Tag: equity

A Ladder Over Pandemic Waters: Short Duration, Quality Loans Give $LADR Rung Up

Reading Time: 9 minutes

Ladder Capital stock is a high conviction name for me. It is one where I see little downside and significant upside and also a situation where you are paid to wait (~10.8% dividend). Lastly, I can’t say enough how high I hold management (which also owns ~10-11% of the equity).

Ladder Capital is a mortgage REIT. Unlike typical REITs that specialize in the actual real estate, mortgage REITs specialize in… you guessed it… the mortgages that secure property.

Mortgage REITs have sold off significantly as the market becomes more concerned with commercial real estate. Several mortgage REITs used significant repo financing coming into the COVID crisis, so when there was a disruption in the mortgage market and all securities were crashing, several seemed unable to meet their margin calls…

That did not really impact LADR. In fact, management issued an unsecured corporate bond in 2019 to reduce reliance on repo funding… very timely. Did I mention management is A+ quality?

I tend to think of LADR as an investment company. We want them to make high earning, good risk/reward assets and we understand that they will use leverage in normal course of business. “Do what you think will make money, just don’t blow yourself up.” It’s clear to me they realize all of this.


LADR trades at a steep discount to book. In a hypothetical scenario, we need to ask ourselves that if we foreclosed on LADR, would we get book value or not. What price could we liquidate the assets for in an orderly liquidation. If we can get book value, the stock has 65%+ upside.

See, a lot of times investors buy financial assets below book value. But if the assets are earning a low ROE, the book value may be worth a low amount. Or you may not realize that book value for a long, long time (think of a 100 year bond with a 1% coupon when prevailing rates are at 6%… it will take a long time to get “book value”.)

My goal of this post is to show you that you can bank on book value here. And that because of the short duration of the assets, we know cash will be coming back in the door soon. As a friend put it, soon a large majority of Ladder’s book will actually be post-COVID loans…

Here is my thesis:

  • Ladder’s book is high quality; Stock at ~60% of GAAP book value, 52% when incorporating appreciation of real estate
    • Book consists of transitional first lien mortgages (which I’ll define later), but also investment grade CMBS, small amount of conduit loans, and they also have a portfolio of triple-net leased properties and other CRE that they own outright.
    • ~93% of their market cap in unrestricted cash; Or 14% of assets
    • 43% of asset base is unencumbered, 74% of which is either cash or first mortgages. This means the company has significant borrowing capacity as well (which is important, as LADR is like a bank – you want them to take $1 and make $2 or $3 of loans with it).
  • Mgmt is top notch and has history of deploying capital attractively. Dare I say, the Warren Buffett of mortgage REITs (patient, cash not burning hole in pocket)
  • Buying back both bonds and stock – both at discounts to par / book value
  • Cash is both a downside backstop, but opportunity as they deploy into distressed sectors

Let’s Break Down Ladder’s Book: Here I will detail the bulk of Ladder’s assets. Note, this is just the bulk. They also have a small amount of conduit loans (which means they make loans which will soon be bundled and sold into CMBS).

Transitional Mortgages (43% of Assets, 53% of Equity): These are loans to commercial properties undergoing a… transition. LADR has a first lien on the property, while the borrower uses the capital to bridge it through renovations, repositioning of the asset, lease-ups, etc.

While COVID has created “income uncertainty” for a host of real estate assets, these transitional properties are inherently not generating much income at the time of the loan! And here’s some commentary on that from Management’s Q2 call:

[Our transitional loans] are close to stabilization and require minimal capital improvements. Our balance sheet loans have a weighted average seasoning of 18 months, which is a little over 15 months remaining to initial maturity and 27 months remaining to final maturity. Further reflective of the lightly transitional nature of our portfolio, we have less than $150 million of future funding obligations over the next 12 months and less than $250 million in total, all of which we can comfortably meet with current cash on hand. The majority of these future funding obligations are conditional and are subject to the achievement of predetermined good news events like tenant improvements and leasing commissions due upon the signing of new leases that enhance the cash flow and value of the underlying collateral. We continue to have limited exposure to hotel and retail loans, which comprise only 14% and 8% of our balance sheet loan portfolio, respectively. Currently, almost half of our loan portfolio remains fully unencumbered, and our exposure to mark-to-market financing on hotel and retail loans is just 1% of our total debt outstanding.

As such, they typically are low duration (<2 years), lower LTV (67%), and as mentioned – 1st lien on the property. In a sense, the property value would have to be marked down 33% for Ladder to begin taking a loss. Here’s a comment from the Q1 call on the borrower – you have to think they’ll want to preserve that equity value if they can and have a long-term view:

These same loans currently have a 1.26x DSCR with in-place reserves. The significant third-party equity our borrowers have in these loans provides strong motivation for them to protect their assets and provides the company with a substantial protective equity cushion. Like all prudent lenders, we’ll be very focused on asset management to protect and enhance the value of our loans

Here is more commentary on the assets performance and the short duration:

The property types are highly varied too. In other words, it’s probably a good thing it’s not all Hotels right now. But even so, they have significant cushion above the loan value.

Let’s say you don’t like this situation. Well think about this: We are buying LADR today below book value. Therefore, you could look at as us buying 1L mortgages on a look-through basis of ~40 cents on the dollar (i.e. 60% of Book value * 67% LTV). Do you think a 60% haircut is coming across the board?


Securities (23% of Assets, 8% of Equity): These are primarily AAA-rated real estate CMBS that has very short duration (2.1 years as of 9/30/2020) and significant subordination (i.e. it would take a lot of losses for the AAA tranche to lose money). In fact, even at the height of COVID where gold, treasuries, investment grade corporate credit were all tanking, the company was able to sell assets at 96 cents on the dollar. This speaks not only to the quality of the loans, but also liquidity.

As I think about this portfolio and the low duration, you should think of it this way: in 2 years, if the company did not re-deploy this capital, they’d have ~$1.45BN on loans that would pay off. They do have ~$1BN of leverage against them, so you’d have $383MM of equity back in cash. Keep this in mind for later.

Commercial Real Estate (16% of assets, 6% of equity though the assets are carried at historical cost, so there is significant unrealized gains not captured by GAAP)

  • Net Leased Commercial Real Estate (~65% of CRE): Ladder outright owns triple net leased properties, where the primary tenants are Dollar General, BJ’s, Walgreens and Bank of America.
  • Diversified CRE (~35% of CRE): these are other properties Ladder owns across office buildings, student housing and multifamily.

Now that I’ve discussed the book, it’s important to quickly discuss how they capitalize themselves. Again, very limited repo facilities and that source of funding continues to decline.

Note the unsecured corporate bonds. This brings me to one of my investment points: Ladder issued these opportunistically and has since been able to repurchase them at a discount to par. Ladder has repurchased $175MM of bonds.

At the time of writing, their 2027 4.25% unsecured notes trade at ~86 cents on the dollar. Every dollar used to repurchase these notes at a discount builds equity value on the balance sheet. There’s also the added benefit of decreased interest, which is a drag when they have so much cash.

As an example, let’s say we had a company with $200MM of assets ($100MM of which is cash), $100MM of debt, which would imply $100MM of equity. Using $25MM of cash to pay down $25MM of debt at par would not build book value on the balance sheet. However, if you paid down debt at a discount, it would.

Here’s that illustration shown below. Notice you actually build incremental equity. Given financials typically trade on a P/BV, I feel like this topic is warranted.

As mentioned, Ladder also has around ~90% of its market cap in cash… so as the market has firmed, they are buying back stock as well (though it’s still small). Buying back stock at a discount to BV also increases BV per share.

But obviously more importantly, it’s an attractive return of capital to shareholders if you think the stock is worth at or above book value. However, management may have opportunities to deploy this in attractive assets, noted below in the management section. 


Adding up the pieces:

I wanted to do a build up of “what you need to believe” here. Maybe you don’t like the assets, even though I personally view them as very low risk. Well, the securities portfolio itself is worth $3/share. That’s very liquid and something you can take home in a few years if they decided not to reinvest the proceeds. We could get those assets tomorrow.

I also started with the corporate debt, subtracted cash, and looked at the equity value after paying that all back against the balance sheet loans (the transitional mortgages). I didn’t assume this debt was retired at a discount at all.

As we discussed, the transitional mortgages are low LTV properties and worth ~$6 share. You could haircut this by 40%, add in the securities portfolio and everything else is free.

Next you have the real estate assets, worth $1.8 share on the books. Fine, don’t give credit to the unrealized value here (another $1.8), but the company did sell 3 properties in Q3’20 for a gain relative to BV.

Our downside is very well protected. Given the short tenor of the loans, we will either see Ladder receive cash or take-over properties and sell above the loan amount (which they did with a hotel in the quarter, one of a few assets in trouble per mgmt).


Management

Often, the missed piece of any thesis is management. Boy, all I can say is go read their calls. These are truly savvy investors, which is what you want in an mREIT.

Here are some examples of great quotes from mgmt:

From the Q2 Call – I get Buffett vibes:

My instincts are telling me that it might be better to actually be the borrower in a market like this as opposed to be a lender. Occasionally, we’ve talked about that on some of our calls. Conduit lending is back in a very soft kind of way. And a lot of cleanup from inventory that was sitting on the shelf is getting done. But I would say the typical conduit loan today that’s getting written is a 3.5% to 4% 10-year instrument at 50% LTV.

I think if we begin to deploy capital, and I think we will, we’ll probably be a borrower of funds like that because I think we can find some attractive situations where, perhaps, somebody has to sell something. And in addition to that, I would say that a stretched senior used to be, if a guy bought a property for $100 million, he could borrow $75 million. I think $100 million purchase today, you can probably borrow about $60 million. And so a stretched senior now goes from maybe 60% to 70%, 75%, and I think that is a sweet spot for risk/reward right now on the debt side.

If you remember, in 2008, when we opened, we had quite a few mezzanine loans in our position because we felt that the capital markets were very fearful and maybe too fearful. And so then once we got to around 2012 or ’13, we stopped writing mezzanine loans because we felt at that point, markets were priced right. And then around 2016, we felt that mezzanine money was too cheap. So I would imagine it will feel and smell like equity in some cases, or at least in some scenario where somebody is forced to transact.

And another from Q3’20 from Pamela McMormack, the other Co-Founder

I’ve been with Brian, forgot, I’m turning 50, I think, since I was 30. And so I’m a little bit of the cycle in that regard. But what I’ll say is, I remember, when we opened the doors in 2008 with the private equity guys, and they were begging us to make loans, make loans, make loans. And we were sitting on a lot of cash, we had raised over $611 million back without placement agent in 2008. And Brian was very patient, had a set up to become a (inaudible) borrower. We’re buying securities, and they said they don’t pay people to invest in securities.

And we were very patient about making loans until we felt like the market was right. We’re not incapable, we’re not afraid. We are intentionally and purposely waiting for what we think is a better risk-adjusted return.

There in lies WHY they have so much cash right now. Unfortunately, COVID is not going away tomorrow and there will be some desperation out there. I like this management team’s ability to take care of it.

Here is LADR’s ROE over the years. Not too shabby! I’d add this to the rationale that the company should trade at at least 1x BV (this ROE excludes gains on sale).

Canada Goose: It’s Still Early Days $GOOS

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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

Reading Time: 10 minutes

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?

Reading Time: 9 minutes

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?

Yep.

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

Reading Time: 2 minutes

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).