Many know the history behind McDonald’s, but if you don’t I highly recommend the movie The Founder. It details how McDonald’s started as a simple restaurant business, but Ray Kroc took it over to expand the business and eventually takes it over. It also gets into the groundwork for McDonald’s strategy it would use for decades to come.
McDonald’s is not in the restaurant business, per se, it is in the real estate business.
As a reminder, this Competitive Strategy series I am doing is trying to unravel why some businesses do better than others, even in highly competitive industries. This post will be brief and mainly focus on this real estate point – to me, it is a truly differentiated strategic decision from McDonald’s.
Why Does McDonald’s Own or Lease the Real Estate?
Typically, McDonald’s will own or lease a restaurant site and lease or sublease it to a franchisee. McDonald’s return on that real estate investment is derived from a fixed % of sales as rent payment from the franchisee. McDonald’s also earns a royalty fee, but the bulk of earnings is actually tied to this “rent” payment.
As you can imagine, this is a unique relationship between franchiser and franchisee.
Here is a comparison of gross PP&E on a group of restaurants balance sheets compared to the number of locations they have. The only names that come even close are Chipotle, which has no franchisees so isn’t really comparable, and Starbucks, which also is mostly company-operated stores.
Think about if you were a landlord and received rent plus a fixed percent of the tenant’s sales. You want the tenant to do well and may even kick in funds to help them (if you think the returns will be favorable to you).
This is the case with McDonald’s. When a restaurant unit needs to be remodeled or needs new capital investment, McDonald’s will typically share some of the expense, which helps relieve some of the burden on the franchisee, while also allowing the company to cycle through new looks and new menu items. This keeps McDonald’s menu relatively fresh and restaurants looking up-to-date.
McDonald’s also does not allow passive investors. This aligns incentives for the store owner to maximize sales and profits (because that is how they derive most of their income) which in turn boosts McDonald’s profits.
As a result, McDonald’s has posted a powerful financial track record over the past couple decades. As shown below, its same-store sales results are pretty impressive when you think about how mature McDonald’s is as a business.
But doesn’t this make McDonald’s more capital intensive?
Yes!
Here is a chart of capex as a % of sales for each of the players:
But that actually doesn’t hinder the company much. Look at its return on assets compared to peers. It actually stacks up quite well, which is surprising when you think about how much more in assets the company has.
What could be the driver of that? Profitability. McDonald’s is just much more profitable than most of its peers. Part of this is scale (can leverage corporate fixed costs well with the number of branches), but also part of it is the way the company has established its fees.
The total return for the S&P500 year-to-date in mid-April is 16.6%. Truly fantastic performance for any year. Clearly, its hard to see whether the gains will continue. The long-term rate of return for the S&P (including dividends) is 9.4% (based on data sourced from NYU). That means this year is clearly above average. Then again, in the past 91 years, how many years have had a higher return than 16.6%??
Well, that may piece of information actually be surprising to hear. There have been 39 other years when the total return on the S&P was higher than 16.6%. That’s about ~40% of the years from the available data!
Clearly, part of the reason for this recent surge was the sell-off in December, where stocks declined nearly 20% from peak-to-trough in just one quarter. The decline was quick and steep and the snap back has been quick and steep as well. We still haven’t recovered to those peaks yet, so a bullish investor could also say we could at least see a couple more points of total return this year from that.
All that said, I have to ask what the risk/reward is at these levels? Is there valuation support?
The consensus earnings estimate for the S&P in 2019 is $164/share. Let’s break that down compared to current trading levels and what that implies (i.e. is the market cheap on its face).
The long-term average P/E multiple is around 15.0x , so this would imply… no the market is not that cheap.
That said, Peter Lynch’s old rule of thumb for if the market was cheap was 20x minus the 10-yr treasury rate (a proxy for inflation). That would put us around 17x-18x. Therefore…the market still doesn’t look that cheap now.
But what if we look to 2020? The market is forward looking after all.
What is interesting to me is that the 2020 EPS estimate is $184 vs. $163 for 2019. That means Wall Street is expecting a pretty strong rebound in earnings growth, roughly 12.9%. That seems pretty lofty, but if they’re correct, that helps explain why the multiple for 2019 is so high.
But even if it is right, the upside for the next 2 years seems pretty capped. Wall Street also has a tendency to reduce estimates, right up until the quarter, which allows for more “beats”.
I could of course be wrong though. And I probably am. There are more than a couple ways I could be wrong, but for me it means pulling back a bit on my risk.
To be clear and candid though, I would never recommend selling on this. There is a great blog post by Wealth of Common Sense blogger, Ben Carlson, that helps reinforce that point. In that, he highlights the story of Bob, the markets worst timer (essentially he only invests at the peaks). I won’t spoil it for you, but everyone should go read it here. The story has had a long-term impact on me.
JP Morgan also publishes a slide on missing the market’s best days and the cost of being out of the market vs. sitting idle. Look at the difference of just missing he best 20 days of the market out of 20 years! That is missing 0.27% of the total days (20 / 7,301). And note how close together the best and worst returns were (in the box callout).
My takeaway from that is: even if you can call the top, being able to call the exact bottom would be even harder.
CorePoint had a nice run from my recent write-up in January, up 12.5%. Q4’18 earnings beat expectations too, reporting comparable RevPAR growth of 9.9% and adj. EBITDA was $30MM, 13% higher than street expectations.
However, the stock was taken to the woodshed on Friday (March 22) when the company’s outlook disappointed.
The company’s outlook called for $173MM to $184MM of EBITDA compared to $199MM by consensus (though only one analyst covers the stock, so hard to say there is much of a consensus). Like many others have announced, CPLG is cost inflation in its operating costs (e.g. payroll).
In addition, the company’s hurricane-impacted hotels would not be adding as much EBITDA as originally expected. The company previously said it lost $20MM of EBITDA from the hurricanes on these assets. Instead of getting the full EBITDA back, mgmt expects just $10MM of EBITDA. It also expects $7MM from re-positioned hotel portfolio, but expects pressure in its oil-related market (company’s largest state exposure is Texas).
This is clearly disappointing, but not sure its worth the 26% drop on Friday. Like anything, it is likely a mix of factors. Part of this could be spin dynamics. In other words, people decided to blow out of CPLG now because they didn’t want to hold the stub piece long-term anyway. Another piece is likely due to the recession fears that were re-ignited on Friday that led to the S&P being down 1.9% in one day (the worst day so far for 2019). Hotels do not do particularly well in downturns.
Silver Lining -> Strategic Opportunities
There were several silver linings that management highlighted on the call, overshadowed by the market’s focus on the 2019 EBITDA outlook.
First, there are several strategic priorities for 2019:
Improve Operating Performance
Clearly, the company is facing cost headwinds. Therefore, its strategic priority is to identify underperforming hotels that have revenue and cost synergies available
Benefit from Wyndham Relationship
CPLG transfers onto Wyndham’s platform in April 2019 and full integration will be complete in 1H’19.
There are clearly cross-selling opportunities and increased distribution for their hotels.
I continue to think it is underappreciated that La Quinta had 15MM loyalty members, but Wyndham had 55MM in 2017. Those Wyndham loyalty members will now be able to book La Quinta’s in 2019.
Divest Non-core Hotels
CPLG sold 2 hotels in Q4 for $4MM. Mgmt noted these hotels were operating at significantly depressed margins.
More importantly, the company has identified 76 other non-core hotels that are operating at a hotel adj. EBITDA margin of 8%, well-below the 26% average of the core portfolio. In addition, RevPAR is 40% below the core average.
I have written about the first two points in my previous post, but I want to focus on the last point because divesting these hotels could be extremely accretive to the equity. Recall, the SEC document here cites $2.4BN of hotel value compared to $1.6BN of EV. To me, if the company can sell these hotels at higher prices than what the market has ascribed to them (currently a 33% discount to the 2018 appraisal), that will be a solid catalyst for the equity.
When reviewing the portfolio as a whole, and what constitutes “non-core” it becomes more clear why it makes sense to divest these assets. The company will lose $138MM of sales, but very little EBITDA in the grand scheme.
What I think is the most compelling case for upside on the equity is what the 2 under-performing hotels were sold for. Very low EBITDA margin, these hotels were sold for $4.5MM. As Sam Zell has said, investing in real estate many times comes down to replacement value. Perhaps what this sale represented.
Anyway, I don’t think it would be appropriate to think that these 2 sales are data points we can anchor on, but let’s run through some scenarios. First, let’s sale they get the same price/sales multiple.
Translating that into what happens to the valuation of the company:
This math roughly lines up with what is presented in the chart above provided by the company. And what this means is that if you think the company can get $230MM for these assets, the core portfolio is trading for ~8.0x and a 12% cap rate!
Indeed, no matter how you cut it, the PF valuation is very attractive.
So let’s say you think the portfolio should be 8.0% cap rate (a discount to the valuation given in the CMBS report). This points to a $21.6 price target. And this doesn’t bake in any growth for the next 2 years, it simply excludes the non-core portfolio.
As cities across the U.S. embarked on huge marketing campaigns to attract “HQ2“, I couldn’t help but ask myself why Amazon was planning a second headquarters. Usually companies like coherence and for the business to act as one under one roof. It is more difficult to do this when you have two “headquarters”. To me, it reminds me of having two CEOs. Two voices. Two cultures. I came to the conclusion that Amazon was preparing for a split up of the company and I would need to think of AWS valuation.
The split would be simple: take the traditional retail business + Whole Foods would go under one umbrella and continue to operate out of Seattle, while the second business would be Amazon Web Services (AWS) and would operate out of its own hub and have its own resources. We should then ask ourselves ahead of time: what is a reasonable AWS valuation.
For those that do not know, AWS is much different than the retail business. It is designed to provide developers quick access to on-demand computing power, storage, applications and development tools at low prices. Thanks to its offering, developers, startups and other companies do not need to focus on infrastructure build out when they are starting a new venture, they can instead focus on their core product and utilize AWS’ resources.
AWS allows faster speed to market in some cases. It also allows this spend to be a variable cost, rather than a high, upfront capex spend.
This led me to ask myself:
What do I think AWS is actually worth? Does Amazon’s valuation today reflect its strength?
Is AWS actually a good business?
Would splitting the company make sense?
Is the AWS valuation not factored in to the stock price today?
I think I am going to go through the answers in reverse order. I do think it makes sense to split the company. AWS operates in a competitive environment with the Microsoft Azure, Google Cloud, IBM among others clamoring for a larger piece of the pie. AWS currently has top share of wallet, but it’s a much different business model than the retail business. Here are my three main reasons for splitting the company:
Allow focus in areas of strength.
Being a company focused on one goal helps keep all employees realize what the goal at the end of the day is: support customers.
Today, while a smaller part of the market, there is a conflict of interest with AWS and CPG sectors (e.g. Target announcement to scale back AWS, Kroger announcing post-Whole Foods it would be moving to Azure and Google)
Typically in conglomerates, new business in certain sectors can go unnoticed or underappreciated as “approvers” up the chain of command have other things on their priority list. Splitting the company reduces this kink in the chain. This appears to be limited risk today as Amazon is growing AWS and its services, but think about the other segments. Perhaps they are moving slower now in the retail segment or internationally than they otherwise would.
Optimize capital allocation
AWS is highly profitable from a EBITDA perspective (though is also highly capital intensive today as it grows). On the other hand, Amazon’s retail business is not only low margin, but also is capital intensive and its return metrics are much lower than AWS (especially internationally where the company still has significant operating losses).
Even if I think returns for AWS will come down over time (discussed more below), you could view the company as funneling good money after bad (i.e. taking resources from a high return business and pushing it into low return business). If I invest $1 dollar into AWS, I get 28 cents back in year 1 compared to 9 cents for North American retail or losing 11 cents Internationally.
You may be optimistic about the LT trends in the retail business and its improving profitability over time, but think about if AWS could funnel more of its cash into higher return projects. It is likely to perform better over time on its own. Freeing up these resources can help AWS invest in its core capabilities and build sustainable competitive advantage.
Better align incentives
Distinct and clear business with their own performance goals matter when you are paying your employees in company stock
Imagine you are a leading employee in the field and asked to work for Amazon. A significant portion of your comp will be in restricted stock that pays out if the entire company does well. But oops, something happens to the grocery business at amazon and the stock falls 20-30%, so now you are well out of the money.
Wouldn’t it be better if your performance and the company’s performance were linked?
Note, AWS valuation being underappreciated is not really a core tenant here.
Is AWS a good business?
“I believe AWS is one of those dreamy business offerings that can be serving customers and earning financial returns for many years into the future. Why am I optimistic? For one thing, the size of the opportunity is big, ultimately encompassing global spend on servers, networking, datacenters, infrastructure software, databases, data warehouses, and more. Similar to the way I think about Amazon retail, for all practical purposes, I believe AWS is market-size unconstrained.”
-Jeff Bezos, 2014 Letter to Shareholders
Clearly, AWS has grown like a weed. Amazon has disclosed the results of this segment going back to 2013 and we can see sales and EBITDA have grown at a ~50% CAGR since then and 2018’s pace actually picked up over 2017.
The business started when Amazon brought infrastructure-as-a-service (IaaS) with global scale to startups, corporations, and the public sector. By this, I mean that they provide the infrastructure that allow these companies to outsource computing power, storage, and databases to Amazon. It essentially turned this services into a utility for consumers, with pay-for-what-you-use pricing models. As an aside, what a beautiful competitive decision that was.
As stated earlier, this allows customers to add new services quickly without upfront capex. Businesses now do not have to buy servers and other IT infrastructure months in advance, and instead can spin up hundreds of servers in minutes. This also means you benefit from the economies of scale that Amazon has built up. In other words, because Amazon has such massive scale, it can pass some of those saving on to you. If you bought the servers and other utilized ~70% of the capacity, your per unit costs would be much higher.
AWS has attracted new entrants as well. Microsoft’s Azure and Google’s Cloud have also grown and attracted share. Microsoft provides some color on the business, which I have estimated in the table above, but Google provides basically no disclosure. Other players with smaller market share include Oracle, IBM and Alibaba in Asia.
Despite growth in Azure, Amazon owns more market share than the next 4 competitors combined. And the rest of the market appears to be losing share.
The logical outcome from this, especially when considering how capital intensive the business is, is that the business forms into an oligopoly. Oligopolies traditionally have high barriers to entry, strong consumer loyalty and economies of scale. Given limited competitors, this typically results in higher prices for consumers. Also traditionally, you would expect earnings to be highly visible and would lead to a higher AWS valuation.
However, this is not always the case and it leads me to some concern on the industry. In some cases, oligopolies become unstable because one competitor tries to gain market share over the others and reduces price. Because each firm is so large, it affects market conditions. In order to not cede share, the competitors also reduce price. This usually results in a race to zero until the firms decide that its in the best interest of all players to collude firm-up pricing.
How could this happen with Amazon Web Services? Well, we all now Amazon’s time horizon is very long and it attempts to dominate every space it is in by capturing share with low prices. As said in its 2016 letter to shareholders:
We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions.
Jeff Bezos, 2016 Letter to Shareholders
In addition, other competitors have benefited from movement into the space and have been rewarded in their stock price (see MSFT). Clearly others think Amazon’s stock price rise is largely attributed to investors’ valuation of AWS – and that may be true.
But Microsoft ceding share to AWS may hurt their results (and stock price) so they may attempt to take more and more share at the expense of future returns.
In a way, what could happen here is more of a slippery slope. They give a bit on pricing because the returns are so good now that a small price give here and there want matter. But then they add up…
Lastly, its no secret that building data centers to support growth is capital intensive, and that will impact the AWS valuation (see financial table above).
They also serve a lot of start-ups and other businesses. This creates a large fixed cost base for the cloud players. If there was a “washing out” of start-ups, such as the aftermath of the tech bubble, AWS and others could see excess capacity, hurting returns. In order to spread the costs, they may attempt a “volume over price” strategy. This will result in retained share, but hurt pricing for the industry as competition responds.
Unfortunately, I DO think returns are going to come down materially over time. And that will hurt the AWS valuation.
The industry reminds me too much of commodity industries. The industry is no doubt growing today, but the high margins we see today I believe are from high operating leverage. This tends to be more transitory in nature and means that returns on incremental capacity invested go down over time.
Take for example commodity chemical companies. AWS reminds me of some of their business models (unfortunately). Some operate in very consolidated companies, but operate at very high fixed costs and have exit barriers. The loss of one customer results in very painful results due to operating leverage. Although higher prices are better in the long run, the company will lower price to keep the volume and keep the fixed cost leverage.
Think about commodity businesses that reports utilization (note, we have limited disclosure on AWS, but that might be a helpful statistic in the future). Higher utilization usually results in good returns on the plant (or in the case of AWS, server). However, when you lower price on the commodity, the competitors, in turn, will also lower price so they don’t lose their existing customers. What results in lower returns for everyone.
As a another case study, P&G used to run its HR, IT and finance functions within each of its business units. It decided to form one, centralized, internal business unit to gain economies of scale. It actually formed a leading provider of these services. But then, P&G looked at its core business and said, “do I need to continue doing these functions or can I outsource it? Or maybe I can sell this whole business unit to another provider, which would give them more scale and lower the cost of the function”. The latter is what ended up happening. Although it wasn’t viewed as a commodity at the time, these functions began to become more commoditized and business process outsource companies (“BPOs”) now have very high competition and lower returns.
Another analogy would be to at the semi-conductor or memory businesses, though perhaps not as commodity as these two.
I personally think that over time, we will see this form with AWS. The fact that pricing has come down so much for the service (one unnamed engineer I interviewed told me that AWS will even let you know if they think pricing is coming down soon to keep your business). According to the Q3’18 earnings call, Amazon had lowered AWS prices 67x since it launched and these are a “normal part of business.” They’ve certainly been able to lower costs as well so far, but how will that change as competitors also gain scale?
How could I be wrong? I could be wrong in many ways, but the one case is that I am underestimating how “entrenched” the business is into everyday use. That could result in very low switching by customers. It could also mean that developers get trained using AWS so default to using its services. The counter to these arguments is that there is a price for everything and clearly Azure has taken share over the past year, so it’s not proving out thus far. If AWS become the winner-take-all, then I am dramatically underestimating the valuation.
So is it a good business? Well, lets look at at it from a Porter’s Five Forces perspective. I think the view on these, in brief, plus the current returns we can see in the previous tables would point to the industry being solid. My one concern comes back to the competitive rivalry. We can have a high barriers to entry business and highly consolidated, but returns are not good.
AWS Valution: Final Thoughts
Based on the market share numbers posted above, AWS is currently attacking a $73BN market. At the rates that the market has been growing, as well as the additional services, I think its reasonable the market expands to $100BN in the near term, especially as adoption increases.
I assume Amazon maintains its market share due to its relentless focus on lowering price and maintaining share. I think the additional share gained by Google and Azure will come at the expense of the other players included in the market share chart above.
For the reasons stated above, I think this results in returns coming down over time. I still model goodreturns to be clear, but that the return on assets comes down meaningfully.
This may be hard to read, but I end up with an AWS valuation of $164BN. Given the value of AMZN today is over $1 trillion, even though AWS accounts for over half of EBITDA now, I cant help but think this opportunity is more than priced in, unfortunately.
However, AWS would benefit in the long-term from being on its own for the reasons discussed above. In the short-run, it may get a higher multiple than the rest of the Amazon retail business since its growing quickly with such high margins.
Because there are now less moving pieces, we can clearly arrive at a price target for the warrants. Based on my previous posts, you know that my price target for Univar is ~$32/share in the next 12 months. I think I am being reasonable in this analysis (though I admit, Univar is hosting its 2019 outlook call next week which could change things).
(March 4 Update: UNVR released 2019 guide of ~$750MM of EBITDA, which reflect 10 months of Nexeo and expectations of flat industrial demand. Seems relatively conservative. They also expect to generate $275MM of FCF, which is still a 7% FCF yield. Not too bad, but not amazing either).
It appears
that Seth Klarman of Baupost agrees with me as he recently took a big stake in
both Univar and Nexeo warrants. Looks like he owns 10MM
warrants, or roughly 20% of the outstanding amount. He also owns 9.5MM
shares of Univar.
Univar
appointed Equiniti as the successor warrant agent pursuant to the Nexeo Warrant
Agreement. This means they will now
handle the warrants being exercised. Unfortunately, in the meantime, this means
the warrants will be pretty illiquid.
I will update this post once Equiniti responds.
Update: Equiniti never responded, but the warrants trade regularly now.
