Tag: Equity Analysis

A Tech Company Hiding in Plain Sight: Yum! China $YUMC

I think Yum! China meets a lot of the criteria of a stock that will compound earnings for the next decade. I like it for 3 main reasons:

  • Long growth runway (China Tailwinds + Market is Not That Saturated + Upside from New Concepts)
    • Targeting 20,000 stores for core brands which is 2x the level today
  • High return on capital business, despite being mostly owned branches as opposed to franchise business model
  • Leader in Technology (core tenant as I think ROIC can go higher)

I know YUMC well from travelling to China. I actually did a college paper on my experience with different fast food brands in Asia; essentially which companies were succeeding with the new Chinese growth story and which weren’t.

YUMC was a leader at the time. Why? Because YUMC has been operating in Asia well ahead of its competitors (KFC first entered China in 1987, Pizza Hut in 1990) and frankly, they got it.

They got that you can’t take a US concept, plant it in China, and expect success. They got that the Chinese may have some similar tastes, but they didn’t grow up eating the same things as Americans. They also didn’t grow up, like I did, with a “Colonel” in a suit in charge of fried chicken chain and ask zero questions about that relationship.

So YUMC changed the items they serve for the local market. They did this well ahead of competitors. It’s been about 7 years since I’ve been to Asia, but I would say the other large chains were still trying to catch up to YUMC. That’s a general theme for this post and what we’ll get to later – innovation.

Invert the issue, too. Do you see many successful Chinese restaurant chains in the US? Not really. The ones you do see are highly Americanized / not Chinese food.

Here’s a snippet from their latest call. Do you think the menus are very similar to US? This is at a Pizza Hut for crying out loud.

For background, YUMC and YUM used to be combined, but YUMC was spun out in 2017. The rationale was that YUMC was more heavily owned restaurants, whereas YUM was mostly franchised. So YUM would become more asset light. At the same time, YUMC could dedicate more resources for growth. At the time of the spin, YUMC had 7,300 restaurants but it now has nearly 10,000. Mgmt says they feel 20,000 is a reasonable long-term target. (I also would mention the spin came around 3-4 years after the bird flu scare in Asia and perhaps YUM wanted to close that chapter / unknown future liability if supply chains get disrupted again).

Long-Runway for Growth

What is also interesting is that at Dec 2016, YUMC had ~7,300 KFC and Pizza Huts. Now, they have 9,000 and the balance (roughly 1,000 stores) are other concepts. These other concepts include Little Sheep (hot pot), COFFii & JOY (a coffee shop), East Dawning (Chinese food) and Taco Bell (theres only 7 Taco Bells in China – they need to ramp that up!).

They also just acquired Huang Ji Huang (a casual dining franchise in simmer pot) and partnered with Lavazza group in coffee (coffee is clearly growing in China – “In 2019, we sold 137 million cups of coffee at KFC, representing a 48% increase from 2018”).

So you’re not only buying a strong brand name of US companies operating in China, you have upside from new concepts. Each of these could probably support 500-1,000+ stores across China.

To put the store count of KFC and Pizza Hut into context, Starbucks has 4,100 stores in China at the end of FY2019. McDonald’s has 2,900 as of June 2020. YUMC is clearly dominant in China. That frankly means they have less of a runway in China with KFC and Pizza Hut, but I’m still optimistic on their other concepts, mentioned previously.

Restaurant chains have a low penetration rate in China, especially in lower-tier cities, with only approximately 332 chain restaurants per million people in 2019 compared to approximately 891 in the United States. While YUMC is “dominant” this indicates a substantial growth opportunity for restaurant chains in China.

Despite the pandemic, YUMC plans to continue ramping store count with a 800-850 target this year. They’ve averaged 2 days a day over the last few years. I’m not saying that will keep the same pace, but I am saying it doesn’t need to for an investor to benefit.

High ROIC Business

I’m very focused on unit economics for any business I study. The gold standard in this for me is Dollar Tree, which in their IPO docs in the 90s stated it cost them about $162k to set up a store and in year one they earned $162k in operating profit. So a 1 year payback period. For investors, understanding that they were earning such high returns + had a long growth runway in stores meant that signing up for the ride was a no brainer (in hindsight).

Now, I wasn’t around to catch Dollar Tree and it seems saturated today. But there are still opportunities. YUMC is targeting 20,000 stores for its core brands, which is double the current amount. Plus, they have a very good payback period.

This all jives with my estimates for returns on invested capital, as shown below (note 2020 is a bit weaker given COVID). As a shareholder, I’d prefer them plow that money back into the business if they can really earn these returns rather than give any back to me. I can’t earn 30-40% returns on my capital, but if you can, please take my money.

I also think YUMC can beat its historical returns for a few reasons (I think upwards of 50%).

The company is opening smaller concepts in tier 3-4 sized cities in China. In fact, 61% of KFC restaurants and 53% of PH restaurants opened in 1H20 were located in tier-3 & below cities as the cash payback levels are much faster. 

Next is that the digital investments it has made will likely lead to higher turns. The restaurant business is all about maximizing turnover. A fine dining restaurant probably can only seat 2-3 sets of customers in any given night, which is why it needs to maximize $/table. Fast food reinvented that with the drive through. The next step is delivery which will further enhance the market YUMC can at any one point and further increase sales per store.

Quick aside here: Honestly, I think brands like YUMC should look at the Uber founder is up to because I think it could accelerate this journey. His idea is that take-out and delivery restaurants probably have too much square footage today (think about the local Chinese joint. People rarely sit inside, instead getting delivery or pickup). What if restaurants shared energy costs and a building and then delivery people went to one central location before they dispatched out to make deliveries. I think it makes a lot of sense, especially for a company like YUMC where a KFC, Pizza Hut, Taco Bell and all their other brands could sit under one roof and cross sell.

Investments in Technology

Now to the meat of the thesis. I’m not sure many other restaurant companies are so point blank about technology and innovation being the forefront of their mission statement. I think Domino’s is the main one that comes to mind, but here is YUMC’s:

Take a look at the slides below. These were items shared by YUMC in March 2019. Talk about being prepared for COVID. When thinking about brands that will come out even stronger from this pandemic, I think YUMC went in with a clear strategy and should come out the other side even better.

Personally, I think you want to invest in companies that come out of a crisis with more market share. What is really interesting is that YUMC’s app now has 268 million members and I thought this quote (and some of the following slides) was really interesting: “Member sales accounted for over 60% in the second quarter. While overall sales declined during the outbreak, our year-on-year member sales grew by double digits.”

Below are some quotes from the earnings calls. I’m not going to provide too much commentary because I think management explains it well (instead I’ll add emphasis).

The thing I would say is that they seem to be well ahead of US counterparts. I think Starbucks in the US gets a lot of credit for their app, but YUMC is clearly using the technology to offer targeted promotions to its members. It also has 10,000 corporate members, so again maximizing turnover, it can target lunches at offices for bulk discounts. Again, part of my thesis is improving economics at each store as well as a long re-investment runway.

“And guess what, we get our mobile ordering before Chinese New Year. We did not know the COVID-19 was coming. And then COVID-19 came, it became a very good platform for takeaway and mobile order. So our mobile order or digital order just increased significantly. And Pizza Hut alone, the digital order for Q2 is 61%. And that, compared to last year’s 29%, it almost doubled. So again, the business model transformed. And for Pizza Hut, when we add the takeaway business, which is very value driven, it’s very much incremental because it’s for 1 person, together with delivery, the non-dining business become more than 40% of our business. So we become less reliant on dine-in business. So that is an example of both short-term and long-term transformations.

“And then I would like to mention the members. We have reached 268 million members. And the members are our digital assets to allow us cross-sell between the brands and between the business within the brands to increase frequency and cross-sell. As I mentioned in my presentation earlier, we saw the doubling of average revenue per active user, and that’s very exciting in the past years and for the coming few years.”

The interesting thing to me as well, to show how far ahead their thinking was, was they acquired a delivery platform called Daojia in early 2017. Now, the market moved to third-party aggregators, so that investment unfortunately didn’t pan out, but they now partner with the other aggregators. They actually acquired a small piece of Metuan which has been a good investment, but the point is clearly the business is being set up to win in the new environment.

“As early as 2010, we identified delivery as a significant growth driver and began to offer delivery services, first through our own delivery platform, and later, in 2015, also through partnering with third-party delivery aggregators to generate traffic. In 2019, we enjoyed one of the highest delivery sales contributions among restaurant chains in China, according to the F&S Report, with such sales accounting for 21% of total Company sales for the same year”

This wouldn’t be an interesting investment without some key concerns:

Pizza Hut in the US is suffering. What’s stopping that from happening in China?

Pizza Hut in the US is suffering from lack of investment and being set up as dine-in stores, whereas “DelCos” are now winning (delivery companies such as Dominos). This, coupled with a menu and offering that needs to be refreshed, is a concern for current operators in the US. The other main concern for Pizza Hut in the US is technology (seriously, the app is horrendous. It’s like a college intern built it).

It’s a different story in China. It seems to me that YUMC is learning from mistakes at YUM. I guess that’s the benefit of owning a large chunk of stores – you quickly can see an issue. If you don’t invest in the brand and turn things around, you’ll suffer much faster than a pure franchisor model.

Any concerns on backlash on the West now that the US and China seem to be in a new Cold War?

This is a hard risk to box. On one hand, I am concerned and think there could be some serious market volatility and even multi-year periods of where Chinese consumers may boycott western brands. A couple positives are that YUMC is basically a Chinese brand at this point (yes, they are American names, but it’s a Chinese company with a Chinese menu essentially…).

The second is YUMC recently sought a secondary IPO on the Hong Kong market, which would help in the case that the US bans Chinese listings on their exchanges. This raised $2.2BN.

As someone reviewing the company, that was a bit frustrating to me as it is dilutive, but at the same time, its more capital to plow into the business. Perhaps they will even use it to slowly acquire US shares – I have no clue. The point is YUMC also has no debt at the moment, so likely could survive a drawdown period.

In the long run, if the tensions subside I think there is upside from optimizing YUMC’s capital structure.

If this is a serious threat to you, then I’d also say watch out owning SBUX and MCD as well as any other global brand.

Bottom line, I think YUMC can compound FCF / share at a 15% CAGR from 2021 through 2028. As you know, this FCF compounding is a significant driver of returns.

I normally don’t build models that far out because its anyone’s guess as to what happens even in the next year. I did so for YUMC basically to sensitize different inputs. My main case assumes Pizza Huts aren’t a driver of any growth and instead growth comes from KFC and new franchise concepts. KFC improving profitability over time which is the main driver of results.

The reason why I really like the story is because there’s upside from factors outside of my model. Clearly, the company has expanded outside of US concepts. This could continue with more M&A or organic initiatives (think McDonald’s when they owned Chipotle, Panera, and oh yeah – they owned Redbox…).

At the same time, the financials may improve more than I expect for a host of reasons: Pizza Hut improving more than I expect, more franchise concepts vs. owned means lower asset intensity and higher FCF conversion, and better cost leverage from expanding to a company with 20,000 locations (I only model getting to 15,000).

The risk / reward skew seems positive in my view.

Hotel stocks – buying opp or stay away? $MAR $HLT $PK $AIRB

I have the opportunity to again share the work from a friend & prior guest poster – the same author who imparted his views on cruise stocks in a prior post. This time, he’s back with some thought-provoking views on the hotel industry and the hotel stocks. Enjoy.

In #Is It time to Buy Cruise Stocks? Pt 2, we went into the heart of the Covid storm, and found that there may be solid upside if the risk sits well with you. For this article we’ll move to some of the “lighter” outer bands, as at least some portion of revenue stream continues for hotels, whereas cruise departures have been completely halted. Let’s start with some high-level thoughts on the industry, and then dig into some of the players.

Macro thoughts

If we break down hotel stays between business and pleasure, it seems reasonable to say that ~40% of booked hotel stays are business related. For the time being that implies a complete halt on 40% of hotels’ revenue. Assuming the other 60% of revenue is vacation related, it may be reasonable to assume ~50% of the vacation bucket is attributable to Loyalty Program members (see snipit from 2019 10-K below).

Digesting the above, it seems like (i) 40% of hotel revenues are completely compromised, and (ii) possibly another 30% is disrupted, as Loyalty Program members develop a lot of their status from business travel.

Enter Airbnb. Its presence represents an approximately decade long build of disruption to the hotel industry. In terms of annual revenue, it looks like Airbnb falls somewhere above HLT but less than MAR – it had approx. $1bn of revenue in Q4 19 (assume $4bn annually at this rate) – we can potentially get more details this year if they move ahead with IPO. Note that when considering HLT and MAR revenue, I’m excluding “Cost reimbursement revenue”, as there’s corresponding expense with this item (e.g. franchisor pays some expenses, and franchisee reimburses). Airbnb is a sizable force in the markets, but I’d also assume it does not have and cannot really get a share of business travel yet (easier from liability perspective to encourage employees to stay at big name hotels, rather than with miscellaneous landlords). What does this mean in Covid?

  • I’d guess Airbnb is benefiting from the suffering of hotels. Would you rather stay in an isolated mountain/lake house, or in a hotel resort teeming with tourists? Assuming you’re not a Covid denier, then probably the former.
  • While business travel should in theory return to the big-name hotels, this may not come for a longer time – why would a business risk Covid outbreaks for the sake of business travel? Seems unlikely unless business travel is essential to the functionality of the business. Further, a blow to business travel inevitably means some level of reduction to vacation stay for hotels.
  • Similar to analysis in Covid so far, showing e-commerce adoption has accelerated, it could be the same that Airbnb share has also accelerated (hence why they may be pushing for an IPO despite a terrible operating year…)

While hospitality may not be an awesome industry to be in at the moment, can we still find businesses that will persevere, and potentially emerge well once the dust settles? In exploring MAR and HLT below, we’ll discover that a sizable portion of their businesses come from franchisor/franchisee relationships. This leads to another question – is it better to be the franchisor or the franchisee? We can explore Park Hotels and Resorts Inc (PK) to get a flavor for the differences. Unlike the Cruise Pt 2 analysis, less of the below focuses on whether these companies have the liquidity to survive Covid – cash is still coming in the door, even if the demand recovery may not be as a resilient. It instead explores more of the pre-Covid operations for MAR and HLT, and thoughts on what that means going forward.


Historical revenue demonstrates a push to franchisor/manager business, rather than own and operate. Note that HLT spun off PK and Hilton Grand Vacations Inc (HGV) (owned hotel and timeshare businesses) at the very beginning of 2017, hence why you’ll see the change in revenue presentation and overall split.

My quick takeaways are:

  • Revenue per Available Room (“RevPar”), hotel room revenue divided by room nights available over the applicable period, has had immaterial changes for each company over the last six years, but MAR converts more $ per room then HLT.
  • MAR derives larger portions of its revenue from franchise/management fees than HLT. Given HLT’s spin offs of PK and HGV, it is clear the biggest players see more value in reducing the tangible assets on their books.

I’m not seeing crazy differences in the debt profile of the two. But compared to cruise lines, MAR and HLT are noticeably better capitalized and have generated sizable free cash flows compared to the debt on their books (15-20% each year). But MAR and HLT are noticeably more expensive – EV/EBITDA at 20x+, while cruises were closer to half that.

How well do MAR and HLT translate revenue into cash? #What Drives Stock Returns Over the Long Term? pointed out that growth in free cash flow per share often drives long term value. In looking over a 6 year horizon, the below free cash flow illustrations seem to speak to this point, with better overall performance from MAR.

In the above, I removed timing differences between reimbursement revenue and expenses; these items are supposed to offset one another over time, so it seems more appropriate to exclude noise from these pieces.

So, what does this mean going forward? MAR and HLT’s stock prices are down ~32% and ~18% since beginning of 2020. As you’d expect these entities faced losses, largely driven in Q2. However, there are still positive free cash flows, expectedly coming from changes in working capital accounts.

Looking at 2019 10-ks, debt maturities don’t become significant for HLT until 2024 (i.e. less than 40m), while MAR’s are more significant at ~1bn+ each year 2020-2022 (bigger red flag). The cash situation for these two feels better than what we saw in cruise stocks, but I think a significant con is that business travel may not come back for some time (i.e. until a vaccine is found)- I’d be more inclined to bet on cruise demand coming back faster than business need for travel lodging.

The Q2 MAR earnings call transcript may be worth a read. In that, they discuss cash burn with in a scenario where demand doesn’t pick up meaningfully from here. Running a quick liquidity analysis on MAR below, survival horizon for MAR seems around 3+ years.

If you’re quietly optimistic that Covid will be meaningfully resolved next year, then there may be potential upside in these stocks, but if you consider FCF yield then you’re probably disappointed at current stock prices. The 2019 FCF per share were $5.57 and $4.76 for MAR and HLT; if we want a 10% FCF yield that implies stock prices slightly above and below $50, but meanwhile the stock prices are around $100 and $90. Additionally, it’s probably going to take some time for FCF per share to come close to the 2019 levels. Not attractive points from a cashflow perspective.

Let’s explore a player on the ownership side of the house to see if that noticeably changes what we’re seeing.


As noted above, PK was spun off of HLT back at very beginning of 2017. As expected in looking at end of 2019 vs Q2 2020, there’s more debt on books to generate cash on hand, and unlike the above franchisors, the costs associated with maintenance and operations of the hotel real estate is entirely reflected on PK’s income statement. The stock price has declined ~62% since beginning of year (significantly more than MAR and HLT), with its discontinuation of dividend payments back in May further crushing investor sentiment. See below for some quick snipits comparing PK’s 2020 financials to 2019.

Reductions in PP&E, wipe out of goodwill, increase in cash with corresponding increase in debt – all things I’d expect to see in this Covid environment.

The income statement data isn’t any better.

Free cash flows are also already negative – noticeably worse cash situation than MAR and HLT, as those companies have still been able to stay free cash flow positive in 2020 thus far.

PK is a Real Estate Investment Trust (“REIT”) for US tax purposes, meaning there are requirements from the IRS that need to be met for the entity to preserve flow through status (i.e. no entity level income tax for federal tax purposes). These requirements include and are not limited to distributing the majority of taxable income to shareholders (REITs often distribute all of taxable income anyway), holding a certain % of assets in real estate, and ensuring the majority of income is derived from passive real estate sources (see Section 856 of the US tax code for additional details). Hotel REITs include additional complexity, as most hotel REIT structures involve (1) creation of a Taxable REIT Subsidiary (“TRS”) where hotel operations occur, and (2) a lease agreement between TRS and REIT whereby REIT owns the assets and TRS makes payments to REIT for use. The nature of this arrangement is intended to mirror a typical real estate arrangement. Hotel REIT players try to maximize REIT income by ensuring the lease agreement strips most of the kosher earnings out of TRS.

My concern here is more a generally pessimistic view of the recoverability of REITs post recession. Distribution requirements make it hard for a REIT to hold on to cash; there is a concept known as “consent dividends”, whereby REIT shareholders may agree to recognize a deemed dividend in their income without cash actually moving outside the REIT, with this fulfilling the REIT’s distribution requirement. But this obviously does not apply in a public REIT context.

Furthermore, REIT investors are mostly concerned with annual yields generated by investment, making cash collection more impractical. While REITs are able to generate net operating losses (“NOLs”) to the extent that they have taxable losses, NOL usage is done on a “post-dividend basis”, making it tough to monetize them since REITs typically distribute out most of their taxable income.

While I think the above points make it hard for REITs to come back after a downturn, I can see a potential opportunity for prospective Buyers (e.g. Blackstone, Brookfield, etc) with cash on hand to buy real estate at a heavy discount (see WSJ article Public Real-Estate Companies Are the New Way to Buy Distress for example). In looking at PK, I tried to compare the net asset value to market capitalization to assess how discounted PK is currently trading. Below I’m assuming that the FMV of land and buildings/improvements is equal to original cost (likely conservative since most of the real estate was acquired back in late 2007).

I’m estimating market cap at ~2bn and net asset value at ~4.7bn; these quick estimates at least directionally tell me that prospective buyers could likely get a pretty sweet discount if they tried to buy the assets.

That said, I think that you can probably find this trend and opportunity across non-hotel REITs as well, and therefore would be more inclined to pass on buying PK.

Thank you again for this great guest post. My main takeaways from this are:

  1. Cruise lines over hotel operators might be better risk/reward, as at least with cruise lines there are signs that demand is still strong once ships can take-off (so becomes just a liquidity consideration in the near term, which you can bracket)
  2. Not getting paid much for the franchisors. The franchisors, MAR and HLT, are historically good businesses. Asset light and generating strong FCF, but at the end of the day, revenues / performance are going to be tied to how the hotels are doing. Its going to be hard for them to just sit and generate FCF when their franchisee base is struggling. With the stocks currently trading at ~20x peak FCF (2019 levels), it doesn’t feel like you are getting paid for any downside risk (e.g. do the franchisees want forgivable loans or some re-cut of the franchisee agreements to survive)
  3. Airbnb wildcard. Airbnb has been a concern to the industry for years, but frankly the impact hasn’t been too noticeable yet (e.g. hotel revenues continued to march up despite Airbnb’s new presence). However, that may change in the future….

Should you hold Apple stock here? $AAPL

I’m an Apple shareholder and the meteoric rise in Apple stock has me questioning whether I should hold on or move on.

One problem with this, and why I don’t think Buffett will sell, is opportunity cost. Selling Apple stock to hold cash isn’t really a great option right now. Yes, yes, cash has option value in itself, but the only reason why I’d be selling is my scant perception is that Apple stock has gone up really quickly and so maybe it is “fully valued” at this point.

Personally, whenever I sell a really high quality company due to valuation – that ends up being a bad decision.

Think about what this would mean right now if you count yourself as someone who is a “traditional” value investor (i.e. someone who looks for low P/E stocks) – this means selling a really high quality company to probably go invest in a lower quality company trading at a low multiple. Not a particularly great trade-off in my view. That multiple is probably low because of low growth, low ROIC, high cyclicality or some other reason.

If I stay on this broad topic, I also think the market is rarely so grossly wrong on a blue chip, top component of the S&P500. Yes, we have had instances in the past where everything just gets overbid in a mania (a la, the tech bubble where even GE was trading at 50x earnings). Also there are plenty of cases where the leaders of the S&P at  the start of the decade aren’t there by the end of it. But largely the market is a pretty good weighing mechanism.

In sum, tech bubbles are rare. But the stock market being a pretty good estimator of company value? Not so rare.  One reason why active management is so hard.

Frankly, if you’re reading this and thinking the stock has gone up too much, you’re probably anchoring to when Apple stock traded at 14x EPS and now trades for 30x without really much thought as to why 14x was right / wrong and 30x is wrong / right.

Ok, back to my view on Apple’s valuation. What do we need to believe here?

First, I like to go a look at Apple’s estimates for some expectations investing. I see that consensus is expecting the company to generate ~$75-$80BN of FCF for 2022-2023.

So let’s say they generate $77.5BN and using a short-hand 20x multiple of FCF (or 5% FCF yield), that’s a $1.5 trillion valuation. Wow. That would be a $363 pre-split price compared to $487 price at the time of writing. What else am I missing?

Well cash on hand is something else. Apple has $93BN of cash & equivalents (another $22/share) plus long-term investments (which is essentially Apple’s hedge fund) which is another $100BN (or $23/share). Yes, Apple has $100BN of debt, but they could have $0 of cash, be 2.0x levered and still be high investment grade. I’m not concerned whatsoever about that debt, so don’t view it as unfair to net the cash.

Add the cash together with the value of the business and you get $363 + $45 of cash, for a quick-hand value of $408 / share. Now, all of this was a very cursory estimate. For example, I change my math from a 5% FCF yield to 4% FCF yield, the price I get is $498/share. At this point, it’s hard for me to say that 4% is any worse than 5%.

I traditionally say my equity IRR over the long-term will approximate the FCF yield + the LT growth rate in the stock. So a 10% FCF yield in a low-to-no growth industrial will probably be around the same return as a 5% grower at 5% FCF yield (as long as you have long-term confidence in the FCF ). Can Apple compound earnings at 6% from here for a 10% total return? Maybe not, but all they need to do is 3% for a 7% return. And for an annuity-like business like Apple, that is as Larry David would say – pretty, pretty… pretty good.

Right or wrong, in a world of 0% interest rates, consistent cash generators will be bid up pretty high. Here’s a quick sample of companies and their FCF yields for 2021. Apple comparatively doesn’t seem crazy.

Of course, there are some other drivers for Apple recently.

The core driver for Apple here has to be the upgrade “super cycle.”

    • If you’ve been invested in Apple for a long time, you understand the stock goes through cycles and I’ve written about it in the past. It’s frankly frustrating, but the function of short-termism.
    • To rehash it, Apple’s sales go through a lull as a large proportion of users upgrade every 2 years or so. So there are big booms and then lulls and the Y/Y comps don’t look great.
    • That’s also when people hark back to the good ol’ days of Steve Jobs and say Apple can’t innovate anymore (right, like the iPad, Watch, AirPods and software moves show the lack of innovation…).
    • The story really has always been the same, but bears repeating. You don’t buy iPhone for the phone, you buy it for iOS. It has always been a software company and they continuously expand on that (AirPods being the latest hardware move, health monitoring seeming to be the next).
    • Heading into a new phone cycle is when people start to realize better results are on the come (and I have no back up, but I would say leading up to the launch is great, after launch Apple then starts to underperform again as people typically expect them to announce a new UFO and are disappointed when it’s just a new phone everyone will buy).
    • ANYWAY – the next upgrade cycle could be huge, especially if Apple is able to launch it with 5G with meaningful new speeds. I’ve seen estimates saying that nearly 40% of iPhone users are due for an upgrade. That would be a huge boon to Apple.

Apple’s bundling could create a “services” powerhouse

    • First you need to understand how profitable “service” business are. Apple has 64% GAAP gross profit margins for services. I assume its CAC must also be much lower than other players, again because of the iOS ecosystem
    • Services is growing well and could become a higher and higher % of earnings over time. Services gross profit has nearly doubled since the end of FY2017 and is now $31BN.
    • Something else to think about: Apple grew Service sales by nearly 15% Y/Y in the latest Q. But COGS only rose by 5%. That’s big operating leverage.
    • These recurring revenue streams are not only valued highly, but has a positive feedback loop in keeping everyone in Apple’s ecosystem!
    • Apple next launched “bundling” most recently and this could be a game changer.
    • Apple reported on its Q3 call that, “we now have over 550 million paid subscriptions across the services on our platform, up 130 million from a year ago. With this momentum, we remain confident to reach our increased target of 600 million paid subscriptions before the end of calendar 2020”
    • Those are huge figures in comparison to a Netflix and Spotify which have 193MM and 140MM paid subscribers, respectively.
    • Again, I view this as classic Apple. They changed the game with iTunes and made it tough to compete. The same could be true with whatever they bundle.
    • Apple could bundle Music, TV+, News, Cloud storage, as well as new growth arenas like gaming and perhaps health monitoring. Charging a low price for all these services / month might mean low profit at first, but huge scale benefits. You also drive your competitors down.

Bundle services… Bundle hardware

    • What if you were offered $100 off a product bundle if you bought a watch, iPhone/Mac, and AirPods together? Look, I only have 2 out of the 3, but I’d be tempted.
    • Apple wins despite the discount because they move more hardware and increase adoption of the iOS ecosystem
    • Then they push the software bundle. Rinse and repeat.

Each of these items make it a bit more exciting to be an Apple shareholder, but more importantly, they may be things that current estimates don’t factor in yet. In other words, especially the latter two items here, there could be further upside surprises.

Nothing I can see jumps off the page to me to say, “holy cow – GTFO.” So I’m staying put.

Is Dropbox a GARP Stock or a TRAP Stock?

Perception around Dropbox stock is eerily similar to Facebook. To be clear, investor perception of what is going on with the company seems to be different than reality.

Whenever I used to pitch Facebook stock I would hear things like,

  • “Oh well I don’t use that anymore – does anyone?” Well yeah, Facebook is growing users still and don’t forget Instagram and WhatsApp (the latter of which is very under-monetized to this day).
  • “I’m not sure some of the risks are priced in yet” despite the company trading at 10-12x EBITDA for an extremely high ROIC company growing 20% per year and with no debt.
  • “What’s the terminal value of Facebook? Isn’t it just the same as Myspace?” Let’s not compare a company with like, a third of the planet as monthly active users, to Myspace…

All of this added up to a great GARP stock – growth at a reasonable price. And I still think Facebook is somewhat underappreciated… but that is why I continue to hold. I think over time, they will outperform low expectations.

Today it’s harder to find value across some of these tremendous powerhouses, but there are some pockets of value. Dropbox seems like a name where there are a lot of doubts and a lot of concerns. This could be another GARP stock, but it could also be a value trap.

Common questions I had coming in to analyze Dropbox are:

  • Are they still growing users? And if so, are they monetizing it effectively while also balancing the risk of people leaving?
  • How do they compare to a name like Box?
  • Why has the stock floundered since IPO?
  • If I’m convinced the stock is worth taking a risk on, what’s my downside?

Is Dropbox still growing?


Let’s not forget, they were pretty early into the cloud storage game – I think Dropbox might personally be the first one I had ever heard of.

This is an industry that is benefiting from increased storage from mobile devices, while wanting to reach those documents anytime, anywhere across devices. At the same time, companies want to seamlessly collaborate and the cloud is a great solution.

Dropbox is estimated to ~658MM users by Q3’2020, though only 15MM (~2%) are paid. This tells me that there’s room to convert customers to a paid model. And when you look at the growth rate of customers, it’s clear they are converting.

But importantly, they are growing paid customers and extracting more and more value from them (i.e. ARPU is going up). Another thing to note, Dropbox closes inactive accounts after a period of time so these numbers aren’t counting a large swath of ghost accounts or anything like that.

On the topic of increasing value with existing customers, Dropbox has really interesting cohort analysis that they’ve shared twice now, first in the IPO and second for their 2019 investor day.

Here’s what they said at their IPO:

 “We continuously focus on adding new users and increasing the value we offer to them. As a result, each cohort of new users typically generates higher subscription amounts over time. For example, the monthly subscription amount generated by the January 2015 cohort doubled in less than three years after signup.“

And then at their investor day in September 2019:

“So for example, for the 2013 and 2014 segments, we looked at all users who signed up over the course of those 2 years, we then compared their ARR shortly after sign up to their ARR today, which is quantified in the 8x expansion multiple on the right-hand side of the chart. The same logic applies to more recent segments with whom we’ve driven 4x and 2x ARR expansion, respectively, and our cohorts really underpin our highly predictable business model. From the moment a group of users begins their journey with Dropbox, we have a high degree of visibility into their monetization patterns over time.”

I think Dropbox may be an interesting acquisition target.

For example, how much more valuable do other one-trick ponies like Zoom and Slack (with now huge market caps, the latter of which is double DBX’s) get by buying DBX?

They can go to their customers with a much more valuable proposition – “buy the premium version of Zoom and get your document solutions taken care of as well. We’ll integrate everything.”  Supposedly, Dropbox looked at acquiring Slack for $1bn, and that deal makes sense, but was turned down by the board. Now Slack is around $16bn market cap, so now the opposite could happen.

Dropbox historically focused on the consumer end market, not enterprise. I see a risk here that a would-be acquirer may already want someone entrenched in enterprise, but if anything, having ~650MM customers, 15MM of which pay, may help the sale. It may help both of them win with enterprise.

DBX is trying to move into enterprise and it just announced it won a contract with the University of Michigan for its school services, which is a huge enterprise win.

How does Box compare to Dropbox?

The longer-term risk is obviously competition from big platforms already out there. Microsoft has Onedrive, Google has Drive, and Apple and Amazon also offer storage. There’s nothing really sexy about storage, it’s really just how the consumer likes to interact with it. In fact, Dropbox outsources the storage to AWS….

However, I would say Dropbox’s offering is the best I’ve seen for collaboration and while the Michigan contract is just one data point, I do like that the company is growing users, growing ARPU and we’re seeing signs of wins on the enterprise side against incumbents. It seems like Dropbox will win Michigan at a cost (seems like Michigan was unhappy with Box trying to move price and limit storage), but the IRR to DBX is likely high (see LTV/CAC below).

I can’t visibly see where DBX is retracing yet, though obviously the tailwinds in the market are strong, so growth in users not being higher maybe is a concern? Its true that the vertical cloud players are growing 15%+ vs. Dropbox’s 10% growth rate.

If I think about whether their product is getting better or worse, I think it also is clearly getting better. Some of their new add-ins are things like HelloSign, essentially a DocuSign competitor, but one that works seamlessly across platforms (such as integration into Gmail). They also seem to have a password manager, similar to Lastpass.

But this also makes me wonder how they compare to others. I would say Box is actually Dropbox’s main competitor and I think the two will be fighting for the same customers now that Dropbox wants to grow in enterprise.

Perhaps I am biased because I work for a large firm that is concerned about security, but I see little odds they choose a Google product for enterprise. My firm actually uses Box. Maybe we’re not using all the functionality, but it’s nothing to write home about. I did think Dropbox’s Spaces looked very similar, but had some cool features anyone curious should check out. Onedrive is the real competitor if it can make its capability more seamless and allow people to collaborate easily with Word, Excel and Powerpoint. This is what truly scares me….  How do you compete with someone who is fine giving away your core product away for free… But again, Dropbox’s win with U Mich implies they beat Microsoft as well.

Google search trends aren’t that inspirational either, though the tough part about this data alone is that DBX has clearly been growing.

Turning to the financials side, I took a look at some recent figures. From this alone, I would say Dropbox > Box.

For one, Dropbox generates a ton of FCF and much better LTV/CAC. Thinking back to HelloSign and the Lastpass competitor I mentioned, I do think Dropbox’s FCF also provides it room to acquire technology and bolt it on to its existing system. In that case, the acquiree instantly gains a lot of users for that technology and it’s scaled, while also providing a positive feedback to existing Dropbox customers who gain more benefits.

Why has the stock floundered since IPO?

Funny enough, the company has beat analyst expectations every quarter since IPO. They actually made a slide about this in their investor deck. However, I think in DBX’s case it IPO’d with too high of expectations. At one point it was trading at 8x EV/S and 31x P/FCF… now it trades at 4x 2020e sales and 17x P/FCF.  In sum, the stock has stayed roughly flat while the company has grown into the valuation.

 If I’m convinced the stock is worth taking a risk on, what’s my downside?

Buying a stock with low built-in expectations is how I think you outperform. Unfortunately, I’m still not that convinced if DBX is a stock worth the risk (i.e. that expectations are low enough).

On one hand, the company guided to a $1BN of FCF by 2024. At 10x FCF, that would mean there is upside in the stock (maybe 20%, though there will be dilution from now until then, but 10x FCF is a cheap multiple). At 15x FCF (still cheap relatively speaking), it has 75-80% upside.

But I do wonder how investors get over the terminal value question (i.e. it generates cash, but am I just left with a stub piece here? Should I value this like a NPV of a declining annuity?). I don’t see Microsoft going away anytime soon and clearly their stock is ripping due to growing annuity like businesses (the cloud).

Also, when I do some analysis of what the LT operating margin the company should operate at, I get a rate that isn’t much higher than today (LTM op margin is ~20%).

With SAAS companies, generally the new business is negative margin, but it’s all about the renewal business which is very high margin (i.e. you spend all the money to acquire new customers and once they’re locked in, you can figure out the churn math and costs to serve your existing base). That’s why it’s hard to value traditional, early stage SAAS businesses by just lapping a P/E multiple on them.

Here’s my math on Dropbox’s long-term margin potential.

Offsetting this analysis is that management is guiding to much higher operating margins over time – in the high 20s to even 30% range.

That’s great, but when I read how they get there, I have some concerns for the long-term trajectory of the business.

“And so this year, as well as longer term, we plan to drive more efficiency and higher levels of productivity across really each of our operating expense categories. So across R&D, we’ll be prudent with headcount expansion as we drive adoption of the new Dropbox and optimize some of those team-oriented conversion flows that are associated with it and then also as we invest in new high ROI product launches. And then across sales and marketing, we’ll be focusing our spend to support adoption of the new Dropbox. We’ve been doing this already this year while prioritizing our most strategic growth and monetization initiatives.

And I would note that as we execute to our expense targets, we won’t be reducing our investment in our growth engine and new product development. We’ve really carefully considered where we can drive material efficiency improvements across the business while preserving investment in our highest potential product and growth bets. And if you look at our execution over the course of this year, I think that’s emblematic of that philosophy.“

No question, I should be happy when a company is financially prudent, but this is a serious question to ask when you have several 800lbs gorillas. Is this GARP or is this a value trap? I do like how they’ve stated that they aren’t reducing spend in the growth department and like I said, I could also see them just shutting off opex and ramping M&A (the Valeant of SAAS stocks LOL).

I think I’m going to hold off for now on Dropbox, but I am watching it carefully. I think they have a good product and I’m sure I’ll kick myself when I see the M&A announcement eventually come through, but I don’t really see a rush to come in yet or any misunderstanding of the business. Unlike Facebook, I can’t count on Dropbox being a category killer in present time. Facebook concerns were centered around some “known unknown” whereas we know a lot of competitors that could chip away at the company.

If there’s another area where I’m probably wrong, its management. Drew Houston is the founder / CEO of Dropbox (and also a recent addition to Facebook’s board). He seems like a sharp guy. There’s been some mgmt turnover at Dropbox (COO and the CFO). That’s either bad – the company is sinking and everyone is moving on. Or its good – Drew is unhappy and a big shareholder so he’s shaking things up. I guess we shall see. We don’t know who the next CFO is, but the new COO came from Google and was at McKinsey prior to that. Seems positive so far.

Is it Time to Buy Cruise Stocks? Pt 2 $CCL $NCLH $RCL #COVID19

It’s always a pleasure to share these pages with like-minded people. Today’s post was written by a very smart, very diligent guy — who just so happens to be a long-time friend of mine. During COVID-19, he’s scrutinized one of the most “center of the storm” sectors: the cruise line stocks . I was thrilled when he accepted the invitation to share his thoughts and work on the blog. I know you will be, too.

With almost five months of lockdown behind us, logic would tell most that the outlook for the cruise industry has gone from bad to worse. As you’d expect, most cruise lines have spent the last few months pulling together survival dollars for what could be the worst storm to hit while not sailing. But even in the darkest of times, could there be light at the end of this tunnel? Article #Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus identified what I think is a very counterintuitive point – even when some of the most horrific events have hit cruise lines, their demand has been remarkably resilient in the following year(s).

For those who like bottom lines up front – I think CCL probably has best chance of survival, and a lot of assumptions used in this analysis are pretty conservative. This is a big gamble, and I’m not expecting any potential pay off until 2022 at the earliest (although reckless day traders may create some wild ups and downs along the way), but the payoff could be exceptional.

The case for strong demand recovery

So what happened after a massive pandemic hit, confining people to their homes in March and April…see Carnival swamped with cruise bookings after announcing August return or What pandemic? Carnival Cruise bookings soar 600% for August trips. When CCL announced cruise returns in August 2020, bookings shot up, with the spike reflecting a 200% increase in bookings over the same period in the prior year.

Who are these people making these bookings? Will these spikes in demand last? Even if there is strong demand, won’t governmental restriction stymie all chances for recovery here?

All great questions. The first two cannot really be answered definitively. If the past can be used to determine the future, it is fair to say that cruise demand has historically come back strong even after disastrous events. Further, many people seem to be of the mindset that Covid is here to stay, and are accepting its spread while hoping for a low death rate (whether this is an ethically acceptable position is an entirely different discussion and far out of the scope of this article’s analysis).

The last question is probably the most important here – where does governmental restriction fit in all of this? In my opinion, it is the most important final step in the recovery. If demand is there, but governments forbid sailing, then demand becomes irrelevant. Your guess is as good as mine here, but demand assumptions for the rest of this analysis are:

  1. No more cruises will sail in 2020 – only revenue accumulated was Q1’20, with a complete halt to revenue for the remainder of the year.
  2. Demand in 2021 is 50% of what it was in 2019.
  3. 2022 resembles normal operations – EBITDA falls somewhere between the min and max annual EBITDA generated in 2017, 2018, and 2019.

After diving into the financials of CCL, RCL, and NCLH (“The Big 3”), it looks like these three cruise lines have the ability to survive into next summer with no cruise activity. While some of these may be able to last longer, failure to resume sailing in the peak season for cruises (i.e. the North American summer months) would likely be a final dagger for these businesses. CCL looks best poised to survive of the three, so more of the below will focus on them. Note that as of date of this post, cruises in the US will not resume until October for The Big 3; however, some European cruises are still scheduled to go ahead as planned.

Survival – what does liquidity look like over the next year?

Let’s start by getting perspective on what debt looked like on the balance sheet for The Big 3 pre-Covid. Looking at Net Debt to EBITDA and FCF as a % of Debt (avoid using equity in this kind of assessment, as companies can mess with it via share repurchases, dividends, etc):

CCL looks best capitalized coming into this mess, and has traded cheaper in comparison to the other two – EV/EBITDA ratio is ~20% less than the other two at the end of 2019.

As you’d expect, over the last few months The Big 3 have moved quickly to build up liquidity to survive this next year, drawing down revolvers and issuing new debt. Some of the debt issued at CCL and NCLH are convertible notes, so assuming these companies recover I think it’s important to factor dilution into any analysis that you run. NCLH also took in additional equity investment from both the public and via PIPE from L Catterton.

Now let’s put together some pro formas for CCL. What does a projected income statement look like?

As expected, these next couple years look rough, but I’d like to reemphasize that 2020 assumes no additional revenue, and 2021 assumes 50% demand – unless Covid goes from bad to worse than we could have ever expected, these feel conservative. This analysis also does not bake in the benefit of reduced fuel prices that may stick around these next couple years.

Where does this get my cashflows?

Using rough numbers here, analysis projects that $7.3bn of financing is needed over next couple years ($3bn in 2020 and $4.3bn in 2021). The good news (depending on how you look at it) is CCL pulled $3bn from revolvers in March and issued $5.75bn of new debt in April (some of which is convertible, and should be assumed converted if CCL recovers), meaning they’ve already achieved the financing needed based on these projections. My above cashflow projections also assumes all treasury shares are reissued at approx. 80% loss, and per the below, 62.5m of the 190m shares have already been reissued.

Other comments on cashflow:

  • 2020 sales of shipsCCL plans to sell 13 ships in 2020 (approx. 10% of its fleet). I assumed $150m sale price per ship in my above cashflow estimates. I don’t think this is actually that alarming, as (1) these ships are probably older, and needed to go at some point anyway (who wants to ride an old cruise ship), and (2) 10% of fleet isn’t that bad given that they are the biggest cruise operator with ~45% market share. Competitors have also done and/or will probably do the same.
  • Cash outlays for ship orders- I’ve assumed that commitments for new ships will be wiped out over next few years. I think it’s fair to assume that CCL is probably under contract to take them, but in this environment they’ll probably tell the shipbuilders to pound sand the next couple years. It’s probably in the interest of the shipbuilders to suck it up as well if they do think CCL can recover – way worse trying to get paid if CCL gets forced into bankruptcy.
  • Credit vs cash refunds- so far, approx. 60% of customers have elected a to receive a future cruise credit rather than cash refund for their postponed cruises – definitely a positive sign for pent up demand

  • Breakeven point- the CCL Q220 earnings call transcript may be worth a read. David Bernstein (CCL CFO and CAO) notes that the breakeven point on an individual ship basis is generally 30-50% of capacity. He estimates that they’d need to run approx. 25 ships for cashflow to breakeven (approx. 25% of fleet). I view this as validation that my analysis is conservative, as I’m anticipating a cash shortfall in 2021 with 50% demand.
  • Debt covenants- I found some of the debt covenant specifics for RCL (net debt to capital ratio, fixed charge coverage ratio, min networth, etc); wasn’t able to find these for CCL and NCLH, but it looks pretty clear that The Big 3 will struggle to meet these. But similar to view on new ship orders, creditors will probably be willing to grant leniency if there is a light at the end of the tunnel – most lenders want to avoid seizure of assets and bankruptcy proceedings.

Other Considerations

  • Bankruptcy- while I definitely see potential upside in an investment in CCL, it is definitely risky. If Covid continues to unfold in a horrific way into 2021, The Big 3 could be pushed into bankruptcies. But important to consider impact to CCL if RCL and/or NCLH go down while it stays afloat. RCL is the 2nd biggest behind CCL – if it files Chapter 11 and is relieved of some of its debt payments, it could suddenly have the opportunity to compete more aggressively. If RCL drives its prices down, it could force CCL to follow, driving CCL into bankruptcy. Takeaway here is that bad news for the other two could ironically lead to bad news for CCL.
  • NCLH differentiation- while NCLH’s balance sheet looked bad going into Covid, two points that I think help its survival case:
    • (1) It historically focused on cruise routes that the other two were not focused on. See snipit from 2019 10-k:

    • (2) its ships are significantly smaller (~30+%) than RCL and CCL. This could come in handy if governments put official caps on the number of people that can be on a cruise at a given time (regardless of ship size).
  • Cruises sailing in 2020analysis assumes no cruises again until 2021, but if some of these carry on (unlikely in the US, but maybe more likely in Europe), it will be very important to track the outcomes and potential regulatory responses.

Bottom line

If betting on the survival and recovery of cruise lines is something that you’re interested in, I think CCL is the best bet. Back in March the market priced death into the Big 3 stock prices, and stock prices of these at the time of this post are not far from those March prices. Applying the lowest PE ratio from the last 10 years (excluding Covid) to this analysis’ EPS estimate shows a sizable ROI is in the cards. By no means should you view this as a real way to project the stock price, but point is that there’s a lot of potential upside here if you can handle the risk.

Caveat emptor. Hope you find this helpful!