.1 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the March Manufacturing PMI® indicates the overall economy grew in March for the 10th consecutive month following contraction in April 2020. “The past relationship between the Manufacturing PMI® and the overall economy indicates that the Manufacturing PMI® for March (64.7 percent) corresponds to a 6.2-percent increase in real gross domestic product (GDP) on an annualized basis,” says Fiore.
Now, a PMI is a “purchasers managers index” and is basically a survey from a wide array of companies in manufacturing in the US. It basically is asking, “are you growing or shrinking?” across a wide array of topics.
Investopedia says, “when the index is rising, investors anticipate a bullish stock market in reaction to higher corporate profits.”
Actually – it can really be used as a CONTRA indicator.
I went back through the data to 1960 and checked the 6-month, 12 month and 18-month S&P500 returns after the manufacturing PMI was at certain levels. It’s not perfect, but its something.
I’ll just put the data out there – would you rather swing hard with the index around 65? Or below 43? There aren’t many cases when it goes above 70, but that generally does not have a good track record.
Look, I try not to market time. I’m typically nearly-fully invested. But I also understand there’s a time to own some names (e.g. cyclicals) and time to eh… maybe cool it and wait for a better day.
Reading Time: 2minutesYou don’t get better at investing without comparing your process with outcomes.
I’ve been thinking a lot about the point of this blog. Currently, I view it as an investment journal. But, I wanted to accomplish a three things when I started:
Put my investment theses in writing. Compare the thought at the time of writing with the outcome (what was right, what did I miss)
Write down themes or ideas I talk about with friends…that end up being “lost” conversation because we never wrote it down
Have fun. Become a better investor. Become a better writer. Hopefully let others share in the outcomes.
In order to hone in on number one and number three, I am going to track performance of stocks I have written about on this blog with their performance against the Russell 3000. Why the R3k? Because I do some big names, some large names. Rarely anything international, and that’s my personal benchmark of what I would otherwise invest in.
If, overtime, I see that I am consistently underperforming, I’ll re-examine the process.
If I am doing well, I’ll examine which ideas seem to perform the best and why.
A few things to mention:
Unless recommend closing a position specifically, the position runs on
Equal-weighted since I’m not posting my full portfolio and also not writing about why I like one idea over another (but this may change in the future)
Using total return so there may be differences in price change vs. total return if there are big dividends
If I write about something twice, I assume that’s buying it twice, obviously excluding earnings recaps or anything like that. The rationale here is I’ve moved away from earnings recaps and when I write about something twice, its more akin to doubling down.
Competitive strategy series posts are excluded (unless I say the stock looks cheap in the specific post) because the point of those posts is to examine business strategy as opposed to the stocks themselves being cheap
Guest posts are excluded so a very timely cruise stock buy in March 2020 is not in the results
Over time, I hope to advance the write-ups I do in many ways. I also want to advance the tracker, but it won’t be in the near term. In the future, I want to show the portfolio. So, for example, future stock posts will say, “ok, I’m going to buy this name I like, so therefore I am selling xyz…”
But that’s for another day.
Head over HERE for the performance tracker. Or click the menu header above at the top of the site and click Performance Tracking.