Tag: equity

Canada Goose: It’s Still Early Days $GOOS

This will be a brief post, but I think Canada Goose is a fantastic luxury brand. Someone buying GOOS stock today is still coming in very early in its life cycle.

A quick digression first: What makes LVMH so great? It’s composed of premium, luxury brands that we all know. Louis Vuitton, Moët, and Hennessy are products that elicit a good feeling whenever you buy them, even if you know the price is a little wild. For some of their consumers, they don’t even look at the price.

I think it’s obvious why LVMH tried to acquire Tiffany then. It exhibits the same characteristics. But alas, the Tiffany’s deal has seemingly failed (for now). Tiffany has high mall / retail exposure and weddings this year are clearly being pushed. I’m sure LVMH is still interested in owning Tiffany’s, just at a lower price.

But as I mentioned in a post on what drives long-term shareholder returns, these brands are able to increase price ahead of inflation, which drives great top line performance and even better bottom line performance. It’s no wonder that these companies have compounded at such high rates (LVMH especially).

But brands are tough. You have to make a feel on how powerful the brand is. Do I think YETI has a strong brand? Yes. But maybe just for now… People may not think it’s very cool or iconic to have that brand of $300 cooler in 5 years from now. Its possible. I do, in fact, have a YETI koozie.

Investing in brands is hard. Picking winners and losers in not easy. Some people though GoPro had a good brand that would protect it in the harsh hardware world. Blackberry was also a ubiquitous brand, but then another brand came along that is more ubiquitous. Victoria Secret seems to be losing share, Lululemon seems to be gaining share…

I could go on, but the point is understand those risks. I just think Canada Goose is different. Footnote, I don’t have one of these jackets despite living in an area that gets very cold. I view it like a Ferrari of jackets.

Here’s another anecdote, one of my close friends shared that she had an early version of the Canada Goose jacket. She held on to that jacket for probably 4-5 years and then sold it online for nearly what she paid for it. That is amazing brand power.

I think the GOOS stock is worth a bet for several reasons (please do not miss the DTC bullet near the end):

  • Best in class brand
  • Long-term optionality to expand outside of just outdoor jackets
    • GOOS did $400MM of sales in FY2017 which has doubled in LTM June 30 2020. It’s still early days.
    • Right now, the bulk of sales comes from selling $1,000+ intense weather jackets. They could easily leverage the brand into other weather gear
  • Still very early days (opening up 4 retail stores in China)
    • Right now, the company mainly sells through wholesale distribution (i.e. Canada Goose jackets in other peoples stores), but they have launched their own stores
    • Right now they just operate 20 stores themselves, but as they grow and expand the brand, it’s possible to see the number of stores increase by a few multiples of the current amount.
  • I’m writing this in COVID-19, a global pandemic that has caused a steep rise in unemployment. However, the cohort of people who are buying Canada Goose are likely the same cohort that has seen very limited employment impacts this year.
    • LVMH, for example, saw sales +4% in 2008 and roughly flat in 2009 in what was close to a Great Depression
    • GOOS sales will be down this year (consensus has down ~20%), but as the pandemic subsides I think they will still be here and be back on track. If anything, consensus probably underestimates mix shift and underestimates new launches from the company.
  • This winter could surprise to the upside
    • Yes, if everyone is still working from home, it’s less about buying that jacket to show off. However, if everyone is still at home, they’ll pay whatever it takes to keep being able to take long strolls.
  • This could accelerate direct-to-consumer conversion
    • “Today’s reality has reinforced long-standing pillars of Canada Goose’s DTC strategy: globally scalable in-house e-Commerce and omni-channel innovation. With digital adoption rising rapidly, the Company has increased and accelerated investments in these areas going into the Fall / Winter season. This includes the launch of mobile omni-channel capabilities in U.S. stores, following a successful pilot in Canada, and a cross-border solution to expand international access.”
    • DTC represent 55% of revenue today. However, it has an operating margin of 47%. If mix shift goes more and more towards DTC, that would be very positive for the company (total operating margins are around 20% on a normalized basis).
    • For example of how this could impact the company, GOOS did $193MM of EBIT for the 12 months ending 3/30/2020 on $958MM of sales (20% margin). If the company grows to $1.2BN of sales and 65% of that is DTC at 47% operating margin, they would produce around $365MM of operating income from just DTC, or about double the TOTAL EBIT they do today

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.

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.

What Drives Stock Returns Over the Long Term? $AMZN $MSFT $KO $COST $ROL

We’ve all heard that the value of a company is the present value of its discounted free cash flows. But I wanted to share something I found pretty interesting. What drives stock returns over the long run? It seems pretty clear that it is the growth in free cash flow per share.

 As the tables below show, this one metric has a high correlation with the long-term growth in the stock price. We just mentioned what a DCF is so that may sound totally intuitive. Yet seeing the results are actually quite surprising to me. I say this in the context of the “random walk” stocks seem to follow day-to-day or even year-to-year. In sum, I think if you have high confidence that a company can compound its FCF/share at above market rates, you’ll probably do pretty well.

The second interesting thing is that I’m not showing starting EV/EBITDA multiple or P/E. All I’m showing is the FCF / share CAGR and the stock CAGR. So did the stock “re-rate” or “de-rate” it didn’t seem to matter in the small sample size.

A couple of notes (admittedly may be selection bias) I’m only showing names with long history and I’m trying to avoid some poor returning stocks with finance arms (Ford, GM, and GE) because that clouds FCF. Last, I’m using the end of 2019 to move out some of the COVID related movements.  One thing this doesn’t capture either is dividends collected along the way, but that should be relatively limited in most cases (but I did exclude Philip Morris for this reason).

In closing, I would look for names that you have a high degree of confidence of growing FCF/share at a strong rate. Obviously, the normal investment checklist applies – does the company have a moat to protect those cash flows, does it have a long investment runway, is it in a growing industry, and is it gaining scale to compound cash flows? Clearly, this drives stock returns.

I think if you were to show more commodity names as well, it would show how hard it is to make money over the long term. Not only do commodities have to deal with the larger business cycle, but they often have their own cycles within whatever they are selling (e.g. gold, copper, TiO2, etc. can move around considerably year to year and decide a company’s fate).

Breaking Down Fastenal’s Moat in 3 Points

Fastenal is a company that sells nuts, bolts, and other industrial and construction supplies. Pretty simple business – and definitely not sexy. How then has Fastenal stock created so much value? In keeping with comparisons to other high-flying stocks on sexier businesses (like my post on NVR) Fastenal stock has beaten both Microsoft and Apple since the 1990s!

FAST Total Return Price Chart

FAST Total Return Price data by YCharts

 It all came down to a certain way they decided to operate – its Competitive Strategy. There probably have been hundreds of fastener businesses that have come and gone over the past 30 years, and many probably never created much value. So what gave Fastenal their competitive advantage? What drove their staying power? And how did they compound earnings so effectively? Clearly, something must be going right to translate into Fastenal stock being such a long-term winner.

One thing I’d like the reader to do is think actually how similar Fastenal’s strategy is to Amazon’s (I think the latter borrowed some things from the former’s playbook).

First, some history to shed a light on the business.

Fastenal was actually dreamt up by its founder, Bob Kierlin when he was just 11 years old.  His father ran an auto supply shop in Wisconsin and Kierlin noticed customers typically drove from store to store looking for fasteners they needed for particular jobs. If a hardware store didn’t have the right nut or bolt, the store would send the customer to Kierlin’s store, and vice-versa. Bob noticed a lot of customers had to resort to buying the part, one-off, via a special order and wait.

Kierlin and four other friends started Fastenal in with $30,000 and rented a store in Winona, Minnesota. They opened a store as a one-stop shop with thousands of fasteners for retail customer needs.

But the idea was a flop and the company almost went bust.

Instead of focusing on the retail customer, Fastenal decided to pivot and focus on the commercial customer. It turned out that price was much less of a factor than timeliness for that market segment — contractors and companies often lost money searching or waiting for a particular part. Kierlin and his partners discovered that there was a great need for a service that could quickly provide the fastener or part that a buyer needed.

In short, Fastenal segmented out its buyer base and identified what their key purchasing criteria was. They focused on industrial and commercial buyers and they realized they didn’t need to be the lowest price, they just needed to have the item in stock.

At the end of the day, you can see why this makes sense.

  1. Fasteners make up a small portion of project costs (e.g. building a home, building a car), but are crucial pieces in the process that can hold up work.
  2. If Fastenal increased price of a particular fastener by 3%, their customer probably wouldn’t even notice in their project and could likely pass it on to the end customer if needed
  3. Fastenal’s customers are many in size but also small in size, so they have limited bargaining power.

Fastenal further segmented based on geographic locations.

Fastenal opened its first branch in Minnesota and continued to target very small towns. Why? By targeting small towns that had healthy construction and manufacturing industries, but were also small towns that were underserved by big distributors, Fastenal could be the only game in town.

Finding New Segments

One thing a business can do to improve its competitive advantage is find new product segments. Think about Arm & Hammer expanding baking soda into a refrigerator deodorant – that was a creative decision to target a market and improved the overall market size.

In some cases, you can find new segments by broadening and you can find new segments by narrowing focus.

Fastenal actually did both.

Narrowing Focus (and Not Being Afraid to Try Something New)

This is from Fastenal’s 1996 10-K. Satellite stores weren’t a major success, but the company did expand to 71 satellite stores opened by 2001. The key was that Fastenal was focused on improving the customer relationship. Fastenal already was getting some business from these customers in smaller areas, but they wanted to make it even easier on the customer to get their Fasteners – and it preemptively did so. Sure, it would cost resources and no one else really saw the returns from doing it, but the customer sure would be loyal. Sound familiar to Amazon?

In fact, do you know what Fastenal says its goal is? “Growth through Customer Service.”

It also reminds me of Dollar General’s strategy of serving rural America. Carve out a niche where you know your customers well and others choose not to serve and that can payoff well.

In 2014, Fastenal identified a new growth driver: Onsite locations. These are sites that are not open to the public, or a wide variety of customers, but instead serve one customer at their location.

In essence, the customer (typically a very large one) might consume enough fasteners that it could source them themselves, but they’d rather benefit from Fastenal’s scale and expertise so they hire them to serve all their needs.

Fastenal had locations like these since the 1990s, but they expanded following 2014 – growing from 214 locations to over 1,100 by 2019 and represents roughly 30% of the company now.

The company really started to build a vending solution in 2011, choosing to do so while industrial activity was still weak from the Financial Crisis.

They would give a customer a vending machine, essentially for free (estimated to be a $10,000 value), but in return it would essentially become a “mini-branch” at the customer’s site. The machines were also available to the customer 24/7 – not just when a supply room is staffed. It also helped the customer track consumption data, in some cases improving their ability to see which of their plants were consuming more or less of certain parts.

Early on, Fastenal learned that it actually cut customer consumption (2011 conference call):

As we talked about on the Amazon review, if I were to distill differentiation with a buyer into two factors it would be: cut their cost and/or improve performance.

In this case, Fastenal cut the costs for its customers buy reducing spend, but it also differentiated Fastenal as a solutions provider. It also resulted in a share shift as customers looked favorably at the vending machines (quid pro quo) and Fastenal “locked” the customer into purchasing from them.

The company now has 105,000 vending devices in the field and generate $1.1BN of revenue.

Expanding Breadth

Fastenal decided in the mid-90s to test out new products. If a customer came into the store for fasteners, they might want to pick up something else why they are in the store. Convenience outweighs price.

In 1995, threaded fasteners were ~70% of sales. By 2000, it was just 51% of sales. Now, Fastenal has 9 different product categories it sells and targeting further product diversity:

The company also decided that in some cases, it made sense to manufacture tools for a customer. This would be rare, but in some cases it would pay off royally (and gain customer loyalty).

In one instance, a Ford plant’s assembly line was shut down by a breakdown that required a few dozen special bolts. Ford’s regular supplier told the company it would have to wait until Monday—three days later. “Meanwhile, it’s costing them something like $50,000 an hour to have this line not operating,” Slaggie [one of Fastenal’s founders] said in the March 11, 1992, Successful Business. “They called us and the part is an oddball, something we don’t have in stock. We had them fax us the blueprint for the machine and we determined we could make it…. We had them finished Sunday afternoon.”

Doing some simple math, $50,000 a day is $1.2MM in cost… for 3 days that would cost the company $3.6MM. Fastenal could make a part and charge $50,000 for it, and I’m sure Ford would pay for that all day…  I have no idea what Fastenal charged in this case, but you can see why Fastenal created differentiation here as a service provider.

Decentralized. By the time Fastenal stock became public, they put out some interesting color on how they decided to manage new branch openings:

By reading the company’s filings, you can tell they first want to train their employees to understand the business and industry and then give them the power to make decisions on their own.

I’m a relatively cynical person, so I wonder to myself how the employees could possibly know more about what to stock than people who have been operating the business for 20+ years. Two words: Smile & Dial.

Putting it together

I could go on about Fastenal — there is a lot I didn’t touch on about how frugal the company chooses to be — but its performance as “just a fastener distributor” has been truly amazing.

I opened this series saying that I was tired of the terms “asset light” or “high margins” being used to say why a business is “good”… instead, you need to understand what the company has done to make its business sustainable and why they will create above average shareholder value in the long run.

Here are some summary financial metrics for Fastenal compared to other distributor peers.

What jumps off the page to me is (i) its gross margins for a distributor, (ii) its EBITDA margins and (iii) EBITA / Assets (a proxy for ROIC).

High Gross Margins: Its high gross margins relay to me that they truly have targeted their customer in a way that isn’t just based on price – otherwise I think the margins would be much lower.

EBITDA margins: Its EBITDA margins are high, which makes sense given the gross margins. But the delta between gross margins and EBITDA margins is nearly 23% of sales — meaning they spend 23% of sales on selling costs and general and administrative expenses. That’s definitely in the upper half of the group and tells me that they are spending a lot on service for the customer.

EBITA / Assets: One might look at this comp set and say, “hmmm, Fastenal’s metrics are good, but its FCF conversion (rough proxy using EBITDA – Capex over EBITDA) isn’t great because capex is so high.” That’s ok for me – when I look at EBITA / Assets, what Fastenal earns on every dollar of capex it spends is much higher than what I could go out and earn! It also will likely lead to above-average sales growth.

I hope you’ve seen from what I’ve outlined above that Fastenal is very similar to Amazon – relentless focus on the customer. But Kierlen also appreciated hiring the right people and giving autonomy, as shown in this interview I found with some hard-hitting reporters.

“I admit things I never knew how to do well – I admit I was never a good sales person, so I hired a good salesperson.” In some ways it reminds me of Steve Jobs (though it was later learned he had a tendency to micromanage), he did have a great quote:

“It doesn’t make sense to hire smart people and tell them what to do; we hire smart people so they can tell us what to do.”