What’s the True TAM of Search?

For work and personal reasons I’ve taken a 3 year leave of absence from the blog. Now that I’m “working” for myself again, there will be plenty of time to get back to the community and share random thoughts.

As the blog has taken on a decidedly technology focus in my absence, the first topic that’s piqued my interest is the concept of information distribution. I will be writing a series of posts on it, ranging from topics like how information distribution has evolved in the Internet Age, how business models are affected and moats are created and destroyed in the process, how its evolution differs between China and the West, and any investment implications. I suppose a lot of this stuff you already know because it’s just common sense and some of it, if you didn’t know, is probably pointless crap to you, so I’m going to break tradition with the usual long-winded style of this blog and keep the posts short for your benefit. Hopefully you will enjoy the new format.

 

Part 1 – The TAM of Search Engines

 

I don’t own Google but I follow the company a bit. This is not an expensive stock. With some reasonable adjustments it’s not hard to get the core search business trading at less than 20 times underlying earnings. The main pushback on the bull thesis that’s emerged in the past year or so is the extent to which the search engine business is nearing saturation, considering that Google and Facebook now account for over 70% of online advertising globally (ex-China). At some point the party has to end if you’ve already won all of the chips, right?

Not that I’m bullish on Google or anything but I think this train of thought really misses the point in the greater context of information distribution on the Internet. To truly appreciate the nature of information distribution, we need to think in a broader context and challenge some assumptions: what if “online advertising”, or even “advertising” is not the right way to measure the TAM (total addressable market) for the search engine business?

For starters, “advertising” is only a subsection of what we label as “marketing”. Just think about how much commissions department stores pay their salespeople. While these costs are not considered advertising in strict definition, it is quite conceivable that some of these dollars would get re-allocated to search engine advertising as retail sales move online and brands shift their budgets accordingly. Similarly, companies spend enormous sums on things like trade shows, business travel, sponsorships, cold calls etc., all of which are marketing channels for potential customers to learn about their products. All of that information could conceivably be acquired by the same customers with a simple click on a search engine, a shift in information distribution that is well underway today.

If we think in these terms, the TAM for search engines would be an order of magnitude larger than the figure that’s often quoted by investments analysts which limits the TAM to a narrow definition of “advertising”.

And we are just getting started.

If we correctly define the role of search engines, we can see that what they are really designed to address is actually something much broader – “search cost”. Search cost is the biggest component of what economists label as “friction cost” in an economy and it can exist and be addressed in many different forms. For example, before the invention of the Internet, the most widely used tool for addressing search cost was actually the physical location. Imagine you owned a 200,000 sq ft building in downtown Manhattan. If you used that space for storage, chances are you would be able to charge the same rent as a 200,000 sq ft warehouse situated in the suburbs; but if you turned it into a mall it would likely bring in many times the amount of rent that an equivalent mall can bring in outside the city. All of that excess rent is a form of marketing that brands and retailers pay to address “search cost”. In a purely online environment, the physical location is disintermediated and what companies would otherwise pay in excess rent in an offline setting would presumably get re-allocated in the form of Amazon commissions or Google keyword ads (By the way Amazon is really just another search engine with a “vertical” emphasis – even though Amazon commissions are not labeled as “advertising” in accounting terms, they are in every sense a form of advertising in substance; we will explore the topic of “vertical” vs “horizontal” search engines in detail in the next post).

In fact, in a market like China where online penetration of retail is comparatively high, the fungibility of rent vs. online advertising is already on full display as many retailers and brands in their expansion strategy now routinely conduct a cost of traffic comparison between setting up new physical locations and raising the budget for Tmall keyword bidding, as if those were interchangeable marketing channels.

As a thought exercise, imagine a world where at some point in the future all consumption moves online. What will happen to the way search cost is addressed? Excess retail rent will be fully eliminated, direct-to-consumer sales will no longer exist as a profession, travel agents will be out of their jobs and we will no longer pay late fees at libraries (which won’t exist). At least in theory, all the money spent on these belong in the TAM of search engines. Once you add up everything, the real TAM becomes quite considerable. Hell, I wouldn’t be surprised if search cost consumes 10 – 20% of GDP for a lot of countries.

The often debated metric of advertising spend as a % of GDP, in my opinion, is more or less a meaningless statistic as it is merely an output of how we label and account for different buckets of search cost. Take Alibaba vs. Amazon 3^rd Party as an example, one is the largest advertising platform in China and the other reports close to zero advertising revenue. In substance both sites serve a similar purpose of generating traffic leads for retail merchants; they simply report the nature of their revenues differently. As a result, this causes “true” advertising spend in the US to be under-reported compared to China. Personally I don’t take this metric very seriously as it is too narrowly defined to have any informational value. What matters more is search cost dollars not advertising dollars.

On an unrelated note, this search engine discussion brings up an interesting point about the danger of the traditional top-down “TAM analysis” that analysts employ when attempting to size the potential of disruptive technologies. With any business enabled by new technology, while the existing size of the market provides a useful reference point for TAM, it is often a very imprecise one because it assumes a static relationship between the size of a market and the technologies that enable it. What we often forget is that the size of a market is actually an output of technology constraints and as technology evolves, the market size evolves with it.

I will give you one example. Vipshop is the dominant online off-season apparel retailer in China. The bull thesis for this name is relatively straightforward: apparel retail in China is a $300 billion market of which the off-season segment is about 20% of overall sales. This would suggest a TAM of $60 billion which given Vipshop’s $8 billion of revenue means the company is less than 15% penetrated. Selling off-season apparel online is a superior model that will displace offline retailers and Vipshop, similar to TJ Maxx in the US, is the undisputed leader with an unassailable competitive position.

I actually don’t disagree with the second part of this statement (competitive position) but the first part (TAM) is problematic. This is because as an off-season discounter Vipshop procures the majority of its inventory from excess inventory in offline channels. As apparel retail continues to shift online (already at 40% online penetration in China, even 50%+ in some cities), the availability of this excess inventory shrinks significantly because online in-season retailers have much lower inventory needs than their offline counterparts (online means no inventory needed for in-store display, shorter supply chains and better sales predictability). In other words, the more apparel sales shift online, the smaller Vipshop’s TAM will get – there are always two sides to every coin. Vipshop’s share of its TAM is therefore a fair bit overstated, which seems to explain why growth has slowed from 80% to 30% in less than 2 years.

Actually, most of the time, new technological developments have a tendency to shrink the TAM as technology is usually deflationary (the search engine being an exception), so be careful when you see IR slides of tech companies where management takes an estimate of the market size today and declares that number as their company’s financial destiny – it most likely overstates the actual TAM.

—- to be continued…

Some Things I’ve Learned over the Years

First some housekeeping. I will be launching a Delaware-based fund/partnership early next year with more details to come over the following several months – so this blog will either turn into a private one exclusive to members within my own network or become a much more casual platform. Needless to say, I am fortunate to have built such a network of like-minded individuals who I highly respect and are much smarter and better investors than myself. I certainly look forward to continuing the dialogue!

An Obsession with Studying the Superlative Business:

Over the years my approach to sourcing ideas has evolved. By far my favorite approach to sourcing ideas now is to identify the very best companies in the world (the top 0.01%), whether public or private, study them in-depth, and subsequently draw the most fruitful lessons I can from them. I love this approach as I have discovered that studying the few companies I admire the most can teach me much more about business than your average run-of-a-mill company. My evolution in sourcing is also a function of compounding my knowledge base of different businesses over time, and slowly realizing that most ideas, no matter how optically inexpensive they may look, simply aren’t investable for a highly concentrated, high hurdle-rate oriented investing approach. In my mind if you’re truly a highly rational concentrated investor, your opportunity cost for owning any name should be absolutely massive. Another way to think about this is to invert the common “low P/E/multiple approach” to sourcing ideas: find the companies with the best chance of maximizing long-term earnings power first, then figure out the right price to pay to ensure the desired margin of safety. For the people who are still stuck in Ben Graham’s “valuation-first/cigar butt” world, my valueless opinion is that the faster you get to Munger’s approach, the better off you’ll be long-term as an investor. Hint: You’ll be much smarter.

What makes a superlative business? To answer this question in a paragraph would be a disgrace to this blog. But here are a few things to think about: they are managed by exceptional people who are obsessed about winning, and have no other major distractions in their life other than the company they manage. You can perhaps think of them as similar to Nietzsche’s Übermensch – a small subset of the human race – and in this particular case the business world – who are making serious progress in advancing humanity forward and are driven by their own independent set of values (not those of others a la the herd). These values are typically formed by unique personal experiences.

Culturally, some of these companies share common traits. They don’t shy away from taking risks and view failure as an option; strictly speaking, they play to win, not to lose. To say that they have an entrepreneurial culture is an understatement. Having such a risk-taking culture helps mitigate risk aversion bias which plagues most companies and people. Just from the realization of this bias alone, I have always approached decisions on assessing the risk of not taking any risks.

What else? Speaking from a numbers perspective, they have an exponential return on invested capital when measured over a multi-decade horizon. This is a function of the business’ competitive moat growing wider over time which can yield a non-linear long-term return on capital profile. If you are an exceptional business, you are by my definition a super durable business that can withstand the test of time and also enjoy an open-ended runway of growth. As for the classical economists who promote competition as the best form of value creation for all – they are all wrong. Like Peter Thiel said, competition is for losers and monopolists are for the studs. Since most businesses do not fit this profile, this is where being forced or at the very least having the intention to hold a business for 10 years or longer should greatly limit your range of investing opportunities.

Let’s think about all the companies that went out of business over the past century or so. How many of these companies that were in business 50 years ago actually stood the test of time? I think the ones that have survived had the leadership and a company culture able to withstand and adapt in rapidly changing competitive environments. Having an innovative culture, with the open-mindedness for business model evolution goes a long way towards staying in business. I don’t think at this point I even need to point out that these companies have a long-term orientation. Without these traits, no matter how dominant a business may be now, it lacks the qualitative characteristics that enable it to stand the test of time. You can see examples of these businesses all the time: once dominant companies that are now having their moats being eroded away by superior, more nimble organizations, and will soon become a shadow of their former selves. Think IBM, Oracle, Viacom[1], and the US department stores.

Take Oracle for example, the upside case expressed by some is that this is a rather cheap stock with an attractive near-term FCF yield. While their on-premise database and application businesses are in secular decline, this is a slow and measurable rate of decline, as switching costs are substantial and enterprise relationships are very sticky; and as the Oracle installed base continue to migrate their workloads to the cloud, Oracle should be able to retain the customer relationship despite cannibalizing itself. What I think the bulls fail to appreciate is that the economics of Oracle’s on-prem business (which is bound to shrink significantly) is much more attractive than what will likely become of their cloud business (which is bound to become the main value driver of the company). Oracle was extremely slow to transition their product to a cloud environment, where switching costs are much lower as customer uptimes are way shorter and having a proprietary/unique tech stack is not as important as offering a lower price tag to enterprises at scale. In fact, the most successful database cloud provider in the future will likely win by offering a much cheaper product based on open-source technologies. Hint: I’ve written up this company on this blog.

Leading disruptors that had no highly profitable legacy business attached such as AWS and Workday in infrastructure/platform cloud services and HRM applications, respectively, already know the endgame scenario in enterprise software, and are investing all their resources and efforts towards positioning themselves for it. What Workday is doing specifically is disrupting Oracle and SAP in HRM & Financial Management applications. In classic innovator’s dilemma fashion they attacked the SMB/smaller enterprise market first with a largely price-driven strategy and a product incrementally “good enough” for customers that outweighed performance-based concerns. So Oracle is fighting a multi-front war and even as it manages to grow their cloud business at a rapid clip (no one disputes this fact) to help offset on-premise attrition, the overall company margin profile of a lower tier cloud software business will be much, much lower than their licensing/maintenance software model – that I can almost guarantee you. It’s not a coincidence that there’s a similar industry narrative for the Pay-TV/the cable networks and department store industries: despite transitioning their business models they all face the same threat of being largely dis-intermediated and thus becoming much less profitable. In fact, we’ve actually seen a similar movie before in the classified section of local newspapers as content and ad dollars largely shifted to digital/online channels. Ask a millennial if they check the local newspaper/classified section when they are looking for a local gig and you’ll know what I’m talking about.

Another common theme among these long-term losers is that they typically opt to use share buybacks/financial engineering as a pitch to shareholders in a desperate attempt to drive outsized short-term EPS growth. This is all but a mirage in value creation – especially for those that elect to lever up to buyback overvalued stock like what some of the cable networks have done over the past several years. Why are they doing this? Hint: it helps to read proxies; sometimes, you’ll figure out that either the CEO/controlling shareholder is a super wealthy empire-builder or will likely retire in a few years. Financial engineering can only take you so far, and scaling value creation successfully via M&A and buybacks over a multi-decade period with a secular declining core business is extremely rare in my view. What’s typically more common is self-dealing and/or integration train wrecks. As a result, it would be an absolute nightmare to hold a share of a business like this for the next 10 years. OK, you may have guessed now that I despise IBM and Oracle and don’t think too highly of their leadership. For good examples of companies that have been successfully navigating these software industry changes, I would look to Microsoft and Adobe Systems.

One final thought on enterprise software is that the technology stack along with how it is sold is evolving over time. The reality is that no new software engineer today looking to build the future is getting trained in .Net, C# or the Java tech stack. With the rise of AWS, a public cloud platform that sells software infrastructure basically as a utility, we are now transitioning to an era where software pricing is based on volume/usage instead of subscription. As a brief history, Software 1.0 was the era of on-premise solutions based on the licensing/maintenance contract model, Software 2.0 was of course the rise of the Software-as-a-Service (SaaS) model with Salesforce as the industry pioneer, and Software 3.0 as mentioned is evolving into software-as-a- platform. AWS is undoubtedly the industry pioneer in this model but there are some smaller, emerging cloud platforms such as Twilio, Atlassian, Shopify and New Relic. Once a platform becomes nearly ubiquitous amongst third-party application developers, an application (such as Uber, for example) can outsource certain platform-as-a-service functions to a platform such as Twilio (in this case communication-based functions such as texting/SMS and voice), and be billed on a volume basis by Twilio. Utility-based business models that become ubiquitous are extremely attractive, and AWS is at the center of Software 3.0.

Something else I’d like to talk about is investor herding. As you may have noticed I’ve written up some pretty well-known “hedge fund hotels” on this blog. Some investors appear to automatically assume that a hedge fund hotel must be a crowded trade. As a fundamental investor I don’t think one can draw any conclusions on what a business is worth based solely on knowing the shareholder base. I think my friend at one of the well-known Tiger cubs said it best: In general hedge funds (at least the top-tier, fundamentally-oriented, research-intensive ones) are better stock pickers than the average market participant. Theoretically they have the better resources, talent and a sensible incentive structure for the investment team to generate sustainable alpha. However there may be periods such as recently where a redemption cycle in full swing can cause outsized short-term volatility in shares with a cap table heavily skewed towards hedge funds. This doesn’t mean the intrinsic value is impaired as the market price reflects the consequence of forced selling.

This broader issue appears more like a psychological issue to some and is certainly not a rational stock picking process. Guys that actively avoid hedge fund hotels might have what I like to call the contrarian syndrome where they are biased to shun from ideas that are widely-held by savvy investors. The opposing psychological bias of herding is certainly a notable risk as well.

The beauty of the market is that there is always a winner and loser in every transaction and almost every participant has a different reason for transacting. I’m sure there is a subset of “value investors” who look at Amazon stock and think it’s grossly overvalued trading at >160x PE. Then there is a subset of “momentum” oriented investors that must own the stock and chase performance at any price. Bottom line is market consensus is objectively captured by the price offered and whether there is a large margin of safety is dependent on one’s estimate of intrinsic value. To their detriment, people seem to over-complicate things due to certain innate tendencies.

JD and Amazon: Scale Economics and the Customer Experience

I’ve talked about both JD and Amazon quite extensively on this blog, but I can’t resist talking enough about them.

Some define these businesses as internet companies, whereas others may label them as online-retailers or e-commerce companies. Honestly, I think these are customer experience companies. It’s the same way Tony Hsieh defined Zappos (the online shoe retailer that Amazon acquired). Zappos’ company culture was highly customer-centric. Zappos call centre representatives would be more than happy to spend hours speaking with lonely bored customers who just wanted to talk to someone. To reinforce the company’s culture and values around exemplary customer service, every new Zappos hire would be required to work in the 24-hour call center for a minimum period of time. JD for example makes sure that each call center rep is actually physically smiling when they say hello to a customer on the phone.

Why are the best consumer-based internet companies, and online retailers in particular, obsessed about the customer experience? The Stratechery blog, in my view, is the best blog online focussed on TMT industry analysis and strategy that talked about an interesting theory called Aggregation Theory. My own take on this theory is that since the marginal cost of distribution or the user acquisition cost approaches close to zero over time for many internet platforms, only the companies that are able to provide the best user experience at scale are able to capture these exceptional unit economics, and in turn commoditize suppliers (product exclusivity is a non-factor) and thus become the long-term industry winner. This theory aligns with the conventional wisdom in e-commerce (all the industry leaders agree), that the best way to maximize value in mass-market retailing is to provide the best customer experience.

Some value investors avoid investing in technology-based shares due to their admitted inability to predict long-term changes in such business models. If we invert this view and focus on what’s not likely to change, we can build conviction around certain long-term drivers. For example, there is almost no question that 10 years from now, customers would want a wider selection of products from Amazon, a better customer experience, and even more competitive prices. Within its major markets, no other company on Earth will be able to add more value to the customer long-term around price, selection and the customer experience than Amazon. Whether a T-shirt is ordered on a virtual reality platform and then delivered to the customer’s door by a robot or drone, or whether an apple is purchased at a no checkout Amazon Go store 10 years from now are frankly quite irrelevant as long as the business has experimented to figure out what provides the best customer experience at scale. In other words we don’t know what the precise economics of the business will look like 10 years from now but what we do know is that the moat is primed to grow wider over time and the business will be much more valuable than it is today. And that, to me is enough reason to invest at the right price. Think of this as a channel-agnostic or you can even say business model agnostic approach to long-term shareholder value creation, and more of an enduring business recipe for success. The companies that understand this are bound to win.

I think the only e-commerce competitors that will survive the ever-expanding Amazon retail onslaught and also perform well will be the very specialized, pure-play online retailers that are already the market leaders within a very particular niche or specific product category (they’ve already built substantial scale and market share in such category). As an example, AO World is an extremely customer-centric, UK-based retailer that specializes in selling 3C and home appliance products online. AO is a structural share gainer in the UK-based market for large home appliances and electricals. The barriers to entry in selling large home appliances are higher than the average retail product due to a specialized logistics and fulfillment requirements for this category. The logistics infrastructure required for bulky “white appliances” such as refrigerators, washers, and dryers requires 2-men delivery crews who are specially trained to install such products at the customer’s home and the company has to provide high-quality post-sales service. This is simply not a piece of the value chain you can outsource to third-party delivery firms and expect high customer satisfaction. In fact I am not aware of any reputable third-party logistics firms that provide large home appliance delivery services. On top of being able to operate the physical element of fulfilling orders more efficiently than your largest direct offline and online competitors, the widest selection of brands of SKUs within the specific category at competitive prices are required for completing the flywheel (achieving sustainably attractive ROICs long-term). In terms of the customer experience selling appliances online over brick-and-mortars yields another considerable advantage as legitimate product reviews/online video reviews are easily assessable.

Some other European-based pure-play e-commerce companies that should do well despite Amazon include: Zooplus which is an extremely well-managed online retailer specialized in selling pet supplies, Yoox-net-a-Porter sells luxury apparel online, and ASOS is an online apparel retailer (with little customer overlap with Amazon) that sells fast-fashion apparel largely to the millennial demographic. What these e-commerce companies have in common are a product selection unrivaled within their specific category which no other retailer can match – including Amazon. This is in part due to the massive SKU count required and the more “long-tail” nature of such categories – especially the apparel category which I will discuss in more detail below – which is not easy for a subscale competitor to replicate. Despite this, there is no question that the business of online retailing will always have the “Amazon overhang”, and likely some competitive pricing and margin pressure will exist no matter the category, but I’m a believer that there is space for multiple category winners and Amazon won’t dominate every single vertical. There’s a big difference between business durability and profitability… it appears that if you have the right time horizon, prioritizing the former over the latter could be a very wise decision, but most investors and CEOs don’t have the right time horizon.

JD is the only e-commerce company in the world that I know of that’s successfully building a multi-category last-mile delivery network that includes both bulky home appliances and fresh groceries. In fact from my knowledge only JD, AO World, Suning and Gome sell large appliances at scale with a specialized self-owned last-mile delivery network; Ocado specializes in selling groceries online but I am unsure whether they operate their own last-mile network. These two categories (the aforementioned large appliance category) – and the cold-chain logistics/fulfillment network required for fresh produce delivery are extremely difficult to replicate as it is not simply a question of having the capital required to build such a network at scale but also how efficient the network is over time. For example for Alibaba to fully match JD’s cost advantage on a per order basis it would require them to in-source all the product inventory themselves and build out a high-quality, modern warehouse network requiring close to 50 – 100mm sqm of GFA if we take the average SKU or order count per GFA for JD and apply it to Tmall’s order volume (this is a rough calculation but given we know that Tmall’s total order volume is a multiple of JD’s – the gross floor space that will be required is safe to say massive). We know this scenario is basically near impossible for several obvious reasons. I will not spill it out in detail here but very briefly Ali has a very software-centric culture, there are already existing 3PL firms that Ali’s merchants rely on which are improving their own efficiency over time, local government zoning laws near major cities are a pain in the ass and China likely doesn’t have 50 – 100mm sqm of GFA of strategically located real estate for modern warehouse buildouts (in fact it might not even have 20 – 30mm and of the total modern warehousing stock available most of it is already taken). Let’s not forget that JD is relentlessly improving their fulfillment network every year and will likely get to 2 – 3 hour delivery windows for most of its network within the next 5 – 7 years due to its huge lead. Taobao sellers often evade the VAT tax and a significant number of them experience chronic losses in the chaotic Taobao marketplace. The fragmented nature of Taobao/Tmall means those small sellers can never benefit from the same type of scale advantages that JD’s 1P operation could. Instead they have to rely on BABA to improve its platform/logistics each year to catch up with JD but even those improvements aren’t going to structurally alter the cost structure of the sellers. In short if you do not own a hub-and-spoke fulfillment model yourself, replicating a direct-seller (1P)’s cost advantage such as JD’s is nearly insurmountable.[2] Data and software can only take you so far without getting your hands dirty with the physical. The lesson here is if you want to secure the best customer experience, you have to in-source the entire value chain. An interesting note: Bezos has apparently said that one of his biggest regrets when starting Amazon was that FedEx and UPS already had the network in place for highly reliable and express parcel delivery services.

 

Thinking Deeper about Online Direct-Sales (1P) vs Marketplace (3P) Models

Two of the largest retail categories (globally and in China) are fast-moving consumer goods “FMCG” and apparel; these categories are growth opportunities for JD as the former is under-penetrated and the later JD is under-indexed to. The former I believe JD is likely to win given the nature of the category and JD being able to leverage its 1P strengths: low return rate, time-sensitive, high SKU count but a bit more standardized on average than apparel, high inventory turnover, high order frequency, specialized logistics required (for fresh groceries) and some health-sensitive products. Recent professional third-party independent surveys support a roughly 50/50 incremental share split between JD and Ali supermarket. I believe whoever has the superior logistics network wins in this category long-term as functionality and price appears to be the major customer purchase considerations. More standardized items and low-SKU count categories (more leverage with suppliers WRT volume rebates) should also attract a more diversified traffic which should help fuel the 3P business grow its selection of merchants and products. Unlike electronics and home appliances, greater expansion into FMCG will capture a broader customer base which JD can use to cross-sell a greater selection of higher-margin apparel, cosmetics, household goods etc in a virtuous flywheel.

Apparel is totally different animal. Many apparel products are driven by fashion where emotion is a larger element in the purchasing decision; this is thus a slightly different type of user problem for online retailers to solve. It is no surprise that the marketplace model works more effectively for apparel merchants vs. selling wholesale as long-tail traffic and demand is dispersed across many different SKUs (with tens to hundreds of millions of SKUs potentially in the apparel category). Tmall’s marketplace as opposed to JD Mall is simply designed/tailored for a better/more user-friendly experience for browsing hundreds of different products/SKUs within the same category such as apparels (takes an hour to find the perfect pair of shoes?) and as a result is a fantastic property for monetizing purchasing intent via ads as engagement is high[3]. We are already seeing Ali’s management switch the narrative from GMV growth to rev growth which is driven by ad revenue streams. This is in contrast to JD’s and Amazon’s site/app which you could label more as “functional utilities” as their user interfaces enable speedy customer checkouts.

JD has had only limited success in selling apparel inventory directly aside from success in more standardized apparel products. This is not to say that they can’t expand their apparel marketplace GMV longer-term if they work on positioning their fashion merchants/sites effectively (such as investing in developing separate, customized sites for individual merchants a la Tmall so that certain apparel merchants have less brand dilution if they list on JD, improving the overall tech stack for their 3P merchants via tools and features, and increasing customer traffic to the overall JD platform which will make it hard for apparel merchants to ignore longer-term. There is also evidence from professional third-party surveys that suggest that JD’s lower overall traffic conversion rate compared to Ali is due to their more limited selection. I don’t see why this can’t change as their product selection expands. Amazon Fashion for example started off targeting the low-end of apparel brands, and continues to work its way up to the higher-end.

So FMCG category is super strategic to building a one-stop shop online shopping platform -> JD must win, Apparel -> not a deal breaker to the long-term thesis but provides additional upside optionality if category expansion is successful.

 

Revisiting the JD Thesis

“When the facts change, I change my mind, what do you do, Sir?”

– John Maynard Keynes

I’m starting to get lazy writing this post 😦 so let’s use point-form notes for this section:

-Remember Bezo’s quote about there being two types of companies: the ones that always try to charge more and the ones that lower prices over time. The latter are applicable to many high-turnover, structurally low-margin retailers who maximize NPV by reinvesting efficiencies into lower price given the rather price elastic demand profile of their category. Examples include many supermarkets, ultra-deep discount retailers such as Costco, Aldi, Lidl, and major categories on Amazon and JD. People often focus on the first-order effect of lower prices = lower margin, and higher volume, but forget to take into account higher volume rebates from suppliers/better mark-ups over time and higher cost efficiencies/inventory turnover = some margin recapture longer-term. As a result such pricing decisions adhere to the goal of maximizing the long-term absolute dollar free cash flow per share, not long-term margins.

On operating leverage:

-Marketing and advertising expense leverage (which is not often talked about) kicks in over time as less traffic will be sourced from third-party traffic and more directly from organic sources such as new customers from either the WeChat/QQ Mobile channel or JD’s app/website. 5 – 7 years from now this will largely be a purely discretionary expense for a dominant franchise such as JD.

-Additional upside from leveraging logistics infrastructure such as unmanned warehouses, self-driving vehicles, and drones to enhance their long-term structural cost advantage. The automated warehouses could decrease their labour costs greatly as this is the biggest component of overall fulfillment costs. I have already noticed that their Asia #1 warehouse in Shanghai has increased its order processing efficiency over time from originally 16k parcels per hour to 20k now.

-If there is a hard-landing in China, offline retailers (mall-based or otherwise) will get absolutely crushed. Suning and Gome, in particular, are much less efficient retailers than JD on every key retailing metric such as inventory turnover, and OpEx as a % of direct-sales. In such a scenario JD should benefit even more as the secular shift to online sales accelerates.

-The overall margin expansion story may be delayed by a more few years (due to aggressive price investments into the FMCG category) than what I originally thought before they reach a steady-state level, and their steady-state margin profile may be lower than what I originally assumed (4 – 6% of Net GMV). Mid-case, at a 3.5% operating profit margin as a % of Net GMV by 2021, with the earnings power capitalized at a very conservative 18x – 22x exit EBIT multiple (or less than 25 – 30x FCF with an implied terminal FCF growth of ~6% assuming a 10% cost of capital), and adding up all the other hidden assets and FCF generated over the interim years, JD shares could potentially be worth between $137 – 166 by 2021YE. This valuation assumes zero upside optionality from all the FCF that will be generated in the interim. I think these exit multiples could potentially be very, very conservative as there’s nearly a non-existent risk of long-term disruption (commercialized teleportation is unlikely) for the dominant retailer whose main competitive advantage derives from scale. By this time they should also at the very least be larger than the current size of Amazon’s entire retail business. As additional downside protection in the absolute worst case scenario, it appears Walmart and Tencent have taken a keen interest in JD and have been buying more stock recently around these levels. In the worst case scenario, could they be a liquidity provider of last resort, or even acquire the entire company? It still gives me a bit of comfort that there is some sort of valuation “floor” here…

Amazon: Still the Best Business in the World

To reiterate the original thesis: Amazon is the best company in the world managed by one of the greatest investors in the world and is one of the most compelling multi-decade compounding stories today.

Who would have guessed 10 years ago that AWS was going to dominate public infrastructure computing and be worth several hundred billion dollars or multiples of Amazon market cap at the time? Not even Bezos. Even without AWS, an investment in Amazon shares would have yielded a fantastic 10-year return. The lesson here is that upside optionality is almost always underpriced for the exceptional business. As for the investors that always have a bias for overvaluing predictable cash flow streams[4] and over-rate mean reversion-centric theses, the people with this mindset will almost always mis-understand Amazon. Exceptional businesses are exceptional businesses for a reason – their returns on invested capital do not mean-revert to the average company over time.

So if we model nearly $500bn of net GMV by 2021 or a 5-year high-teens CAGR, an operating profit margin of mid-single digits on Net GMV (50% contribution profit margins for 3P sales, 5% contribution profit margins for 1P sales), and assuming the Prime business remains largely a cost-center or is around break-even levels on a rough contribution profit basis, there is a viable path to $30bn of retail operating profits by 2021.

Under this scenario and assigning a 20x multiple on 2021E EBIT, the retail business alone could be worth ~$570bn by 2021 on a future earnings power basis, or slightly above $1,000 per share. I remain a firm believer in the multi-year margin ramp-up of the retail business given all the potential leverage below the gross margin line that should kick in from increasing asset utilization rates from the fulfillment centers, increased warehouse and sortation center automation (which would reduce labor as major input cost), and potential mainstream breakthroughs in driverless vehicles and drones. With 3P GMV potentially consisting up to two-thirds of total company GMV 5 years from now, the higher-margin contribution profit mix from this segment, along with higher product margins for the 1P business from volume scale, category expansion (as Amazon is currently under-indexed to higher-margin categories), should drive overall consolidated retail margins higher substantially. Another perspective on long-term margins: as customer acquisition costs approach 0 long-term for the online retailer, marketing expenses alone which is currently around 5% of total retail revenues, will be purely a discretionary growth expense.

On the terminal value considerations, Amazon’s market share of total US retails sales excl. gasoline is only ~3.4%; their online share is closer to 35% of all US e-commerce sales. I’m honestly not sure if these figures are on a GMV or net sales basis, but that’s inconsequential and is a rounding error in a multi-decade DCF model. Obviously, not all transactions globally will shift online but we don’t even have to assume 50% end-state penetration in the US to create a massive TAM here. This is true today and will remain true even 5 – 10 years from now. With that said, assuming we discount our capital at 8%, I think an implied 5% perpetual growth rate on 2021 projected cash flows will look very conservative 10 – 20 years from now.

On AWS, the public cloud computing infrastructure and platform-as-a-service TAM is at minimum $500bn globally and likely closer to over $1 trillion if we include SaaS applications. Assuming base-case scenario 45% EBIT margins (incremental EBIT margins are already well above 40% as per the latest Q) on a 40% revenue CAGR to 2021, AWS could be earning around $30bn of EBIT and capitalized at 25x could be worth $750bn or over $1,500 per share 5 years from now. As for Google Cloud I think they have some room to grow and they are the leader in cloud-based AI features but aside from that I think their company culture sucks and their moonshot track record has been horrific. Hello drones, Hello Google Fiber. Despite Google cloud trying to differentiate mainly by price on core compute and storage cloud services, we are already seeing the leaders AWS and Azure operate in a highly oligopolistic manner with pricing cuts passed on to customers shallower than the implied Moore’s Law cost savings. Quite frankly, it is pretty embarrassing for a company like Google to have ceded to Amazon such a massive lead in public infrastructure computing when they already had the largest server infrastructure available globally. I think it just goes to show much big of a difference company culture can be to creating shareholder value.

Finally, we have the $140bn of FCF (~37% of Amazon’s market cap today) that could potentially be generated in the interim 5 years. To assume all this cash will be reinvested at a 0% rate of return is extremely conservative in light of management’s approach to allocating capital (which is to continually invest in high IRR projects on a 7 – 10 year horizon to the dismay of the vast majority of public market investors) and the widening moat which continues to offer attractive incremental reinvestment opportunities over time.[5] Jeff Bezos is by far one of the best and most under-rated (in my mind) investors in the world; allocating capital to someone smarter and a better investor than myself with such an exceptional track record of value creation is almost never an unwise decision I think. I believe my numbers have not priced in a more bullish scenario that accounts for additional upside in promising opportunities such as India e-commerce, higher monetization of FBA, Prime video streaming/Amazon studios, potential last-mile logistics for C2C, B2B, B2C commerce, Freight forwarding/logistics, at-home personal/virtual assistants, E-Sports via Twitch, O2O services and countless other adjacent markets that have yet to be tackled and that no one has yet to appreciate.

                       

The Personal Growth of an Entrepreneur

I’ve been hearing from pretty reliable sources that over a recent period Richard from JD hasn’t been working as hard as before, he’s been pleasure tripping around the world over the past year or so with his wife, and he recently purchased a private jet and a few large homes.

Despite how reliable my sources may be, I’m not sure to what extent they are true, or how much it actually matters. It is also important to discern between fact and rumour. There were rumours that the company was going bankrupt right before it IPO’d in 2014. There were also rumours that Richard was shacking his former personal assistant while still dating his current wife. The lesson is we have to be very careful when sourcing news from potentially fake or unreliable sources.

I think to some extent, someone’s personal life can be “walled off” from their business life, and thus should be off-limits for judging a person’s character. I’m sure the range of opinions on this topic is very wide, so whatever. I personally have a more “laid-back” view than others. Common sense is if someone is snorting cocaine every day, they are not fit to be CEO. They don’t have to be a saint or the perfect man who’s going to marry daddy’s little girl. As for the private jet and mansions, let’s be real here: most of us are not going to stay in the same home like Buffett did if we became billionaires. Richard came a long way from being dirt poor and surviving largely on a potato diet. At this stage money shouldn’t really be the primary motivator for him since he’s worth over $7bn. With that said, he’s recently moved his bed into his office and is essentially living at the company now.

My own hypothesis on his recent behaviour (and I am making no excuse for it) is that his management style might have changed after he got married late last year. I think he might have went through a phase – call it a mid-life crises. This is a man in his early 40’s that didn’t get married until last year because he dedicated the vast majority of his adulthood towards building JD. As far as I’m concerned, he deserved a long honeymoon.

After getting married, and seeing JD become a much more successful company post-IPO and the Tencent Partnership, perhaps he just wanted to put in less facetime in the office, and at the same time tried implementing a more decentralized management structure. Steve Jobs for example who is another legendary tech CEO was a giant asshole before falling in love with his wife. He would often yell at his employees for minor mistakes. Richard was a bit similar during JD’s early days; according to many JD employees, he was not an easy boss to work for. What’s interesting is that he’s been physically absent from the company for long stretches of time in the past. For example, he studied overseas for over a year prior to JD going public, and the company was still firing on all cylinders during this time.

It’s obvious he didn’t like how the marketplace was being managed by Haoyu Shen. Now that he’s axed him, he’s taking greater direct control of the business again. So I do believe leaders can change over time, and their motivations can certainly change – this is all part of growing and learning as a person and entrepreneur.[6]

In terms of the company’s performance over the past year or so, the transitory issues surrounding JD’s marketplace segment was a bit concerning, so some criticism is warranted. However, on the most important operating metrics/key drivers such as net GMV, 1P and consolidated gross margins, operating cash flow, the incrementals, and the cash conversion cycle, business is actually looking quite good. I think the investment set-up looks quite favorable going into 2017 as margins begin to inflect materially and as we lap the transitory GMV issues.

One final point is that even if you believe there is a risk of an empire-building mindset, keep in mind that SBC is a major part of employee comp, similar to Amazon. Richard may be a billionaire but he absolutely needs his employees to work hard to fulfill his long-term vision, and if the JD stock price does not go up over time, employee productivity will likely be affected. This in my mind is basically an insurance policy for Amazon and JD shareholders or any investor invested in a similar company with a super wealthy CEO and like-minded employee comp structure.

Big picture: Richard has accomplished what few have (no unambitious or unmotivated person builds one of the best e-commerce companies on the planet, period), he’s still a very young CEO at 42 and has the potential to remain an effective CEO for the next few decades as long as his motivation remains intact. To the interests of long-term JD shareholders, a young benevolent dictator is a thing of beauty.

As much as you can admire someone for his past accomplishments and for what they say, actions always speak louder than words. So if I find out he’s partying every day I would dump the entire JD position immediately.

 

Inductive Reasoning

I take a management-first approach when it comes to investing in emerging market companies so I spend quite a bit of time conducting due diligence on the people behind the company. On a deeper note around the topic of Richard’s integrity (central to the JD thesis), I’ve summarized my thoughts below.

There are many frauds in China and one obviously has to be weary of investing in stock scams and promotions. My own experience of studying frauds is that the vast majority of them are typically run by highly promotional management teams that rely on deception in order to enrich themselves and sell stock at a highly inflated price. There is no solid evidence that I’ve come across to hint that this is anywhere remotely close to the case of JD.

My main points are as follows:

-As mentioned in my JD paper, Richard hasn’t sold a single share post the IPO event, he’s paid an annual salary of Rmb1 per annum, and has a 10-year option vesting plan. I also mentioned about the accounting differences between JD and Alibaba regarding purposely defining GMV in a much more conservative manner than Alibaba. As per footnotes in the filings, if defined on an apples-to-apples basis under Alibaba’s definition, JD’s reported GMV #’s would be at least 45% higher (~$200bn in gross GMV for 2017E, or ~80% of Tmall’s projected 2017 GMV size). We know Alibaba’s accounting is sketchy and Tmall’s disclosed GMV is overstated – but by 2018-2019 JD’s GMV could be higher than Tmall’s if measured on a like-for-like basis. Also worth noting is that JD’s largest direct retail competitors such as Suning, GOME, Amazon China, and Dang Dang are struggling and have no incentive to report bad numbers. I find it highly unlikely that Richard would have this type of compensation scheme and have the co’s numbers reported so much more conservatively than their largest peer if it was a fraud.

-JD use to deploy a very unique recruiting process which is very telling. They only hire fresh graduates with no previous work experience post-graduation for their management trainee program. From my knowledge, the focus of their recruiting process is not centered around in-person interviews because they are looking to avoid hiring people that are very good at selling themselves in person, which would potentially disadvantage other applicants that may be a better fit for their company but who are not as good at interviewing. Instead, there is a “final written exam”, where the topic is unknown beforehand. Before all the applicants sit down for this exam, a person from JD approaches the applicants, and essentially offers a bribe where they will reveal the topic of the exam for a cash compensation. This is actually the real test and there is no written exam. If the applicant takes the bribe, they failed it. I am not aware of any other company that tests potential applicant’s integrity this way.

-The recently released “corruption memo” revealing the names of the 10 employees who were arrested by police – this was not a “leaked” memo as reported by Western press sources which probably screwed up on the translation. It was released publicly on purpose likely as a warning to future employees on the consequences of acting illegally such as taking bribes from suppliers. Richard’s early life experiences of having employees embezzle money out of his first restaurant business that went bankrupt has driven him to a zero tolerance policy towards any corrupt behaviour at JD. Delivery personnel are not allowed to receive gifts from customers such as water, for example.

-JD’s largest shareholders were was a sign to me, but not a given conclusion. It is really not so much that these investors are among the largest shareholders of JD that gives me any comfort, but how Richard has dealt with them in the past which is telling. The Tiger Global deal was a particularly telling one; the company was in desperate need of cash and weeks away from bankruptcy, but Richard still did not renege on his verbal deal with Tiger (which was less attractive than the new competing offer). In terms of investing alongside some of the best investors in the world, I think a critical lesson can be drawn from the Valeant episode. I suspect due to massive commitment bias they were all unable to clearly see the red flags emerging in Mike Pearson’s behaviour, the flaws with the VRX business model, and how aggressively he ran the company.

-Sidney the CFO is the one who typically meets with groups of large investors. Sidney is quite non-promotional and I personally find management’s long-term expectations for the business (20% consolidated gross margins, low double digit 1P margins) very reasonable. As for Sidney’s 8 – 9 months at Longtop Financial – the massive accounting fraud – after speaking with a few people familiar with “ramp-up periods” for new CFOs in major companies, there is typically at minimum a 1 – 2 year transition period for a new CFO to get very familiar with a company’s books and controls. Since Sidney was at Longtop for less than a year, it’s possible he figured out pretty quickly that the company was sketched and left shortly after finding a new CFO role. Perhaps more importantly, his name was not brought up in the subsequent investor lawsuits.

-The company has the best fulfillment service in the world, period. These are some incredible achievements that I think required real human ingenuity, talent and hard work. Generally speaking, I don’t think people with this kind of vision/ability would commit fraud – it wouldn’t be worth the risk of losing it all. Also, the founder-CEOs that committed massive public company frauds were all super promotional (think Mike Pearson, Bernie Ebbers and Eike Batista) yet JD hardly has an IR effort! This is not a business model centered on paying for friendship/companionship such as a MLM scheme, or price-gauging on life saving drugs, this is about passing on as value to the end customer as possible via supply-chain efficiencies.

-Third-party data supports JD’s numbers. The best data is from the State Post Bureau which is the state regulator that monitors all express activities in China. They publish stats on total express delivery revenue which historically has tracked BABA/JD’s combined GMV almost perfectly (historical correlation > 99%). From this data point, we can deduce that as long as BABA’s GMV has been roughly right, then JD’s GMV would have to be at least roughly right. For JD’s numbers to be fake, both JD and BABA would have to be fudging numbers in concert which is highly unlikely given their animosity toward each other. In addition, Tencent has perfect visibility into JD’s WeChat-related sales data. I think they would have sold their stake a long time ago if there was something fishy here. Instead, they have been recent buyers of stock at these levels.

-Last but not least, Richard’s personal motivation portrayed through his company speeches and Chinese interviews where he says he wants to sell only high-quality authentic products to every Chinese citizen and take good care of all of JD’s employees by allowing them to retire in dignity if they work hard. I find it pretty unlikely that a fraudster would publicly announce these types of admirable goals, essentially live in his office now, and not sell any of his paper stock tomorrow worth around $7bn in aggregate and just quit. JD is one of the most customer-centric companies I’ve studied – similar to Amazon – it would be highly unusual for a fraudulent company to pass on so much value to the customer. If I had to create a fraud, I would first try and make sure that it appears very, very profitable… is this not common sense? And honestly, if I wanted to create a get-rich quick scheme, I definitely wouldn’t compete against Alibaba.

On Investing in China

Is China an investable market? I think studying the history and development of China in the 20^th century and analyzing long-term trends provides us with some insights here. We know post the Mao era/Cultural Revolution – roughly from the start of Deng’s leadership – that China has been reforming its economy. Deng normalized diplomatic relations with the US, instituted major market reforms including the development of a private sector and market economy, opened the country up to global trade and foreign investment; this subsequently lifted the majority of the population out of poverty over the past several decades. Deng was a very practical leader, and ridiculed the notion that it was better to be poor under socialism than rich under capitalism – a common mindset among China’s leadership during the Cultural Revolution when untold numbers of people died from famine. This was in stark contrast with the Mao school of thought which valued egalitarianism above all else (a value aligned closer to Stalinist and Marxist policies). We know Mao’s intentions were good but his policies were a great failure.

Let’s face it, democracy has its issues as demonstrated by the recent US election, and is not the best fit for every country in the world. There is no one more credible or smarter about the issues surrounding Asian economic development and politics than the late Lee Kuan Yew (LKY), or the father of Singapore. LKY valued a clean government free from corruption, with high standards in ethics, integrity, competence, and intelligence; he wanted a society driven by meritocracy, a highly educated workforce, and of course respect for the rule of law. For example, he made sure that the compensation of senior government officials were closely tied to the compensation packages of private sector CEOs in Singapore, which helped reduce corruption. On the social stability front, there were no poor ghettos in Singapore despite there being visible Indian and Malaysian minorities who lived harmoniously alongside ethnic Chinese Singaporeans. In each individual neighborhood in Singapore, Singaporeans of different ethnicities were forced to live alongside each other proportional to the national ethnic population mix. This ensured that there would be no minority ghettos like we see in many countries in Europe, where resentment can easily breed into violence as seen today.

LKY believed in social Darwinism, but he was primarily a pragmatist with a largely non-ideological approach towards governance. Singapore was essentially a real-life experiment of the Hobbesian model (a social contract between the people and the State, where some liberties and freedoms are given up in exchange for security and social stability) which became extremely successful. During LKY’s era as the unequivocal benevolent dictator of Singapore until his retirement, Singapore’s GDP per capita grew from a third-world country level into now one of the highest levels on the planet.

The miracle of Singapore did not go unnoticed by the Chinese. Circling back to China: it is now a middle-income country, on its way towards becoming a high-income country over the next several decades. Some can say China is actually the most capitalistic country on earth that still labels itself as a communist one.

Ever since Xi took office, consolidating power and eliminating government corruption has been his main priorities. Some factions of the military were loose cannons under Hu Jintao’s administration, and were dangerously anti-American; Xi basically threw all of these crazy generals in jail. It is also important to note that Xi’s de facto second in command, Wang Qishan, (who’s in charge of the corruption crackdown) was a student of history and the Singapore model, was greatly praised by LKY as one of the most capable people of China, and has no offspring who would benefit from him enriching himself.

Here are LKY’s own words commenting on Xi:

“I would put him in Nelson Mandela’s class of persons. A person with enormous emotional stability who does not allow his personal misfortunes or sufferings to affect his judgment. In other words, he is impressive.”

 – Lee Kuan Yew

Xi is smart and what he understands is that conflict with the US will derail China’s long-term growth. As a result, cooperation is the only viable path the country can take towards its goal of becoming a 21^st century superpower. As for the VIEs issue specifically, an action by the Chinese government that effectively wipes out foreign investors is an action that goes against all of what the Chinese government has been trying to achieve over the past 4 – 5 decades: long-term economic development and global cooperation. What the political figures who have the most credibility on the US-China issue (Deng, Xi, LKY, and Henry Kissinger – arguably the greatest statesman in the 20^th century and the person who laid the groundwork for the normalization of diplomatic ties between the US and China in the 70’s) all have in common is they simply value pragmatism in their statecraft over ideals.

As for the Taiwan issue, the island can be wiped off the face of the earth by the PRC overnight, so I don’t think it’s wise for Tsai Ing-wen to fuck around here. We also know Trump is an idiot and needs a bit of time to be lectured/advised on international relations. I think what’s driving current Taiwan – PRC relations is largely a very complicated history and social animosity between the two peoples. Sadly these things do exist like other common prejudices, no matter how much some people hate to admit. For the record in Asian circles the unofficial social pecking order among Chinese people in East Asia are Hong Kong > Taiwan > Mainland China. It’s also not a coincidence that the GDP per capita of these three “states” follows the same descending order. Over the next several decades, as China outgrows both special regions economically, this will likely change.

As for the event risk pertaining to a massive banking crises/currency devaluation, if you have an anti-fragile organization with ample liquidity and a quality LP base then you’ll likely benefit from such an event. Being the incremental buyer of last resort/provider of liquidity in times of great market distress has often times yielded very lucrative gains for the prepared… Most importantly, I’m not smart enough to know what the macro developments will be like over the next several years; I’ll admit it. Short-term political and economic based speculations are worthless and futile anyway. However, on the longer-term considerations, such as over the next 10, 20, 30, years, I’m confident that income per capita in China will grow enormously.

With all the added uncertainty that comes with investing in a foreign market – and one that is so culturally unfamiliar for many Westerners – why even bother? Quite simply, the exceptional return potential available at large scale. The number of long-term oriented institutional investors in China remains close to non-existent today. Honestly, investing is never easy, but structural advantages do exist for those open-minded enough to exploit them. The few smart, long-term oriented investors focussed on China such as Hillhouse and Capital Today got in really early, simply picked the best companies levered to the Chinese consumption and internet theme,  and as a result, accumulated a few of, if not the best investing track records over the past 10+ years. It didn’t take a genius to figure this out, but a disciplined approach to long-term investing.

Liberty Global / LILA/K

No post on this blog is serious without a discussion of a Malone-related company. It’s safe to say that ever since LILAK became a tracker, the story has been a complete shit show.

Has it historically been wise to invest alongside Malone? For the most part, yes. But now with dozens of related entities within the complex, we have to be very careful with picking the best story.

Let’s start with Global. First, the failed Vodafone transaction in the spring of 2015 caused the event-driven funds to sell en masse. The unofficial explanation provided by management was a valuation gap that couldn’t be bridged. This sounds reasonable. Vodafone is primarily a wireless company, and wireless companies in general deserve a lower multiple than higher-quality fiber/coaxial-based fixed assets. Soon thereafter, Fries starts giving out “long-term OCF” guidance of 7 – 9% OCF growth for the next few years (for the first time in the company’s public history, I might add) as the competitive situation in the Netherlands continues to deteriorate and the Ziggo integrations are becoming more challenging than originally estimated. Even up to this day, there is no indication that the KPN Fiber JV in the Netherlands is slowing down its FTTH rollout or its aggressive promotional pricing.

Unfortunately, the competitive position in Switzerland appears to be deteriorating as well. Most of Global’s issues in its most competitive markets is a problem of high population density making the economics of overbuilding a lot more attractive for European Telcos. The Netherlands for example, with a super dense pop/sq km of 400+, makes FTTH a very viable economic proposition over large parts of the country. On top, Gfast technology makes it possible to further upgrade copper networks in these shorter local loop markets; Gfast can provide downstream speeds up to the several hundred mpbs range with a relatively cheap incremental cost of capital compared to FTTH. Forced unbundling regulation of the local loop supported by many Socialist regimes in Europe also adds further competition by resellers. As the minimum speeds being offered by the Telcos continue to be well above the industry demand curve, pricing power for both duopoly operators and resellers will likely continue to be soft. Europe, in contrast to the US, is simply a much more competitive broadband market.

With these issues at hand, I don’t see a path towards 7 – 9% OCF growth. No one believed management’s announced guidance and for good reason. I think even 5% OCF growth including project Lightning could be a stretch. Now they’re saying 7 – 9% excluding Ziggo, just lol.

So why has Mike Fries suddenly become so promotional in such an “unliberty-like” fashion? First of all he got most of his options and RSUs struck earlier this year when the stock got absolutely crushed. Secondly, there’s the added incentive to sell/merge with Vodafone if your operating performance is deteriorating. It’s obvious a stronger share price brings with it a stronger bargaining chip to the table with Vodafone.

As stated, management’s rationale for demanding a discount on wireless assets given their lower quality is reasonable but what I don’t understand is the disconnect between paying 11x post-synergy EBITDA for an Latin American asset with a considerable wireless mix vs. not striking a deal with Vodafone at likely better terms and massive synergy benefits.

Now with the deteriorating results of CWC along with the accounting adjustment from IFRS to US GAAP for CWC/Columbus (shouldn’t they have adjusted their purchase multiple for these changes beforehand?), it’s obvious they overpaid.

The LILAK thesis for many Liberty followers was largely based on trust in the management team given their multi-decade success investing in and operating cable assets globally. This becomes even more important when it comes to investing in a business operating less familiar/foreign regions. But just the credibility I think Mike Fries lost over the past year or so with his sketchy behaviour should warrant some caution… I like to think as the management team you get the stock price and the shareholder base you deserve as results come in over time. Fries should seriously just focus on operating the business well instead of revising the guidance every single quarter.

LILAK a narrative parallel to TCI or early Global/UPC?

I don’t think so. TCI was an actual monopoly in the burgeoning US Pay-TV industry when wireless and high-speed data services were not around. TCI was a major financial backer of upstart cable networks which allowed the company to distribute exclusive programming in its pipes. Market power can be pretty insane if you control both the content in the pipe and the distribution. On the M&A front Malone was rolling-up local cable systems run by mom-and-pop entrepreneurs at valuations probably closer to 4 – 5x EBITDA. At peak, TCI had a 30%+ market share of all US Pay-TV homes. When cable and telecommunication assets were near/at peak valuation levels at the turn of the century, satellite distribution became an emerging threat, interest rates were heading up, and the balance of negotiating power was shifting to the cable networks, Malone sold TCI to AT&T. The timing was impeccable.

Will the CEO of LILAK be capable of executing such a successful playbook in Latin America? Maybe… but I seriously doubt it. Seems like it’s been dealt a much tougher hand.

Charter Communications / Liberty Broadband – Still the Best Special Situation Compounder that everyone has heard of

Houston, we have a cost problem:

Excluding programming costs, the average US cable operator has an OpEx per resi sub/month cost of ~$50. For European peers, this is closer to $15 per sub. Certainly household density, competitive intensity and labor costs play a major role here, but the gap is startlingly wide. It’s likely that for the longest time US cable operators were run by complacent monopolists. This may soon be about to change.

Patrick Drahi is still a stud:

Last year Altice entered the US cable industry with their purchase of Suddenlink and CVC, along with announcing massive cost cuts and synergies. Believe it or not, Altice’s $900mm synergy target for CVC is likely achievable and potentially conservative. Excluding programming, CVC had an OpEx cost per resi sub/month of $60 – 65. Assuming Altice fires all of the family friends the Dolan’s hired as middle managers earning a $300K+ salary, and stripping out the Dolan’s/senior management compensation, among other bloated HQ expenses, we could potentially get to roughly $100 – 200mm in overhead cuts. That leaves about $700 – 800mm left for resi sub-related cost cuts. The implied target OpEx synergies management are looking to shave are then around $20 – 25 per resi sub/month. If these targets are met, CVC’s OpEx per resi sub/month will be $40 – 45, which is still well above its European peers at $15 per sub! Numericable for example has an OpEx per sub/month of $15, and let’s not forget, France is a much more competitive market than FiOS territory. That’s just on the OpEx side, as we haven’t factored in any programming cost synergies with Suddenlink, or their plans to move towards more skinny Pay-TV bundles and outright drop certain networks. This could shave another few hundred million off. Finally, the CapEx per passing for CVC is much higher than European peers due to the many duplicate hardware in their network. If upgraded and maintained under Altice, this could shave another $100 – 200mm off long-term.

So on Charter, I think the real, and still rather conservative, cost-synergies will be closer to $1.4 – 1.6bn on full run-rate numbers by 2019. Just the programming synergies alone could be $650mm in a few years if we assume Charter moves to TWC/BH’s lower rate card and if they achieve a pro-forma programming rate card in the mid-$50s per resi sub/month by year 2 post-merger. If we model just an OpEx per resi sub/month for Charter of ~$50 just from the scale benefits of merging multiple systems in a contiguous combined footprint, we can get to over a billion in OpEx synergies easily. Just from the OpEx and the programming synergies alone we can get to $1.6bn in cost savings or double management’s $800mm guidance. Also, this figure doesn’t account for the duplicative overhead and executive compensation costs for BH and TWC, nor any CapEx savings from the benefits of leveraging a larger sub base for purchasing set-top boxes, modems and other network equipment…

So over time, it’s very possible that the actual synergies end up being double or even triple management’s original $800mm estimate – which would still be a MSD % of pro-forma revenues – and roughly in-line with prior cable merger deal synergies.

Why is there so much upside on the table? It’s obvious there was management sandbagging from the get go. This was done to avoid overbearing regulatory scrutiny over job cuts and announcing an attractive profitability outlook for rationalizing a huge merger. Also, Rutledge’s compensation package (including options and RSUs with exercise prices up to the $500’s per share) for the pro-forma business was struck shortly after the merger closed, incentivizing him to downplay the potential upside. If these ambitious share price targets are met over the next 5 years, he will become a billionaire on paper. The only strong pushback I can think of is that Rutledge is not known as a cost-cutter, despite being a great cable operator. However, now with the Trump administration in place along with a less onerous regulatory environment, I see potentially more leeway for aggressive cost cuts. On the revenue front, the new industry-friendly FCC could mean the approval of data caps and usage-based pricing which would likely mean additional upside for broadband pricing.

As for the HSD penetration runway, If we define “high-speed broadband” as a service providing minimum downstream speeds of up to 25 – 50mbps, then “real” US high-speed broadband penetration is understated relative to published industry figures (which typically define a broadband household as one with any fixed-line internet connection including DSL). If high-speed broadband penetration defined under these minimum speeds eventually reaches 80 – 90% in the US over the coming 10 – 20 years (not unreasonable given the robust demand outlook), then it’s possible that Cable will take the vast majority of incremental share over the next couple of decades. We’ll likely move to 10GB eventually, but this will probably be closer to 15 – 20 years from now. Cable’s technology roadmap looks promising and it appears DOCSIS 3.1 alone (which is slowly getting rolled out by Comcast and Cox in select markets over the next few years) can get Cable to those speeds without upgrading the last-mile to fiber-optic.

Currently Charter’s HSD penetration is ~45% within its footprint. If the industry moves towards 90% penetration eventually, and assuming a 50/50 share split between Cable and FiOS (16% overlap), a slightly more favorable share split between Cable and U-Verse/upgraded DSL (25% overlap), and of course a 100% share split vs DSL in the rest of Charter’s network, Charter can potentially grow its top-line at at least MSD rates for the next couple of decades, driven by new net adds, modest base inflationary pricing expectations, upselling faster data speeds, and increasing commercial sub penetration. In any event, I think with the synergies outlined and the fantastic incremental margins from broadband subscription growth, Charter’s EBITDA margins should be closer to at least 40 – 45% 7 – 10 years from now, which would still be below Altice US’s targets for CVC and Suddenlink at 50% and European peers.

As for 5G, I’m too lazy to discuss that today, so let’s leave it for another time, or on a good day.

On valuation, assuming a continuously levered capital structure at 4.0 – 4.5x with aggressive capital redeployment into share buybacks, I see a pathway to $40 – 50 of fully-taxed levered FCF per share by 2020 or $20.5bn+ of EBITDA at a slightly less than 40% margin. At an implied 9 – 10x EBITDA exit multiple / or ~18x levered FCF per share of $40 – 50 (potentially very conservative assumed exit multiples given the aforementioned multi-decade attractive growth runway), Charter stock is worth $750 – 900 per share 4 years from now.

In conclusion, I believe Charter Communications / Liberty Broadband remains the most attractive cable asset to own globally and one of the most attractive long-term investments in the US large-cap TMT universe today. Did I mention John Malone? 🙂

“All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” – Blaise Pascal

Happy Holidays,

Richard

[1]Outside of getting acquired which I think is increasingly unlikely other than a carve-out of the studio business, I still think Viacom is a short and the equity could potentially be worth close to zero 4 – 5 years from now. The cable network segment comprises of the bulk of the value of the company and earns juicy EBITDA margins north of 35%.

[2] We also know for a fact that their last-mile unit cost per order is lower or at least on par with any of the prices third-party last mile franchises charge to merchants (assuming we take into account all the costs across the entire last-mile delivery chain including inbound delivery, sortation centers, line-haul, delivery stations I estimate JD’s average fulfillment and last-mile delivery cost per order was ~$1.70/$0.85 in FY2015 (vs 8 – 10 RMB for the industry ASPs), at the same time JD’s service quality is superior (based on customer service ratings/surveys, cash on delivery service available), and faster, more reliable, with a friendlier return policy. So better service than the industry with a marginal cost structure equal to or lower than industry ASPs.

[3] In fact, e-commerce search engines will likely become the most valuable advertising properties long-term over horizontal search engines as incremental traffic growth increasingly shifts directly to e-commerce properties; these properties are superior in creating purchasing intent right at the bottom of the funnel.

[4] There’s a big difference between how asymmetric the risk-reward profile of an investment (or how wide the distribution of future outcomes) is vs. the probability of a large permanent loss of capital.

[5] The barriers to entry in new or adjacent markets are lowered due to the valuable customer data and existing scale built in an adjacent market.

[6] I’ve observed that successful leaders may have many different management styles and philosophies. If I had to guess the most important thing for a CEO on a daily basis is to prioritize tasks. But on a more strategic level prioritizing company long-term initiatives is as equally if not more important. How Bezos allocates his time within an increasingly complex business such as Amazon with many different projects and moonshots is a mystery to me. At Baidu you can bet Robin is spending most of his time on AI as he knows the search business will soon be in secular decline. Like a lot of great tech CEOs the recurring pattern appears to be that they are extremely passionate about their business, have a solid technical background, quite introverted and typically not very charismatic. The best tech CEOs have all these traits at minimum and are great allocators as well!

A Response to the JD Short Thesis on SumZero

Some of you may have seen the 50-page JD short write-up that was recently posted on SumZero. The author essentially compares JD to Valeant and slaps on a $12 price target for his short thesis.

Coming up with such a sensasonal comparison, I was expecting to come across some high-quality analysis to back-up the attention-grabbing headline and hopefully learn some new insights from someone with an opposing view. Instead, what I got was a very biased and inaccurate report. A condensed version of the short seller’s paper can be found a here.

Below I will address all of the short seller’s major arguments.

 

1. Returns/cancellations may be as high as 20-25%. Net GMV removed after IPO.

Anyone who has put in some effort to study JD and the e-commerce industry knows that gross/reported GMV is before returns/cancellations (which the company clearly defines in its filings). That is practically how any discerning analyst models the business including the sell-side. I don’t know anyone who models gross GMV as being completely monetizable, or bases their valuation off of gross GMV alone. All Chinese e-commerce companies disclose only gross GMV which is common knowledge for those that have studied the industry, but somehow for the short seller this is a red flag for JD…

JD stopped disclosing net GMV after the IPO because all of its competitors including BABA only report gross GMV and reporting agencies/media were using JD’s net GMV figure to calculate their respective market share vs. Tmall which basically penalized them vs. the competition. But if you call up IR which doesn’t seem like the short-seller did, they would tell you what the net GMV and implied return/cancellation rates are. To the extent that gross GMV is useful as a financial metric, growth in gross GMV could be used as a rough proxy for measuring growth in net GMV or “net monetizable revenue” once one has come up with a reasonable return/cancellation rate.[1] Certainly this metric when properly adjusted is a key business driver for a company scaling in high-growth mode and by nature is very different from the questionable metrics used by internet companies during the dot-com boom as the author tries to draw a historical comparison to…

Historically returns/cancellations have been about 18-21% of GMV for the 1P and 3P business (IR will confirm this with you). Another way to confirm this is through public filings as JD reports both the gross GMV and net revenue figures (under the “online direct-sales” line) for the 1P business (the only difference between the company’s definition of net GMV and net revenue is the VAT which is 17%).

For example, in FY2015 JD reported gross GMV of RMB 255.6 billion and net revenue of 167.7 billion for the 1P business. The way to get the return/cancellation rate is to arrive at net GMV by adding back the VAT (167.7/0.83 = 202 billion). The difference between gross GMV and net is 53.6 billion (255.6 – 202) which implies a 20.9% return/cancellation rate. Where the short-seller miscalculated is instead of dividing the net sales by 0.83 (if the tax is 17% then what remains is 83%) to properly account for the effect of the VAT, he mistakenly grossed it up by 17% which understates net GMV and overstates the return/cancellation rate.

In any case, we can see that the return/cancellation rate has trended up over time. There are two primary reasons for this as management has clearly communicated: 1. The mix-shift away from electronics into more general merchandise, especially apparel, has increased the return rate (the return rate is still at industry-low levels around mid-to-high single digits whereas cancelled orders make up around 80% of the gross-to-net GMV gap); 2. More purchases are now done on mobile (mobile accounted for 30% of total orders in Q3 2014 vs. 72% by Q1 2016) where consumers tend to leave more orders uncompleted and where there is likely more impulse-type buying. Management is working to bring the completion rate on mobile down to a level more similar to desktop over time.

Accusing the company of a lack of disclosure where JD clearly defines gross GMV and net GMV in its filings and would readily supply information on net GMV over a simple phone call seems pretty ridiculous.

 

2. Brushing on 3P marketplace reported by media and recent JD comments: 10% GMV discount

Brushing is a common phenomenon on all marketplace e-commerce platforms including Taobao/Tmall, eBay and Amazon (I am reasonably knowledgeable about this as one of my best friends was a Powerseller on eBay, where brushing is extremely common). The idea is that to get better reviews and more importantly, a higher review count for their products, some 3P merchants would “brush” by buying their own products and write favorable reviews (and never delivering the product, for obvious reasons), in turn driving up the reputation of their stores and their rankings over keyword searches.

This problem in particular is prevalent over Taobao which does not charge a sales commission, and hence “brushing” is practically free for the merchant. On Taobao and to some extent on Tmall, this introduces an adverse selection problem on the platform as the bad actors crowd out the good actors who refuse to brush and artificially boost their ratings.

Brushing is a much smaller issue on JD for a number of reasons. Firstly, 56% of JD’s LTM GMV is 1P (self-operated) which by definition has zero brushing. Secondly, a very substantial % of GMV on the 3P platform is generated by flagship stores owned by the brands themselves who rarely engage in brushing. Thirdly, JD’s commission is much higher than Taobao/Tmall which makes brushing very costly for the sellers and lowers their ROIC on brushing relative to more legitimate marketing channels such as keyword bids and display ads. Finally, all of JD’s merchants are large brands or retailers that are over a certain size limit; JD is much more selective about its 3P merchants (far more initial due diligence and ongoing monitoring on marketplace merchants) and has a soft cap on the number of merchants allowed on its platform (JD only has around 100,000 3P stores vs. over 10 million on Taobao).

When a 3P merchant is caught brushing, JD generally kicks the seller off the website permanently whereas Alibaba follows a much more lenient “3-strike” rule (only removing the seller after catching him brushing/selling counterfeits three times). Unlike Alibaba which refuses to acknowledge brushing as a problem, JD has been heavily investing in anti-brushing technologies and has specifically called out their recent anti-brushing campaign as having a modest impact on GMV growth.

Furthermore, JD’s reported GMV has always excluded GMV generated by merchants with abnormally high return and cancellation rates, as well as any cancelled orders above 2,000 RMB to partially account for the effect of brushing. No other Chinese e-commerce company is as conservative with GMV reporting. Brushing is estimated to account for as much as 15 – 25% of Taobao’s GMV whereas most estimates put it at low to mid-single digits of 3P GMV for JD. Assuming 5% of JD’s 3P GMV is “brushed”, the impact on JD’s total GMV is less than 2.5%. Moreover, since 3P merchants mainly use brushing as a marketing tool, as JD’s technologies make it harder to brush, these sellers will increasingly have a stronger incentive to shift their marketing spending to keyword search advertising which would ultimately help offset any lost commission revenues related to brushed transactions.

As for the newspaper article which alleged that a JD employee helped sellers with brushing activities, JD has specifically responded that the employee was new to the company and was immediately terminated after the incident. The reality is no matter how much effort is exerted, you cannot completely prevent corrupt behavior at a company with over 110,000 employees.

 

3. Improper counting by orders placed and limited disclosure: 5% GMV discount

This argument is just plain bizarre. The author claims that GMV is inflated because 1. It includes shipping fees (well, nearly all of JD’s orders include free shipping to the customer and the shipping service is a key component of the online shopping value proposition; Alibaba also includes shipping revenue in its GMV and Amazon includes shipping in net revenue); 2. It includes GMV from equity investees – by that logic if Amazon owned 20% of one of its suppliers it should not count revenue derived from that supplier as actual revenue!?); 3. It includes internet finance revenue (will be discussed in point 9 below).

 

4. China-based auditor is unable to audit 100s of millions of orders: 5% GMV discount (We note that it is a gigantic task for JD’s auditor, PricewaterhouseCoopers Zhong Tian LLP to audit 100s of millions of orders placed which count towards GMV. As such given even the auditor cannot audit GMV, we would place an additional 5% discount/hair cut to the reported GMV figure.)

So the author has decided to give JD an arbitrary 5% GMV discount simply because it is impossible for the auditor to independently verify every single order on JD. I’m out of words here. Seriously, the same can be said about any large company engaged in large transaction volumes – Amazon, P&G, Wal-mart, JC Penney – you name it… Perhaps the author is trying to imply that management are disingenuous when disclosing key business drivers? In no part of the author’s paper did he touch upon any aspect of the founder’s background, character, or past dealings with major stakeholders – perhaps this not so surprising in such a biased paper as Liu could potentially be one of the most ethical corporate executives alive today.

 

5. JD is Enamored with GMV While Losses Grow Larger

JD’s core business is actually profitable, despite operating in a growth phase. The current reported losses are due to one-time impairments and current investments running through the PnL that are tied to fast-growing businesses such as JD Finance and JD Home/Daojia that are at present subscale. JD’s reported FCF profile also turned negative in 2015 in part due to the heavy investment in fulfillment center construction – this is mostly growth-related CapEx. But if you analyze JD’s FCF generation a few years back, you can clearly see that the core business is solidly profitable and this is in large part due to the Finance unit being started only in 2013, coupled with the company’s prior strategy of leasing warehouses to meet order capacity. If the author provided a sound argument that JD is investing in low-return projects, then criticism of the current heavy spending is warranted.

Perhaps the author didn’t catch this, but JD added two new internal KPIs for 2016 (that will affect employee compensation) – and both are focused on increasing profitability – Cash Flow Days and Operating Profit.  The author has also omitted the steady gross margin expansion JD has shown year after year driven by rapidly growing 3P contribution profits.

I believe the right way to think about the GMV metric is to use it as a relevant benchmark for comparing the profitability and margin structure of the target business to other offline and online retailers at similar scale. GMV is a relevant metric for hybrid or pure-play marketplace retailers since a marketplace business (commission-based revenue model) has a very different margin structure to a direct-sales/1P business. Depending on the average product/gross margin of the 1P business, and the average commission/take-rate of the 3P business, comparing the profitability of a hybrid online retailer to a pure-play direct-sales retailer by assigning a steady-state or long-term margin on GMV could be a useful tool for analysis. Conventional analysis such as assigning a margin as a % of revenue for both 1P and 3P units is also possible, but less useful for straight comparisons between different retail models. Remember that GMV should always be adjusted for returns/cancellations, and any VAT taxes. No competent analyst I know of uses gross GMV for straight comparison/modelling purposes.

What the author seems to be missing is the massive operating leverage that will become evident from owning your own fulfillment assets as order volumes continue to grow as well as the sizable gross margin expansion from 3P GMV growth and increasing scale in the 1P business. The author seems to be skeptical that JD’s 1P gross margins will eventually expand despite his own admission that GMV will likely grow at least in the 30%+ range (faster than any direct competitor). I view this risk as very low given JD’s track record in execution and the fact that they are already the largest direct-sales retailer and are growing all categories at a volume rate multiples of that of their largest rivals Suning and Gome. The author also does not take into account the considerable likely incremental cost-savings in the future from more automated warehouses and the use of delivery drones.

Ultimately, it is the margins (gross and operating) and FCF, in particular, that matters most to JD’s long-term intrinsic value (something the author has yet to have an opinion on) and JD management understand this as well (apparently the author doesn’t think so) and have their own opinion of what type of margins JD could achieve long-term if you speak with them. Overall, it appears that it is the author who is myopically focused on GMV and short-term reported losses over having an informed view of what the economics of JD’s business could look like longer-term.

 

6. Paipai acquisition boosted JD’s GMV by RMB 33.6bn ($5.3bn). GMV was counted, but RMB 2.8bn impairment created for shareholders. Questionable capital allocation for GMV?

The $5.3 billion the author quoted is cumulative GMV over two years (seems like he made the number artificially larger to exaggerate his claim). Ever since the Tencent – JD strategic partnership transaction closed, JD has always disclosed core GMV on an ex-Paipai basis (Paipai is a C2C platform originally owned by Tencent). JD shuttered Paipai last year because as a C2C platform similar to Taobao, Paipai is fraught with counterfeit products and given the sheer number of small merchants on the platform, it is practically impossible for JD to enforce a counterfeit-free platform. In sum, JD’s decision to kill Paipai was motivated more by reputation management over short-term economic considerations.

More importantly, the author omitted the biggest component of the Tencent deal which gave JD an exclusive position on Tencent’s flagship mobile apps WeChat and QQ (35% of all time spent on the internet in China is spent on Wechat). WeChat and QQ now account for 20 – 25% of JD’s customer traffic and have helped JD significantly accelerate its growth profile. To completely disregard this contribution while isolating a minor part of the deal to discredit management’s capital allocation track record is one example that highlights the author’s overly biased position.

 

7. JD counts in its GMV orders placed in JDs websites but operated by equity investees like Bitauto and Tuniu where traffic generated through JD platform…The question is why should JD be counting in its GMV when this is an equity investee?

It doesn’t appear that the author has ever used JD’s website. GMV generated through both Bitauto and Tuniu actually take place on JD’s platform under its travel and auto verticals so Bitauto and Tuniu are effectively 3P sellers on JD just like any other 3P merchant. Both account for a negligible amount of JD’s GMV currently.

 

8. These investments (Tuniu, Bitauto and Yonghui) have been a dud and burned real cash…

This argument is analogous to saying that because a stock in your portfolio has fallen below your cost basis that it must be a permanent impairment of capital… please spare me.

Both Tuniu and Bitauto are publicly traded on the NASDAQ and JD’s write-down of value in both was driven by the fact that their market capitalizations have fallen substantially over the past year (JD acquired a stake in both during 2015). For context, Tuniu is the third largest Online Travel Agency in China (think Priceline) and has recently established an alliance with industry leader Ctrip (forming effectively a monopoly); Bitauto is one of the top two advertising platforms in the internet auto vertical. Both are rapidly growing players in industries with massive TAMs. To say that the investments have been a waste of money simply because of short-term volatility appears quite unfair to say the least.

JD has not realized any capital losses on these investments and it is also obvious that Chinese-related securities as a whole have not been performing well over the past year. Both stocks have gotten crushed over the past year (each down by more than 50%+) and I am not saying that over time JD’s investment in either Tuniu or Bitauto might not turn out to be a disaster but I definitely think it is premature to jump to a conclusion that they are without properly assessing management’s decision. One has to consider that management is very focused on long-term value creation and that is also reflected in their capital allocation decisions. Now if the author provided some sound fundamental analysis to support his claim that Tuniu and Bitauto were a waste of shareholder cash instead of relying on Mr. Market as his informer of intrinsic value then I’m all ears. In any case whether these equity investees become very valuable or not, they are not key value drivers to either the long or short thesis.

 

9. JD’s consumer finance business GMV as % of GMV has been rising (with limited disclosure). JD has no track record in growing, operating and managing risks in internet finance.

First of all, what JD refers to as consumer finance GMV is not the revenue of the JD Finance business but rather the portion of GMV that’s tied to JD’s consumer financing offerings (for example, it’s the GMV recorded when you buy, a fridge on a consumer loan from JD Finance). JD has separated JD Finance into a standalone unit that will be self-financed in 2016. This unit was valued at $7.2bn post-money in January (which the author conveniently omitted in his analysis) by top-tier investors and will likely be IPO’d sometime within the next few years. It is true that JD’s experience managing internet finance businesses is rather short but the same can be said to just about any internet finance company on the planet. The whole point is they will try to get better at it and create value by leveraging JD’s massive distribution platforms. To reiterate in my original JD paper posted several weeks ago, JD Finance’s management team is prioritizing risk management over speculative lending growth.

 

10. As GMV grows, are investors underestimating the risks in JD Finance business? Internet Finance is a space with intense competition with larger, more profitable players!

Internet finance is a multi-trillion dollar opportunity in China. It appears the author believes this is a liability (note that the business is now siloed away from the core business in the worst case scenario that it never achieves minimum efficient scale) solely on the rationale that 1. This is a new area for JD and 2. This area is competitive and yet extremely well-informed people at Sequoia think this business is worth at least $7bn.

Admittedly there is competition in the Chinese internet finance space, especially on the online payments side given the larger size of AliPay for third-party payments. But as I mentioned in my paper, the market opportunity is large enough that at this early stage multiple players can create a considerable amount of value given their online distribution advantages and richer data sets over the state-owned banks.

Has the author provided any rationale that this business is not worth at least $7bn today? No, in fact he did not touch upon the nature of the fundraising round in January. Bigger picture, JD’s core business alone could be worth at least $200bn over the next 5 – 7 years, which frankly would make the internet finance division’s value look like peanuts today.

 

11. JD’s Management Has Limited Tenure For a 12 Year Old Company Which is Rarely a Promising Sign For a Company Yet to Make Money

The author really just answered his own questions here. JD is a very young company and as a result has short-tenured executives. It is also important to keep in mind that when JD was founded it was very much a one man show where Richard pretty much took on most of the executive responsibilities as the company did not have the money nor reputation to hire professional managers. JD upgraded its C-suite in the early 2010s after receiving investments from Hillhouse and Tiger Global and that allowed Richard to delegate more responsibilities to professional managers.

 

12. Who is Jiaming Sun Owning 55% of the VIE, more than Richard Liu, JD’s Founder? A Mystery

It wouldn’t be such a mystery if the author had done any research in actual Chinese. Sun Jiaming is one of JD’s earliest employees and as recently as a year ago was the SVP of General Merchandise at JD. He recently left the company for personal reasons but like Liu he had to enter into a series of contractual agreements to ensure that JD would retain effective control over the VIEs should he stop being a JD employee.

 

13. JD is a Hedge Fund Darling and Has Nearly Unanimous Buy Ratings by Analysts. Is It A Crowded Trade Like Valeant?

Yes there are some very smart people who own JD in size who hold a better opinion of the company than the author. By the author’s logic is any name heavily owned by hedge funds doomed to fail as an investment?

It’s simply not enough to be “contrarian” to do well with an investment – you also have to be right. Simply calling JD a hedge fund hotel and comparing it to Valeant without providing any sound fundamental analysis to back-up the claim basically kills any credibility the author had in my mind.

Looking at JD’s shareholder base and the extensive sell-side coverage, I would view the story as pretty well-known by major institutional investors (so it is definitely not an “under-the-radar” type of mis-pricing): JD is typically pitched as a vehicle to gain exposure to the growing Chinese internet and consumption theme. However, I am not convinced that the long thesis is well understood by the majority of potential shareholders who sit in an office in New York and lack a variant perception. As for my numbers they are materially higher than Street consensus over the next several years and I am highly skeptical that the market is accurately pricing in the long-term earnings power of the business. If the current stock price represents the market consensus then I think a sound case can be made that consensus is way too conservative on a longer-term time frame.

I would also note that there are those that actually conduct their own independent due diligence in order to develop a well-informed view of their holdings (and pencil out the numbers accordingly) vs. those that conduct limited due diligence and simply piggyback off of their buddy’s ideas at other funds. Price-agnostic buying of “outsider” companies based solely on getting exposure to a robust narrative such as TDG, CSU, or any Liberty-related story, for example, is almost a guaranteed path to generating mediocre returns.

It is also important to consider the quality of the funds holding the stock vs. simply labelling the stock as a hedge fund hotel that is ready to crash. Different funds have different time horizons, investor bases (quality matters) and average cost bases that could affect the short-term liquidity of shares. In JD for example, despite the numerous Tiger Cubs in the stock I basically treat their exposure as one de facto position since they like to share the same ideas with each other (hedge fund circle jerk is real). Hillhouse of course is well-known for taking concentrated positions with a very long-term time horizon.

Frankly when it comes down to it whoever owns the stock is irrelevant for the long-term fundamental investor in my view – except in the rare case that a large shareholder is actually adding value to management by leveraging its exceptional proprietary research to create additional value. Over the short-term it could affect the stock’s liquidity and cause higher than average volatility since shorter-term funds can crowd in and out of the stock – I view these liquidity events as more of a potential opportunity for the longer-term investor – but it could very well be a real risk for the shorter-term investor/trader.

Finally the stock is hitting fresh 52-week lows and is near its IPO price which took place more than 2 years ago; sentiment at the moment appears quite poor – calling it a crowded trade like Valeant at this point seems like a stretch at best… I am not even going to get into how JD is different from VRX since the author obviously made no worthwhile effort in his own case despite his claim.

 

14. “Services and other” revenue has deferred revenue included and limited disclosure

The author seems to take issue with the fact that 4% of JD’s deferred revenue account (a whopping $80 million) is related to Bitauto and Tuniu. “At APS, we note that there are accounting ways counted here like deferred revenue from 2015 resulting from “resource” arrangements with Bitauto and Tuniu, equity stakes where JD is deeply underwater. Burning cash but booking accounting revenue?”

Really not sure what the author here is suggesting really. There is a clear business relationship between JD and Bitauto and Tuniu both of which are NASDAQ-listed industry leaders. To not book revenue would be illogical when a service is provided or expected to be provided.

 

15. JD’s Non-GAAP gross margins need to be adjusted to reality

6. The author is correct in stating that JD’s 1P gross margin has been flat in the last four years. However, this has been the result of an intentionally low-pricing policy as part of management’s plan to quickly gain scale (management has stated quite explicitly at meetings that they have been deliberately holding gross margin flat and reinvesting scale benefits back into pricing), similar to what Amazon has been doing for the past twenty years. One interesting data point is that despite being the largest retailer in China, JD’s gross margin is over 10 points below its offline peers such as Suning and Gome which has helped them to win substantial share in the price war. 2016 is the first year JD is letting 1P gross margin expand (already increased 80 bps in Q1 this year) and management’s plan calls for 1P gross margin to increase from around 6.5-7% currently to 13-14% in the next few years. In my own estimates I am assuming 1P gross margins to expand closer to 12% by 2020.

1. Outbound/last-mile shipping costs are not captured in COGS – this is also correct, but the author is completely wrong on everything else when it comes to JD’s cost structure compared to Amazon. First of all, JD lumps its shipping expenses into the fulfillment costs line under Opex because JD’s fulfillment operations are integrated with its proprietary last-mile delivery. Amazon’s fulfillment cost is also recorded as an Opex line item but outbound shipping is lumped into COGS because Amazon outsources the majority of its last-mile delivery to UPS/USPS/FedEx. The short-seller’s analysis which adds all of JD’s fulfillment costs back to COGS is misleading and not comparable to Amazon. To make JD’s results apples-to-apples to Amazon we need to add back only the last-mile delivery portion of fulfillment. More importantly, Amazon also has a substantial 3P operation (50% of Amazon’s orders are 3P compared to 44% for JD) which similar to JD is 100% gross margin and overstates Amazon’s 1P gross margin in the consolidated revenue line. Finally, prime membership fees and AWS revenue at Amazon are both very high gross margin revenue streams (offset by much higher Opex ratios than retail) that skew the numbers.

1. JD’s use of weighted average inventory – the author’s assertion that electronics prices are falling 10 – 15% a year is purely fictional. According to the National Stats Bureau of China deflation in prices of electronics and appliances has only averaged about 1.3% for the past three years. Also the author seems to be forgetting that JD is a direct retailer with substantial scale, not a supplier that may have to eat deflationary pricing. More importantly, JD’s inventory turnover is very fast at about once every 35 days so COGS for the first 11 months of the year would be the same regardless of whether JD uses weighted average or FIFO. The impact of the inventory accounting choice is very small.

 

16. JD’s inventory has grown faster than 1P direct sales in 4 out of the last 6 years and in the last 2 years. Rarely a promising sign given huge $3bn of inventory as of Dec 2015

Even according to the author’s table inventory turnover has been very much flat for the last five years (2009 is irrelevant given the company was super tiny at the time):

Also it’s important to note how fast the inventory turnover is – if you calculate inventory turnover correctly (by using average inventory for the denominator rather than ending inventory like the author did), JD’s inventory turnover comes out to be over 10x or once every 35 days.

 

17. JD relies on Non-GAAP accounting metrics but several of the expenses should be viewed as real expenses and given real cash was burned on investments

The author is correct in stating that stock-based comp should not be added back as it is a real expense. However, practically ALL best-in-class high-tech companies do it so JD’s practice is not out of line with industry standards. Furthermore, stock-based comp at JD makes up a much smaller % of its market cap than most Silicon Valley tech companies, suggesting that JD dilutes shareholders less on an annual basis. Note that on my own numbers I fully expense stock-based comp as a real expense when assessing profitability. In reality whether you adjust for SBC or not, the equity here is demonstrably undervalued.

 

18. JD consolidated operating cash before internet finance working capital is scant and GMV conversion to operating cash is limited even before internet finance business started

JD actually has generated positive maintenance free cash flow every year in the last four years when CFO is adjusted for the internet finance business which is a negative drag to JD’s working capital position. But more importantly, JD is currently in a high-growth phase and accordingly has been heavily investing in growth-related capex over the past couple of years (tied to expanding fulfillment capacity via fulfillment center buildouts, equipment, etc) like any fast-growing online retailer well-positioned in the most attractive e-commerce market globally would be.

It is true that JD has reported little accounting profits despite raising a substantial amount of capital over its rather short 12-year history as a company. But I think it is first-level thinking to take reported financials as a proper measure of the economics of the business or assume that the business will be in a perpetual state of cash burn – without being thoughtful about how the economics of the business will look like in the future. My own view is that JD has steadily increased its earnings power over time, management has consistently focused on maximizing value over the long-term (and this means raising enough capital historically to pursue this goal), and the time and capital it took to build a moat around the business today illustrates the substantial barriers to entry in becoming a tier-1 e-commerce platform.

Allow me to demonstrate in greater detail why I believe the author’s thinking is flawed here. Aside from wrongly adjusting the Gross GMV figure, the author failed to properly adjust JD’s reported EBIT and FCF to normalized levels in order to account for the substantial growth-related investments. A more sophisticated type of analysis would include a deep dive into the unit economics of JD’s business on a customer and/or order-level basis in order to assess whether any incremental invested spending/capital is generating a sufficient incremental rate of return. Now one can have a legitimate debate about the magnitude of the rate of change over time for these metrics, yet the author has failed to even mention them. At this point in time, all the key drivers are solidly moving in the right direction (and have been improving historically) and JD’s unit economics have already hit a positive inflection point (customer-level IRRs are likely already in the triple-digit range driven mainly by the growth of 3P contribution profits, a steadily declining fulfilment cost per order/customer, and a larger customer base). For the long-term investor, it is a thing of beauty to be invested in a company that has a long runway to invest substantial amounts of capital at high incremental returns.

 

19. JD has a number of related party transactions that are large and merit closer attention. What is Staging Finance entity given it is responsible for RMB 1bn of related party transactions?

All of the so-called “related party transactions” took place with companies that are equity investors/ investees of JD (Tuniu, Bitauto, Tencent, Staging Finance). Nothing strange here.

 

20. Some Insiders Have Been Net Sellers In Last 12 Months. Share Buyback Not Yet Conducted. Instead, JD Has Raised $2bn In the Last 5 Months

The claim that insiders have been selling stock is simply bogus. Fortune Rising is an employee Incentive Pool where shares are periodically sold for employee awards. Richard Liu has not sold a share since the IPO and owns close to 20% of the company. The buyback hasn’t been conducted but I expect them to be buying back shares very soon, especially with the stock trading at these levels.

It also appears that the author taken the recent financings out of context by suggesting that JD has conducted $2bn of straight dilutive equity raises when in reality $1bn was a series A funding round raised for the JD Finance unit at a $7.2bn post-money valuation (worth a whopping quarter of the current JD market-cap today) and another $1bn was a recent bond issuance at very attractive terms – likely done to increase the company’s firepower to repurchase undervalued shares. The author seems to believe that JD is doomed in a perpetual state of capital raising when in reality the balance sheet is very strong, the core business is already FCF positive and its margins are on the verge of a major inflection point. Perhaps most importantly, JD Finance will now also be independently financed. Overall, I believe the risk is to the upside with respect to a greater chance that JD will be buying back their own stock at these levels vs. diluting the equity; count this as another potential near-term catalyst to my own thesis.

 

21. Other additional points

The author’s subsequent analysis regarding 1. JD’s slowing GMV (which is natural given the law of large numbers and it’s impossible to maintain 80% growth for a $70 billion retailer??), 2. Intense competition from Alibaba/Suning (JD is growing at 3-4x the speed of Suning’s overall business which is struggling to clip a double-digit growth rate and is taking market share from both Taobao and Tmall), 3) However, some investors had valued the stock once at peak market cap of $50bn due to its GMV and revenue growth. It’s nice to know that the author is competent at reading stock price histories. Seriously… is it not a surprise that a Chinese “high-growth internet stock” could have a volatile share price print over any period of time?

 

22. JD.com vs. Amazon.com

So I think I have a right to a damn opinion here since I’ve studied both companies quite extensively. Overall, I agree with the author that a comparison between JD and Amazon is irrelevant given where each retailer is in its respective growth cycle and their different business mixes. Amazon is different from JD in many ways, particularly in its business mix (AWS + online video streaming + Prime + other moonshoots vs. JD’s end-to-end fulfilment network + JD Finance + O2O), but similar in many ways also, namely the corporate culture, extreme emphasis on the customer experience and long-term focus on creating shareholder value.

The author seems to be suggesting that the market consensus is long JD to get exposure to the “Amazon 2.0” theme in China which admittedly could reflect the thinking of some of the longs in the stock today. Where I disagree is that 1) JD is an extremely well-managed business, (like many of the large Chinese internet companies are) – likely better managed than Amazon – look at what they did to Amazon in China for example 2) JD is a much more attractive investment compared to Amazon today.

Consider that Amazon is currently trading around 1.5x 2016 GMV (or slightly less than 1 times if you assume AWS is worth $150 billion), and that JD is trading at less than 0.4x 2016 net GMV (less than 0.3x when JD Finance is excluded), it’s obvious to me that JD is being valued at a massive discount relative to Amazon despite growing GMV at more than twice the rate that Amazon is and operating an extremely attractive market for e-tailing.

Also the author’s negative view of JD’s massive employee growth and his analysis of the cost structure is simply misplaced. Other than Baidu’s growing self-owned O2O unit Baidu and Tencent operate a much more asset-light business model than JD and hence do not have a large growing blue-collar labor force and are not comparable benchmarks. So JD’s employee base has grown a lot over the years – cool – has it ever come across to the author that JD’s fulfilled order volume has grown from ~194mm in 2012 to ~1,263mm units in 2015 – a more than 6x increase and much faster than total Chinese parcel volume growth? I guess the author assumes that parcels deliver themselves magically in China. Has the author mentioned at all in any part of his write-up about JD’s growing competitive advantage in logistics by operating its self-owned fulfilment network? The author seems to be missing the whole essence of JD’s business model which is a combination of managing an online platform and end-to-end fulfillment network which is quite a powerful model in the right market and if managed by the right people. It is also interesting to note that Amazon has started to in-source parts of the logistics process as their order volumes continue to grow. (For the record I have great respect for the leadership in both companies and believe that over time both companies will become increasingly more valuable).

So the author seems to jump to a simplistic conclusion that operating an asset-heavy business is an inferior model to an asset-light one such as Alibaba and appears to be basing his conclusion on the current financial profiles of both companies. This is almost like saying that Walmart is an inferior business to eBay simply because it is a more asset-heavy business and thus has a higher cost structure, yet we all know how this big-box retailer came to dominate retailing in America. I have detailed extensively in my own paper why I think JD will be a long-term winner in China and will not go over it here again.

 

Final Thoughts:

What I always try to do is to have a superior understanding of the opposing argument better than the other side in order to deserve the credibility to voice an opinion. Although it is obvious that the author has spent a considerable amount of time on this short thesis (50 pages…), when it comes down to it he provides zero justification for his arbitrary $12 target price (FWIW at that price the stock trades at less than 2.5x and 3.5x EBIT and FCF on my 2018 #’s and less than 1x for both metrics by 2020).

If I were to construct a robust bear thesis on JD I would try to prove that it is a massive fraud since it’s the only scenario in my mind where the equity is worth near 0. However, the author has provided no “smoking gun”, nor has he approached with his analysis from this angle – the author claims that he has conducted channel checks, but where is the evidence of empty warehouses or fake suppliers or merchants? Frauds are also typically highly promotional companies that are overvalued on fake reported numbers alone which I argue that JD is neither.

Instead, the author primarily relies on speculative near-term catalysts (that are unlikely to materialize in my view) for his thesis over sound fundamental analysis (doesn’t seem like there is any margin of safety at all in his trade). With nearly $3bn of net cash sitting on the balance sheet, an improving margin profile over the next few years, and the JD finance unit being independently siloed – I see a future equity dilution as a low probability. Over time, the company’s earning power will become increasingly evident to the market – this is a long-term thesis that requires time to play out after all (if the stock was obviously undervalued to the casual market observer, I would be less confident that it was wildly mis-priced).

The only thing in the report that the author brought up as a legitimate concern to me is the CFO Sidney’s background at Longtop Financial Technologies – Longtop turned out to be a major accounting scandal that was exposed in 2011. Sidney worked briefly at Longtop when the company was still private as the CFO from July 2005 until March 2006 (around 8 – 9 months). From my understanding Longtop was engaged in fraudulent accounting since 2004 until it went bust. I believe Sidney was unknowingly a victim of fraud at Longtop (keep in mind he was there years before the company went public and he was not named in the lawsuits that ensued after Longtop’s collapse in 2011). The subsequent company he joined thereafter was acquired by Blackstone. I will definitely circle back to this issue at a later date and appreciate the author for highlighting this. For now, Sidneys’ position as JD’s CFO implies that Liu has basically endorsed him. My own impression of Sidney is that he is very straight-forward in his communication, is very thoughtful about the business and does not overly promote the business like what the author has implied throughout his report. Richard Liu himself is not promotional at all but it seems like the author has a different opinion. If he author can provide a sound argument that Liu is unethical and thus the equity is uninvestable then that would be a much more robust short thesis.

Other than that the author’s work here was extremely biased (the analysis was even misleading in my view), omitted major facts pertinent to his argument and failed to explore any element of the bull case (there was no acknowledgement at all of the real possibility that JD could be a multi-bagger investment over the next several years). The paper overall was very short on any real fundamental analysis, with little thought about the future economics of the business, and lacked any rigorous analysis on JD’s key business drivers. I’m also sure that Mr. Munger would be absolutely delighted if he found out that his picture was included in this paper…

In sum shorting JD stock presents an atrocious risk/reward profile since the equity can double or triple overnight and remain demonstrably undervalued (that’s what I would call a large margin of safety).

 

[1] This is a bit of a side note but to clarify in my paper I defined 1P net GMV as 1P Gross GMV net of returns/cancellations and the VAT, and 3P GMV as 3P Gross GMV net of only returns/cancellations (since JD takes a commission out of the entire 3P-related transaction where the VAT is not stripped out of that calculation). Originally I took a more conservative route and stripped out the VAT from the 3P-related transaction when calculating 3P net GMV.

 

JD.com – A Multi-Decade Compounder

Idea Overview:

Occasionally when the stars align Mr. Market presents us with a phenomenal long-term investment opportunity. I believe a long position in the shares of JD.com (“JD”) offer such an opportunity for investors to compound their capital at exceptional risk-adjusted rates of return over the next 5 – 10 years (or potentially decades into the future).

JD is China’s largest online direct-sales company and trades at 2.4 – 2.8x 2020E EBIT and maintenance FCF respectively. The company has a great “flywheel” business model,[1] and benefits from several powerful secular tailwinds, which will help sustain a massive open-ended growth runway. Equally as important, the company is controlled and managed by a phenomenal CEO who is an extremely competent operator and has a great track record of growing shareholder value per share while prioritizing the interests of minority shareholders.

I believe JD shares are easily worth multiples of the current stock price under any reasonable, conservative scenario, and even under a draconian scenario I see the shares compounding at 20 – 25% annually over the next 5 – 7 years. In the most likely future outcome, I believe JD’s intrinsic value per share can reach $140 – $180 by 2020, which would yield a MoM of 5.7x – 7.4x over the next 5 years, or a 40 – 50% annually compounded internal rate of return.

 

Key Value Drivers in Thesis:

• JD’s competitive advantages are strengthening over time; core operating margins are on the verge of a multi-year inflection as Gross Merchandise Value (“GMV”) continues to grow at a market-leading rate.

Partly due to ongoing current investments into fast-growing, emerging businesses that have been internally incubated (JD Finance and JD Home/Daojia), JD has yet to report positive GAAP operating profits. These segments are currently loss-making and have masked a steadily improving margin profile for the core JD e-commerce business, which should expand its gross margins closer to 20%+ and operating margins as a % of net[2] GMV closer to mid-single digits over the next 5 – 7 years.

The key drivers behind this inflection are: 1) a direct-sales product mix-shift away from relatively low-margin electronic products to higher gross margin categories such as home appliances and general merchandise[3], along with higher mark-ups, 2) the growth of contribution profits from third-party marketplace businesses such as commissions, advertisements[4] and logistics & warehousing services, which are all very high-margin or are under-monetized services, and 3) greater scale economies. Specifically, rapidly growing first-party unit volumes will increase bargaining power for procuring merchandise from suppliers, and a steadily incremental increase in order density in under-penetrated cities will lower JD’s average fulfillment cost per order over time.

 

• JD Finance’s value is massively under-appreciated by investors.

JD owns 85% of JD Finance which serves as an internet-based lender and payments processor to suppliers/wholesalers, 3P merchants, and customers within JD’s e-commerce ecosystem[5]; other ancillary services include crowdfunding, insurance and wealth management.

This unit will become entirely self-funded for the remainder of this year and benefits from leveraging the rapid growth and transaction data of JD’s core e-commerce business within a closed-loop ecosystem. JD Finance may potentially IPO in the Chinese A-share market sometime in the early 2017 timeframe, which would create a clear catalyst to unlocking its under-appreciated value. An IPO or spin-off will also remove its reported losses off of the core e-commerce business PnL.

A private funding round led by Sequoia in January valued this business at around $7.2bn, or ~25x 2015 sales. If valued at 5x 2020E sales post-dilution, JD Finance could be worth closer to $12.3bn to JD equity holders five years from now, and would make up more than ~40% of JD’s entire enterprise value today.

 

• JD is led by one of the world’s best CEOs. Richard Liu is very shareholder friendly, has extremely high integrity, and has created one of the most well-managed and successful e-commerce companies today.

The quality of the people managing the business and their ability to intelligently allocate capital cannot be understated in a long-term compounder thesis. Up to this point, Richard has largely been correct on all the major strategic decisions for the business, and has executed near flawlessly towards becoming the dominant e-commerce franchise in China long-term. I believe his interests are well aligned with minority shareholders, and that he is working to maximize shareholder value for all investors.

 

Why does this opportunity exist?

• The market’s failure to accurately price in JD’s earnings power on a longer-term time horizon has created a massive opportunity for fundamental investors willing to make a longer-duration investment. Namely, the scalability of JD’s business model is under-appreciated as FCF generation is back-ended; 5 – 7 years from now, margins are likely to be substantially higher as normalized earnings power continues to ramp-up materially. The fact that JD currently reports no positive earnings makes the idea optically unattractive to potential investors.

The Street in particular appears myopically focused on the next few quarters’ revenue prints and near-term margin implications, at the expense of developing a well-informed longer-term outlook. They are also focused on the wrong metrics such as total revenues and reported EBIT. Given the nature of JD’s business (1P + 3P platform), net GMV, normalized operating profit and earnings power are the more relevant valuation metrics.

• Investors appear overly concerned about the credit quality of JD Finance’s lending business. In reality, management is prioritizing risk management over short-term profitability for this division. Current losses and the unfavorable working capital dynamics to the core e-commerce business have also contributed to near-term investor worries. Public disclosure of key metrics has been very limited, but I believe risk here has been over-priced.

• General macro concerns over the health of China’s economy have depressed valuations across all sectors of companies operating in China. Chinese equity ADRs listed on US exchanges, in particular, appear unloved by Western-based investors and currently trade at large discounts. In reality, there is a large disconnect between China’s consumption vs investment spending, with the former expected to steadily increase over time, and greatly benefit businesses leveraged to consumer spending such as JD.

 

Core E-commerce Business Model and Competitive Advantage:

JD’s core e-commerce business can be divided into 2 segments: the direct-sales platform and third-party marketplace.

First-Party (“1P”) or Direct Sales Platform:

JD operates the largest online direct-sales platform in China (~$39.5bn reported GMV FY2015), enabling the company to achieve superior economies of scale in product procurement and turnover its inventory at a faster rate than any other national competitor. The business is run incredibly efficiently given its size; at an average inventory days of 32-33[6], inventory turnover is amongst the lowest of global and local peers such as Amazon, Walmart, Suning and GOME, despite its direct-sales GMV being a fraction of Amazon and Walmart’s GMV, respectively.

JD’s 1P business makes up ~57% of total company GMV. Electronics and home appliances are the largest product categories at 80% of the total 1P GMV mix, with the “general merchandise” category making up the remainder. Electronic products currently sell at mid-single digit gross margins, home appliances are at around high-single to low-double digits, and products within general merchandise have margins around mid-teens.

 

Third-Party (“3P”) Marketplace Platform:

JD’s online marketplace (~$29.5bn reported GMV FY2015) was launched in October 2010 and has already grown to ~43% of JD’s total company GMV. Similar to Amazon’s third-party marketplace business, there is a network effect at play here as more merchants attract more customers in a positive feedback loop. Third-party merchants are vetted very carefully to ensure product authenticity and must be able to meet JD’s demands for a timely supply of authentic products and also provide high-quality post-sales customer service.[7] Despite the careful vetting process, the business has been growing rapidly at an average rate of nearly 200% per annum over the past 4 years.

 

Why is JD’s Competitive Advantage Durable?

“The company that wins the customer’s mindshare, the company wins the ecommerce war.”

– Richard Liu, JD.com Founder & CEO

 

The source of JD’s competitive advantage is its end-to-end nationwide fulfillment network which allows the company to provide a high-quality, consistent and speedy delivery service at large scale; this strengthens customer loyalty/mindshare over time and increases economies of scale within a positive feedback loop; this in turn allows the company to price a wide selection of authentic products competitively and incrementally take market share within a largely 2-player B2C market with Tmall, creating a high barrier to entry to potential online shopping platforms.

 

“We believe that JD’s self-owned logistic network has become our core competitive advantage that consumers have come to trust.”

– Richard Liu, JD.com Founder & CEO

 

The nature of China’s e-commerce industry is different from that of western developed markets. Mainly, two stark realities that e-commerce companies have to address in China are unreliable, low-quality[8] third-party courier services and the ubiquity of counterfeit products[9]. JD has tackled both issues with great success to date by adhering to a stringent process of selling only authentic products on its platform and taking an asset-heavy approach to investing in its own in-house logistics network.[10]

This strategy is differentiated from Alibaba’s predominately asset-light approach[11] to last-mile delivery, but has allowed JD to build considerable brand equity over time with customers. In essence, the trust that JD has built with its customer base with respect to authentic products is a major intangible asset[12], along with the substantial scale benefits of owning the largest in-house logistics network out of all competitors.

 

“The majority of JD’s customers has shopped on other platforms before but was tired of having to be on alert for fakes all the time. So they came to JD even though our prices may be a little higher than the other places.”

– Richard Liu, JD.com Founder & CEO

 

Key Pillars of Successful E-Commerce Platforms: Tmall & Taobao vs JD

Conventional analysis of e-commerce business models suggests that the key drivers to success are low prices, high-quality customer service and a wide selection of products. My research suggests that all three factors are important in the China market, but not equally so.

Based on surveys I’ve conducted on online shoppers in China and along with supporting research from proprietary, third-party studies[13], product authenticity is by far the most important factor for millennial and higher-income shoppers when deciding which e-tailer platform to stick with. The results of my own proprietary survey suggests that online shoppers rate delivery service and product authenticity highest on JD.com, whereas selection and to a lesser extent, competitive prices, are rated more highly on Alibaba’s major e-commerce platforms Tmall and Taobao.

Please see Appendix 1 for further details and the results of my survey.

The results of these consumer studies provide insights into how JD has managed to steadily grow its B2C market share – when measured in total transaction volume (GMV) – from ~17% in 2012 to ~22% in Q3 2015, according to iResearch. The major demographic groups that represent JD’s core customer base are technologically savvy millennials and higher-income shoppers, mainly between the ages of 20 – 45. These shoppers tend to be very sensitive to the speed of delivery, less price-sensitive and care greatly about product authenticity. Shipping speed in particular is very important in a market such as China, where customer behavior has already been modified to expect free and speedy shipping when shopping online.[14]

 

“The real Internet population is people born after 1985. January 2000 was the real beginning of China’s Internet. None of the key Internet players were really born before that. There were only about 4 to 5 million Internet users in China then, while there were 130 million in the United States. The people born between 1980 and 1985 had already completed their education in college by 2000. They mostly started using the Internet in a working environment.”

– David Wei, Founding Partner & Chairman, Vision Knight Capital

 

Price and product selection are still very relevant, especially in the online shopping world where search costs are very low, which is why I believe a platform such as Tmall will continue to do well and grow along with the B2C market for the foreseeable future. Tmall is Alibaba’s B2C marketplace platform (~$176bn annual reported GMV LTM). Combined, Tmall and JD have a 82% share of China’s B2C market, and both continue to take higher incremental share at a fast clip.

 

“I think low price is something a customer always wants and there is always the philosophy that either you want to offer customers the best price or you want to play smart. For traditional companies or offline companies, the information is not transparent: one location is different from another and hence it is hard for customers to compare, so may be they can do things differently. But for online businesses, people easily check up your prices, compare them and even complain about them. We receive a lot of such complaints every day. We will keep a low price policy forever.”

– Shi Tao, Vice President & GM of Global Business, JD.com

 

Taobao is the other major Alibaba marketplace platform that relies on low prices and a wide product selection as key selling points. Despite the size of Taobao (~$280bn annual reported GMV LTM), annual GMV growth has slowed considerably (~20% over the LTM). Given Taobao’s C2C business model and Alibaba’s limited ability to enforce product authenticity over sellers, fake products have proliferated over the platform.[15] Moreover, due to a lack of control over third-party merchants, return policies on Taobao are typically not as customer friendly as JD’s guaranteed 7-day, free return policy.

 

“If you need to return the goods to a Taobao seller, once the money is released, it can become quite a challenging experience. You never know how fast it will ship and whether the product is still in stock.”

– Toine Rooijmans, Cofounder, Dining City

 

Alibaba’s answer to Taobao’s reputation for fake products was the creation of Tmall. Tmall was spun out of Taobao in 2010 with the premise of guaranteeing authentic products. Although not completely devoid of fake products like JD[16], Tmall has been growing impressively with an annual reported GMV growth of ~50% over the LTM. Tmall has also been cannibalizing Taobao’s business, and given Taobao’s issues, I fully expect their business to continue to slow, and potentially start entering into secular decline over the next several years as transaction volume continues to shift from C2C to B2C.

In my view the question that can summarize the entire “JD.com vs. Alibaba”[17] investor debate is this: If there are primarily two dominant existing businesses/platforms operating within an open-ended, secular growth industry, and together they will take the lion share of future growth in a de facto “winner-take-all” outcome, would you rather be invested in the business that will very likely generate more value per unit of incremental growth over time in an exponential-like trajectory, or the business which currently has a more attractive and stable financial profile, yet will likely have a lower rate of return on incremental invested capital than the former?[18] 

 

Leaving valuation considerations aside, I think the answer for long-term fundamental investors is very clear: JD.com is the better bet.

 

Major Direct-Sales Competitors

Globally, the business model of brick-and-mortar retailing across broad product categories is melting away, with the internet and the convenience of online shopping as the main catalysts. This phenomenon is even starker in a developing market such as China, where the lack of a sophisticated offline supply chain network and high rental rates have advantaged online platforms greatly and allowed them to reach critical mass to the detriment of offline retailers.[19] Due to the massive lead of platforms such as Tmall/Taobao and JD, China will likely experience structurally higher e-commerce penetration levels than developed markets.[20]

JD’s direct-sales business is already substantially larger than any direct competitor, including any third-party merchant on JD, Tmall or Taobao’s platform. As a 1P retailer, JD’s scale advantage in product procurement from suppliers allows the company to implement higher mark-ups or price lower than competitors, which drives higher volumes and thus higher cost efficiencies in the supply chain. This successful playbook is nearly identical to the one Walmart used to become the world’s largest retailer.

Given JD’s massive share lead, I believe the “game” is already over for all of JD’s direct-sales competitors, whether offline or online, with the possible exception of Vipshop.com and a few other niche vertical players.

Suning and GOME are the closest direct offline competitors to JD, as selling home appliances and electronics make up the majority of their sales mix. Despite being the largest offline retailers (excl. groceries) in China, they have been pressured by online competitors such as Tmall and JD to restructure their businesses[21]. Offline pricing integrity has suffered greatly as Suning, for example, has adopted a same-price policy for online and offline stores. The most relevant comparable to Suning and GOME is Best Buy, which has been in a death spiral of continually being pressured to consolidate its store base with a less efficient cost structure and compete against Amazon.

Amazon entered China in 2004 but despite an initial market share advantage, has yet to gain any real traction (Amazon China at its peak owned 20% of the B2C market and has since shrunk to less than 1%). I believe Amazon has largely failed in China because all of the key decision-making was deferred to HQ overseas, instead of empowering the local managers on the ground; this led to inefficient decision-making processes and an inability to respond agilely to the fast-evolving challenges and demands of the local Chinese market.

 

“Global companies tend to push one-size fits all solutions while to succeed in China you need to localize your strategy.”

– Krzysztof Werkun, Partner, China Renaissance Partners

 

“They (Amazon) rely heavily on the system, the technology. But their policies, local strategies, and local marketing are kind of not flexible enough. That’s why they are behind us in China. We make a very quick decision based on the market challenge. But I don’t think Amazon is doing that. What Amazon does in China is follow its global model and global process. If they apply the model in Germany, France or Japan, they also do it in China. They don’t consider if there are specific challenges and customer needs. That’s the difference between us and Amazon.”

– Shi Tao, Vice President & GM of Global Business, JD.com

 

Another one of the smaller B2C competitors, Vipshop.com can be thought of as the online version of TJX. It is a flash sales website that adheres to an off-price, off-season retailing model with apparel as the major category. In essence this business occupies a niche within Chinese online shopping by targeting a certain customer demographic that primarily shops on mobile and buys on impulse.

I don’t have a strong opinion on the future success of this business, but search costs online are lower than offline retailing; a price comparison between websites is quick and convenient. This appears less of an issue for TJX where their core customer demographic are middle-aged, higher-income women who are typically in the habit of going to a TJX store and expecting discounted branded goods.[22] Given that both JD and Alibaba have fast-growing flash sales sites, along with JD’s low-cost advantage in fulfillment and having a substantial overlap in customer bases with Vipshop, Vipshop’s already narrow moat could erode further longer-term. JD’s flash sales site in particular has been growing rapidly at 200-300% per annum and will continue to be a focus for the company as they continue to expand aggressively into apparel.

 

Beginning of the End of Major Pricing Wars

As mentioned above, JD’s retail competitors are at a major competitive disadvantage.

On its path to success, there have been several multi-year price wars where JD has largely crushed its rivals such as Newegg (private), Amazon China, and Dangdang.com. With the three and a half year old pricing war against Suning and GOME centered on home appliances and electronics[23] potentially drawing to a close near-term, I believe we are near the beginning of a multi-year runway for JD to steadily price major categories at higher mark-ups relative to competitors, creating additional room for 1P gross margins to inflect upwards.

I’ve compared prices across several popular electronic and home appliance items on JD.com’s and Suning’s online websites.

 

Please see Appendix 2 for the price comparison results.

 

The results of this project suggest that, for the moment, average prices for JD and Suning are listed within a narrow band. However, for the JD buyer, in addition to benefiting from competitive prices, the buyer gets a faster and more reliable delivery service, best-in-class customer and post-sales service[24], and an option to conveniently return items for no incremental fees.

 

“There are two kinds of companies – those that work to raise prices and those that work to lower them.”

– Jeff Bezos, needs no introduction

 

Suning generated total sales of ~Rmb135.5bn during 2015, and GOME is a smaller business than Suning. For reference, JD reported net direct-sales of ~Rmb134.3bn for 2015 for its electronics and home appliances category, but this revenue stream alone will likely grow 3x-4x faster than either Suning or GOME’s entire business over the next several years. Having less efficient cost structures, Suning and GOME have seen their operating profit margins erode significantly over the past few years and have little to no more room going forward to sustain a major price war with JD.

Even if Suning and GOME decide to irrationally price at 0 to negative gross margins, they are doomed to fail. Advantaged with its greater scale to squeeze lower prices via larger volume rebates from suppliers, JD can easily afford to continuously match or even price slightly above Suning or GOME’s listed prices and still achieve higher relative mark-ups and thus higher product margins.[25]

 

Category Mix-Shift

An additional leg to my overall 1P gross margin expansion thesis is that JD is quickly diversifying its product sales mix away from low-margin electronic items; general merchandise gross margins are 2 – 2.5x higher than electronics and home appliances, but are likely growing twice as fast, leading to sizable overall gross margin expansion.[26]

Richard Liu has made it a priority to be the number one direct vender of home appliances by the end of this year, and to be a market leader in apparel within 3 years. Part of the strategy is to shift more apparels out of the third-party marketplace into direct-sales as JD believes it can achieve incrementally more scale efficiencies than third-party merchants selling these products directly over time.[27] Apparels are also among the highest gross margin category in all of e-commerce. Given JD’s additional advantage in being able to leverage its scalable logistics network over higher levels of SKUs/volume, this strategy appears sensible.

Currently, JD’s 1P business is earning 6-7% gross margins, and assuming general merchandise products grow to 40% of the total 1P mix vs 20% today, along with higher mark-ups, 1P gross margins can potentially expand closer to low-double digits, or by more than 500bps by 2020.[28]

 

2015 – 2020 Total 1P Gross Profit Bridge:

In my most likely scenario, I model JD’s direct-sales business to grow at a ~31% CAGR over the next 5 years. I will discuss my forward growth projections in greater detail in the valuation section, but for reference, this business has grown at a ~71% CAGR over the past 4 years. Under this scenario, overall 1P gross margins expand by a total 300 – 400bps over the next 5 years, contributing ~52% of the delta to the 2015 – 2020 1P gross profit bridge. Product category mix-shift and volumes account for the rest of the delta (~48%) in total gross profits.

 

Critical Mass, Pricing Power, and Completing the Flywheel

As previously mentioned, Tmall and JD combined control ~82% of China’s B2C market. Given that both platforms have already achieved a critical mass of merchants/suppliers and market share, both platforms should be able to continue to grow their respective market share well into the future.

Despite Tmall’s advantage in product selection and its competitive prices, neither vendor may ever satisfy the needs of all consumers. However, I believe JD has the greater potential to grow its incremental customer share at a higher rate than Tmall.

How I think about this issue is this: A company’s reputation, brand and mindshare with consumers are relatively difficult to change over time. Consumer shopping habits are typically very hard to change. JD has already demonstrated that it places the customer first primarily by selling only authentic products and offering the highest-quality delivery service in the industry, and this advantage is not easily replicable.

If selection and to a lesser extent, competitive prices, are the two areas where JD has the most room for further improvement, then JD has massive potential to grow beyond its core customer base. These variables, in my view, are “low-hanging fruit”, compared to the time and investment needed to build a superior customer service and trust.[29]

As mentioned, search costs in online retailing are generally lower than in offline. A shopper can easily compare prices and product selection across multiple shopping sites quickly. As JD continues to leverage its flywheel to expand into under-penetrated categories such as apparel, baby, cosmetics, and groceries, and grow its third-party marketplace, its platform becomes more attractive to buyers.

As its scale in procurement grows faster than any other vender, JD’s pricing power will only get stronger over time. And there are already signs that this is happening.

 

1) Delivery the product to the end customer is an integral piece of the e-commerce value proposition. Steady raises in the minimum order value threshold for free delivery are de facto hidden price increases, which has been a recurring practice for JD over the years. In fact, JD recently increased its minimum order size from Rmb68 to Rmb99 for free delivery.[30]

 

“We’ve raised the minimum purchase amount that qualifies for free delivery in each of the past three years. We started with zero – even if you bought something for five yuan, we delivered for free. Then we raise the amount to 29 yuan ($4.64), 59 yuan and then 79 yuan this year. Next year we’ll raise it to 99 yuan. We may charge for all deliveries in 2017.”

– Richard Liu, JD.com Founder & CEO

 

This is brilliant as it naturally forces consumers to lump their purchases into larger orders (leading to higher average GMV per order/average transaction values, all else equal) and also potentially reduces order splitting. In the future, price discrimination via offering different shipping speeds is also a possibility. JD is also currently experimenting with an Amazon-like Prime membership service with a small group of consumers, which could help further increase customer stickiness.

2) Prices for third-party marketplace-related services are increasing. The annual service fee for a 3P merchant doubled from Rmb6,000 in 2014 to Rmb12,000 in 2015. Take rates for certain categories such as jewellery have also increased.[31] JD already charges higher take-rates of between 2 – 10% relative to Tmall at between 0.5 – 5%.

As JD’s active customer base grows over time (currently at 155mm), merchants will become more captive to JD’s platform. Most merchants would be incentivized to have a presence on both Tmall and JD to maximize their sales, leaving JD room to increase take-rates.

3) Finally, certain product categories such as baby and fresh groceries/food have stronger inelastic demand profiles on JD’s trusted platform, and thus sell at premiums. These categories are particularly health-sensitive to Chinese consumers; in consequence, consumers are willing to pay a premium for these products on JD.com for the perceived safety and peace of mind.[32]

I think JD’s flywheel is already complete: despite relatively higher prices than competitors, JD continues to grow its GMV (both 1P and 3P) at the highest rate.

 

Core E-Commerce 2015 – 2020 Blended Gross Profit Bridge:

Over time, steady growth in penetration rates and prices across value-added services such as advertising, cloud-based software & data analytics, marketplace commissions & fees, and warehousing & delivery[33] is likely as JD’s closed-loop ecosystem becomes more attractive to suppliers and third-party merchants. JD’s 3P monetization rate is currently 10.5% as a percentage of net 3P GMV; I think their 3P take-rate/monetization rate can expand closer to 14%, or by 350 bps, by 2020.

JD currently delivers ~25% of its 3P parcel volume, and sorts a single-digit percentage point of 3P parcels in its warehouses. The 3P warehousing service is relatively new – introduced only recently in mid-2015 – hence the current low penetration rate. According to IR, JD’s penetration of third-party last-mile delivery services hasn’t meaningfully ticked higher because JD would incur too large of a loss to deliver merchandise for many of the lower volume 3P merchants on its platform.[34] However, as JD grows its warehousing capacity, penetration rates across both 3P warehousing and delivery services should increase.

With the exception of the warehousing & delivery services[35], the 3P services are all very high-margin revenue streams, (likely 100% gross margin excluding any traffic acquisition costs) and are among the fastest growing service lines on JD’s platform.

I am modeling core e-commerce blended gross margins to expand to the low 20’s percent range by 2020 from 13.4% in 2015, with 1P gross profits and 3P gross profits driving ~47% and ~53% of the total change, respectively.[36] The improvement in overall gross margins should fall straight to the bottom line.

 

Unit Economics of JD’s Logistics Business

“Distribution and transportation have been so successful at Wal-Mart because senior management views this part of the company as a competitive advantage, not as some afterthought or necessary evil. And they support it with capital investment. A lot of companies don’t want to spend any money on distribution unless they have to. Ours spends because we continually demonstrate that it lowers our costs. This is a very important strategic point in understanding Wal-Mart.”

– Joe Hardin, Former Walmart executive vice president, logistics and personnel

 

Unit-Economics

The cost structure of a fully-integrated logistics business can be broken down into three main parts: Fulfillment Center[37] (“FC”), Line-haul transport (“LHT”), and Last-mile delivery. Last-mile delivery constitutes ~50% of the total cost per parcel/order, and line-haul makes up ~37%.[38]

Since JD is currently pricing its 3P delivery service around marginal cost, I think it would be instructional to compare JD’s average delivery cost per order vs. industry ASPs. JD’s total fulfillment cost per order was ~$1.70 in 2015, the lowest amongst all major B2C platforms in China.[39] Shipping cost (or last-mile delivery cost) per order was half of this, at $0.85.[40] Industry ASPs for 3^rd party couriers are currently around Rmb10 per parcel, or $1.50. Note that this service doesn’t include storing inventory for the merchant, and last-mile courier firms are currently already earning very thin margins.

Conservatively, JD’s current net GMV per 1P order is around $21. Out of that $21 they make an average 6 – 7% gross margin, or ~$1.40 per order. Contribution losses per order are around $0.30 if we fully expense fulfillment costs.[41] By 2020 I think JD’s fulfillment and shipping cost per parcel can easily get below $1.50 and $0.75 respectively, driven by robust parcel volume growth and increasing order density in lower-tier cities. In consequence, by 2020 JD should easily be profitable on a contribution profit basis[42] as 1P gross margins expand, and should also be able to earn a positive contribution margin on third-party delivery and warehousing services.

 

For more details on my fulfillment unit economics assumptions, please see my model in Appendix 6.

 

So despite owning its logistics assets in-house, JD’s cost structure is already very competitive vs. third-party couriers (who typically have a lower-quality service), and the company is well-positioned to leverage more cost efficiencies over higher levels of parcel volumes over time. Morgan Stanley estimates that China’s total express delivery parcel volume will reach ~48mm in 2020 from ~19mm in 2015. JD will likely expand its volume share of this market from 6.5% in 2015 to 13% in 2020.

 

Brief Overview of 3PL Operators with Franchise Models

China’s logistics industry remains highly fragmented and inefficient[43]; it is unlike the oligopolistic competitive structure that exists in the US, where UPS and FedEx ensure a consistent and timely delivery service with nationwide coverage.

The largest 5 – 6 private express delivery operators in China primarily use the franchise business model. These operators make up the lion share (76% in 2015) of the China express delivery market in terms of parcel volume, and deliver the vast majority of parcels ordered on Taobao and Tmall.

 

For a brief overview of China’s major 3PL firms and Cainiao, please see Appendix 4.

 

How the franchise business model works is this: the franchisors invest in the line-haul network assets – trucks, planes and regional sortation centers – typically via leasing these assets, and in turn, charge their franchisees for using them.

Franchisees either focus their business on first-mile pick-up or last-mile delivery. First-mile pick-up is the process of moving merchandise from the merchant’s warehouse to the centralised sorting stations controlled by the franchisor. Last-mile delivery is the process of shipping the order to the customer from local delivery stations. Note that this model has spawned thousands of local franchisees/entrepreneurs.[44]

 

JD’s Advantage over Third-Party Logistics Firms

“When you own and manage your distribution and logistics channel, you have a great competitive advantage over companies that rely on third-party suppliers. It automatically shortens your lead times, but also you can constantly look for ways to improve your operation and try to make it more efficient. You never have to rely on what’s going on in somebody else’ shop. In our case, we generally know where things are in relationship to when we want them to arrive, so we can schedule and plan to move goods into the stores at the right time. That maximizes our in-stock positions, which is vital. You can’t generate sales unless you have the product there when the customer wants it.”

– Joe Hardin, Former Walmart executive vice president, logistics and personnel

 

JD’s nationwide fulfillment and delivery infrastructure allows it to provide same-day delivery to 137 cities and next-day delivery to 884 cities in China. Currently over 85% of orders fulfilled by JD are delivered on the same-day or the next. No other logistics or e-commerce company in China is able to offer such coverage.

JD’s logistics business is an end-to-end solution; this means that JD controls the entire value chain from procuring and storing the inventory, all the way to last-mile delivery. The only piece of the logistics process that is outsourced is the inbound shipping of goods from the supplier/manufacturing to JD’s fulfillment centers.[45]

Order Cycle Flow Chart for JD:

As shown above, the typical order for JD moves through two to three distribution layers: Warehouse/Fulfillment Center -> 1) Regional Sortation Center -> 2) Delivery Station -> 3) End Customer, or straight from sortation center to a pickup station or to the end customer. Unless cross-regional line-haul is required (an additional layer)[46], this is the typical logistics process for an order fulfilled by JD.

 

Here’s the typical transaction cycle for an order on Tmall or Taobao:

As shown, the order moves through at least 4 – 5 distribution layers (transitioning from the merchant’s warehouse or a Cainiao-owned warehouse to the 3P courier). Since most sellers on Taobao or Tmall are too small to have a national warehouse network, cross-regional line-haul is inevitable for orders going to regions without inventory.

This inefficiency stems from the fact that merchants operating on marketplace platforms typically manage inventories on their own, but lack the scale to build out their own in-house nationwide logistics network. With lesser overall volumes, a merchant may not have the right inventory available in the region close to the final destination; in consequence, an order usually takes longer and is more costly to deliver if line-haul services are required. 3PL firms that use a franchise model can only leverage the volumes they receive on their part of the value chain, which ultimately limits their scale longer-term as order volumes increase.

JD simply has a superior hub-and-spoke model with fewer layers of distribution and higher cost efficiencies; local economies of scale are achieved via a dense network of delivery stations that are strategically located around its self-owned fulfillment centers. As JD’s direct-sales volume increases, higher order density helps justify the economics of a denser warehouse network, higher line-haul frequency and a shorter last-mile delivery radius. Once order density reaches a critical mass within a local market, JD can group multiple orders together into a single route (since they have the SKUs available) with increased frequency vs. last-mile franchisees.

 

 

“We do not believe the franchising or subcontracting models for logistics, which tend to have limited value-added services, are able to provide the type of customized delivery services that JD can provide.”

– Richard Liu, JD.com Founder & CEO

 

The main weakness of the franchise model is that franchisors have limited quality control over their franchisees; service quality, as a result, is lower (Please see Appendix 3 for customer service scores for major 3PL firms). This is important because customers generally have direct contact with last-mile delivery staff.

Another issue with the franchise model is that the incentives are misaligned between the franchisor and franchisee. It appears that last-mile delivery franchisees are incentivized to generate greater volumes even by sacrificing profitability since there is a possibility that they could sell the franchise a few years later for a good ROI. JD management has stated, for example, that in some rural cities, last-mile franchisees are charging Rmb2-3 per parcel as promotions, which should be well below their break-even levels. The franchisors, however, care more about having a sustainable business long-term. Whether the franchise model will be sustainable over lower industry price-points remains a mystery, as the economics for the franchisees appear to be deteriorating in a highly commoditized environment.

Finally, third-party couriers do not use ‘open-box’ services or cash-on-delivery (COD), which is a service that Chinese shoppers love.[47]  In contrast, JD’s delivery personnel are extremely well trained, are paid higher than average market salaries with generous benefits, and employee turnover is lower.[48] In fact, if you under-perform (too many late deliveries or customer complaints) as a delivery personnel at JD, you are likely to get fired promptly.

Overall, the barriers to entry in building a nationwide logistics network are substantial; it would take a lot of time, logistics know-how and capital for anyone who attempts to replicate JD’s network. Compounding the challenge is the fact that land located near strategic logistical hubs is difficult to secure due to misaligned local government incentives.[49] At the same time, a solid ROI is questionable as industry ASPs for express delivery services continue to decline while major input costs (labor, fuel, rent) are all rising well above the rate of inflation.

Given these challenges, and the fact that Alibaba/Cainiao’s strengths are not in managing asset-heavy businesses such as logistics[50], the probability of them expanding into last-mile delivery in any meaningful way is low. Instead, Jack Ma will likely stick to his strategy of taking minority stakes in companies with strategic logistics assets.

As JD continues to expand and densify its own network in lower-tier cities, it is well positioned to roll out a 2 – 3 hour delivery service in several years’ time, and thereby increase its overall lead in logistics.

 

Asia No. 1s and Fulfillment Leverage:

“Over the next 15 to 20 years, the real cost of building warehouses is going to be staggering.”

– Jeff Schwarz, Global Logistics Properties Co-founder

 

JD is currently operating around 213 warehouses (a majority of which are locked into long-term leases and have an average GFA of 25 – 35k sqm) with a total GFA of 4mm sqm. To meet future parcel volume demand, Richard Liu intends to expand JD’s GFA to at least 10mm sqm, likely over the next several years.

JD’s new Asia No.1 warehouses will drive this expansion. These are custom-designed, hyper-scale, and self-owned standalone warehouses, similar to Amazon’s modern day fulfilment centres.[51] The main benefit of these hyper-scale FCs are the incremental cost savings, (namely labor costs due to high automation) such as being able to sort more packages per hour.[52] More specifically, owning self-built warehouses will also help reduce long-term rental and labor inflation risks, and reduce order splitting.

JD currently has 7 self-owned fulfillment centers each providing a GFA of ~100k sqm. Management has stated that they intend to have a footprint of at least 25 Asia #1 fulfillment centers (“FC”)[53] longer-term.

A picture of JD’s new Asia No.1 in Shanghai

     A picture inside JD’s Asia No.1 in Shanghai

The first phase of JD’s Asia No.1 FC in Shanghai (GFA of ~100k sqm) incurred total CapEx spending of around Rmb0.8bn. To be conservative, I assume JD will spend an average of Rmb900mm for every 100k sqm of GFA for its Asia No.1 capital budget.[54]

JD will need to construct 6mm sqm in GFA to reach their 10mm goal. In aggregate, I am modeling total cumulative CapEx spending of $5.5bn over 2016 – 2020 budgeted for Asia No.1 construction. This is well below the cumulative cash flow they will generate from working capital alone.

 

Core Business EBIT Bridge 2015 – 2020:

I am conservatively modeling flat to slightly positive leverage from fulfillment due to the heavy investment phase and aggressive expansion into lower-tier cities over the next several years. There is potentially meaningful long-term upside to my EBIT margin assumptions by as much as 100 – 200 bps as fulfillment[55] costs as a % of net GMV steadily declines. A scenario that captures a more automated fulfillment process (use of fully-automated, unmanned warehouses and an increased usage of flying drones, for example) is not difficult to imagine.

Most of the upside in operating margins will be driven by gross margin expansion. Base case, I think JD’s operating margin as a % of total net GMV can reach 5% by 2020.

 

JD Finance:

“In ten years, 70% of JD’s net profit will come from financial business.”

– Richard Liu at Growth Forum held by ZhongGuanCun 100 Club, March 2014

 

Business Overview

JD Finance began as an independent operation in July 2013; business lines include consumption loans (Baitiao), supplier and merchant loans (Jingbaobei and Jingxiaodai), Online Payments (JD Payments and JD Wallets), Crowdfunding and Wealth Management services. The business is currently making losses but the top-line has been growing in the triple-digit range.

 

Supply Chain and 3P Merchant Financing (~19% of total revenue) – Provides credit to 1P suppliers and 3P marketplace merchants. The total outstanding loan balance for supplier and merchant financing combined is around Rmb5.1bn as of 2015Q3, with average loan sizes at Rmb6mm and Rmb200,000, respectively.

I believe investors are overly concerned about the credit exposure of this business. Credit risk for 1P suppliers is de minimis, as the supplier’s inventory in JD’s warehouses collateralizes the loan.[56] Over 80% of the total outstanding loan mix for this segment is supplier financing. Supplier loan periods are very short: under typical industry payment schedules, JD pays the supplier right away; but instead, it offers supplier financing by charging the supplier interest over a 30-day period.

Rates for supplier and merchant financing are around 10% p.a.[57], which are very favorable compared to 18% for Ali Finance and 20 – 30% for comparable services.

 

Consumer Credit (~23.5% of total revenue) – Currently has around 2.5mm active burrowers, which is a very small percentage of JD’s total annual active customer base (155mm in 2015). At an effective interest rate of 11%, rates are typically much lower than comparable rates offered by state-owned banks; this service is particularly attractive for consumers who cannot get credit cards from the banks such as students.

Premium consumers are targeted where NPL is low at around 0.6 – 0.7%. But as this segment’s credit-evaluating system becomes more sophisticated, and as its database of consumer data expands, it could extend financing services to a wider consumer group. Credit risk could also be borne by a third-party via securitization.

At YE15, ending balances of consumer financing were around Rmb10bn, and the average loan size should be around a few hundred dollars USD. Non-performing assets (defined as receivables or loans more than 90 days overdue) accounted for only 0.2% of total volume, and coverage ratio was well over 300%.

 

Online Payments (~48.5% of total revenue) – Revenue model is a commission out of total transaction value. JD payments currently has around 500,000 merchants and 70mm active customers on its platform. The platform had a GMV of Rmb105bn in Q32015 (Rmb60bn on JD’s platform and Rmb45bn outside); this is around 50% of JD’s annual GMV.

This service is currently priced at zero percent commissions as a promotion to third-party merchants. Alipay and Tenpay dominant the online payments market with 50% and 20% share, respectively. Alipay charges 0.7% – 1.2% and Tenpay charges 0.6%.

 

Valuation Post IPO: Massive Upside Potential

The future growth potential of this business is very attractive as it benefits from a massive total addressable market; China’s SME and consumer financing markets remain in their infancy as the state-owned banks are highly risk averse. Most of the Chinese population is severely under-banked; only 20% of Chinese adults have a credit score from the PBOC.[58] Moreover, the state-owned banks are widely hated, as service in general is atrocious (line-ups at certain bank branches can easily last up to 30 – 60 minutes).

JD Finance’s lower customer acquisition cost (via online distribution) and its rich database of transactions are its main competitive advantages over China’s state-owned banks. Having a longer transaction history with its customers allows JD to better assess credit risk than the banks.

I think we are only in the early innings of the internet disrupting traditional banking in China. Similar to how mobile has leapfrogged PC/desktop, and e-commerce has leapfrogged offline retailing, online banking will eventually leapfrog traditional banking in China. Why is there a need for any physical branches at all if consumers are comfortable with banking online and if the services offered by financial technology companies such as JD Finance have a superior value proposition?[59] The only major roadblock could be stiff regulations; but over time, the rationale for banking services to shift online appears sound.

 

Lending Segment Growth:

Both the supply chain and consumer financing segments should continue to grow rapidly, driven by increasing customer penetration, larger average loan sizes, and the overall growth of JD’s e-commerce business. Management’s focus right now is on improving risk management over short-term profitability.

In terms of the growth potential of the consumer lending business, Rakuten is a potential benchmark. Rakuten is the largest e-commerce platform in Japan has around 40% of its shoppers using credit cards and outstanding consumer loans represent 30% of its total GMV. I have modelled much more conservative long-term growth and penetration rates for all of JD Finance’s lending segments.[60]

In addition to traditional interest revenue from loans to suppliers, merchants, and consumers, as JD Finance’s customer database grows there is also the potential to expand into third-party credit rating services, which is typically a very attractive, asset-light business with high barriers to entry.

 

Online Payments Growth:                                                      

This segment also has massive potential as online payments can be a great business with fantastic incremental margins once a critical mass of merchants and payers is achieved. I expect in-house GMV penetration to increase modestly as it is already around 50%.[61] Given JD Payment’s relatively small market share, it is conceivable that once JD Finance is IPO’d out of JD, a partnership or JV with Tenpay could be considered, which would leverage additional synergies from data sharing and greater incremental market power.

Independent Company Valuation:

JD Finance’s business is currently quite synergistic with the core e-commerce business. However, due to the inherent conflicts of interest between the payments division and e-tailing[62], I think it’s inevitable that JD Finance will become an independent, publicly-traded company. Another benefit of separating JD Finance from the holdco is the elimination of the negative drag on JD’s operating cash cycle.

In the event that JD Finance goes public, the value discount assigned by public market investors on this business will likely collapse. I think JD Finance will be a very high multiple business if freely traded, especially if management decides to pursue a more asset-light lending model.[63]

Whether management eventually decides to pursue an asset-light or a pure lending model[64], this business will become more valuable over time. PayPal as a publicly-traded comparable is a dominant online third-party payments operator with a more mature growth profile; it trades at 4x 2016E revenue. I think JD Finance is much better managed than PayPal, and has a much more attractive long-term growth profile. At 5x 2020E sales of $2.9bn, JD Finance could potentially be worth closer to $14.5bn by 2020, or $12.3bn post-dilution to JD equity holders.[65]

 

Management & Corporate Governance:

• Founder & CEO Background: A Rare Breed

“Investing in a project is primarily investing in a person, and I have spent a lot of time looking for a Killer entrepreneur. For my first meeting with Liu Qiangdong (Richard Liu), I noticed his computer whereon he had written “The Best or Nothing”, which convinced me that he was just the person I had been looking for. Liu Qiangdong started up his (first) business ever since his campus life. In my eyes, one that starts up business on campus is rarely driven by his own desire for fame or money but by his born nature of entrepreneurship. Furthermore, an entrepreneur on campus must be brave and good at personnel management. Liu Qiangdong was a social science major and taught himself programming. Having no computers of his own at that time, he had to take a bus for one or two hours to a relative and waited for an opportunity of doing programming exercises on the computer until the evening when the workers came off duty. After he learnt it he programmed for others and made profits thereby. Later he opened a shop at Zhongguancun where he sold more CD writers than any other peer, and the situation was likewise good for his CD business later. His experiences impress me with his cleverness and entrepreneurship. In addition, he is also an honest man who tells you everything instead of the flattering remarks only, which pleases me a lot.”

– Kathy Xu, Capital Today

 

In a market with a reputation for spawning frauds and atrocious corporate governance, JD stands out with an exceptionally high-integrity CEO with great respect for the interests of minority shareholders. I believe the best way to illustrate Richard Liu’s character is through sharing stories that revolve around how Liu has dealt with JD’s major stakeholders in the past. Many of the stories below are rough translations from the book “The Founding of JD.COM”, a biography on Richard Liu and the JD story (the English version of the book, “The JD Story: An E-Commerce Phenomena”, is coming out in September and available for pre-order on Amazon).

 

High Integrity:

Early CD business

When Richard started his CD business, he had no supplier relationships, no capital, no customers and no team. He started everything by himself, insisting on selling genuine, branded products, and refusing to bargain with customers. The business grew mostly through word of mouth as the customers felt his prices were reasonable and he was one of the very few vendors who did not sell knockoffs, even though at the time it was very easy to produce knockoff CDs – all one had to do was print a logo on an empty disk and replicate the cover. The gross margin of selling knockoffs was multiples of that of retailing the real product.

One of the early practices that he insisted on was issuing receipts to customers (which the counterfeit sellers never issued for fear of being busted by the police). Every order would be followed up with a receipt to prove to the customers that they were getting the real deal. When the company was once audited by the government for three days, officials were surprised to find not a single dollar of evaded taxes (VAT), zero knockoffs and zero counterfeit CDs.

 

Private Round with Tiger Global

In 2009, Tiger Global offered to invest in JD at a $200 million valuation. Richard took the proposal to the board, and after some discussion decided to counter propose with a $250 million valuation. After Tiger immediately took the offer, Richard realized that they got lowballed and Tiger must have had much better expectations for the business.

At the time JD was in discussions with another fund for the financing round. That fund offered to invest at a $300 million valuation; if JD accepted that offer instead, the dilution would be less severe than Tiger’s deal.[66] One of Richard’s executives argued that since the agreement with Tiger was only a verbal promise and had not been set in formal writing, they should take the superior offer instead. Richard refused: “Great leaders must all fulfill their promises. If your words mean nothing, how can you lead a company?” At the end, JD took Tiger’s investment.

Tiger learned about this episode shortly after, and proposed an additional investment at a $700 million valuation (presumably because they felt bad and to make up for the difference). Richard replied by saying that JD didn’t need any more money and if Tiger wanted to increase its stake they would have to buy shares from other shareholders instead.

 

Capital Today

In 2008, some people (presumably investment bankers?) proposed to Richard a scheme to push out Capital Today as a minority shareholder, which would deliberately lower the valuation of JD and allow Richard to issue a ton of stock to enrich himself. Richard again refused: “Capital Today helped JD get through its most difficult period. I must honor the agreement I signed.”

Capital Today was JD’s first outside investor. Kathy Xu, Capital’s Today’s founder, once told Richard that she would be happy to make 10x on her JD investment. Richard told her that he wanted her to make at least 100x. Upon JD’s IPO in 2014, Capital Today ended up realizing a 160x return on their investment.

 

Hillhouse Capital

Hillhouse’s Zhang Lei and Richard Liu met at an Internet conference in late 2009. Both had been graduates of People’s University in Beijing. After Richard gave a talk at the conference, Lei approached him asking if he needed capital. “Of course, but most venture capitalists don’t understand me.” At the time, investors favored businesses that were capital light (like Alibaba’s marketplace model), and most internet entrepreneurs built their businesses that way to appeal to investors. Richard refused to characterize JD that way: “JD is capital heavy. The only way to ensure that the customers can get the best service quality is to be capital heavy and control the delivery process.”

Lei found Richard’s candidness to be rare, and decided to make an investment after chatting with him for just two hours. Lei asked Richard how much cash he needed; Richard asked for $50-$75 million. “Either you let me invest $300 million, or I won’t put in a cent,” Lei replied. Allowing Hillhouse to make that large of an investment would make the hedge fund JD’s largest shareholder. The end solution was to allow Hillhouse to invest $265 million, and Richard would retain control over the board through super voting rights.

 

Conservative, but also Ambitious:

Capital Today Investor Agreement

In the original Capital Today investor agreement, there was one contingency term where if JD achieved certain growth targets, Capital Today would give away some of their shares to JD executives as a bonus. A partner at Capital Today phoned up Richard asking to set near-term sales targets. Richard’s original proposal was this: Rmb 350 million in sales by 2007, and Rmb 1 billion by 2008.

These were almost unthinkable milestones at the time because JD had only generated Rmb80 million of revenue in 2006 and the targets effectively implied that they would grow 4x in one year and another 3x the following year. “are you kidding me?” The partner thought.

Capital Today became concerned that the company wouldn’t achieve those targets and would in the process hurt morale, and therefore negotiated a more reasonable plan whereby JD would aim to double its revenue consecutively every year for the next four years. In reality, JD achieved Rmb 360 million of sales in 2007 and Rmb 1.3 billion in 2008, handily exceeding both of the original targets that Richard proposed.

 

“Even if JD can get 100 points (in performance), we would tell our investors that we forecast 80, 90 points. It’s better to be a little conservative, even if that means in the short run our stock only reflects 80, 90 points. We will know that the company is really 100 points when our results come out and speak for themselves. Conservative communication is key to building investor trust and confidence. The only thing we care about is maximizing the long-term value of the company, not maximizing the short-term stock price.”

– Sidney Huang, JD.com CFO

 

Reported Numbers Unlikely Overstated:

It can never be guaranteed to non-insiders, but based on these stories, I find it highly unlikely that JD is a fraud. What’s more likely is that Richard is one of the most impressive entrepreneurs and CEOs in China, and has higher ethical standards than the vast majority of Fortune 500 or S&P 500 company CEOs.

Moreover, now that JD is a publicly-traded, SEC-registered company, any shareholder unfriendly actions would be much more heavily scrutinized and likely a greater blow to Richard’s reputation than if the company was still private.

In fact, even during the company’s early days, in order to ease investor concerns over the company’s finances, Richard would let investors pick a random week and mail all of that week’s reports to the investor straight from the ERP systems. The logic was that no company could fake data 365 days a year and it was extremely unlikely that Richard would get weekly reports containing fake data. JD had no audited financials during that period as they couldn’t afford an auditor yet. PWC is now JD’s auditor, and they are by far the best auditor in China.

JD’s direct-sales competitors (Dangdang, Suning, Gome, and Amazon China) are all struggling in terms of performance (and they have no incentive to report bad numbers), suggesting to me that someone else has to be doing well. In contrast to Amazon, there is a lot more disclosure of KPIs and relevant operational metrics contained in the 20-Fs, including: reported GMV, the number of merchants, suppliers, SKUs, orders, and annual active customers.

Finally, Richard is not an empire-builder. He cares deeply about maximizing shareholder value per share given that he respects the company’s minority shareholders as illustrated by his past actions. He certainly cares about growth, but not growth at any price. And he definitely cares a lot about profitability.[67] As a result, I think he is less likely to pass on an excess of economic surplus to consumers like Jeff Bezos of Amazon and Costco may have, for example.

                                                                                  

• Company Culture: Militaristic, Familial, and Performance-Oriented

“If we don’t work hard today, tomorrow we will go bankrupt.”

– JD.com company saying

 

Part of understanding how JD was able to beat its early competitors such as Amazon and Dangdang (who were among the earliest entries into China e-commerce) is by studying its culture.

First of all, hiring the right people is extremely important. Hiring the right people, and training them well reduces employee turnover, which in turn reduces costs. JD specifically looks for recruits from a working class background who are fresh out of college for their management trainee program (candidates are not allowed to have prior work experience). Management trainees are actually sent to military school for their first week of training, and must perform delivery duties for their first six months to learn the basics of the business.

Fast execution, and accountability are very important. Similar to the key ingredients of success at FedEx and UPS, (which are both asset-heavy, logistics businesses with large express delivery divisions), perfecting a supply chain requires timely execution and an employee workforce that operates like a military unit. In addition, other similar aspects between FedEx/UPS and JD include the fact that these companies almost always promote from within (lifetime employment is common), employees hold a lot of stock and everyone has equal respect, regardless of rank.

Layered on top of JD’s ruthless efficiency is a maniacal focus on customer experience. JD has a delivery policy labelled “211 program” where the company guarantees that items placed before 11 AM are delivered before 6 PM on the same day, and items ordered after 6 PM (before 11 PM) must be delivered to the customer by 11 AM the next day. There is no E-Commerce company anywhere in the world (including Amazon) that is able to match JD’s delivery speed. Delivery personnel are required to build relationships with customers; receiving over a certain number of complaints would result in automatic dismissal for the delivery person. Likewise, if a customer complains about receiving counterfeit products, when verified, the purchasing manager responsible for sourcing the product is automatically fired.

 

“JD.com features strong execution….Once we attended a meeting lasting from 9:00 am to 6:00 pm. After the meeting was over, everybody rushed to the front of the meeting room to see a PC screen. I wondered what they were looking at and then found out that all the 68 issues discussed during the meeting were shown on that screen, attached with the respective persons in charge and deadlines. I think that this is what makes JD.com outstanding. While Liu Qiangdong was studying at Columbia University, his team was still as efficient as before during telephone conferences.”

– Kathy Xu, Capital Today

 

Having the right system and culture in place has allowed JD to scale up its operation at an astonishing speed without compromising quality. In the last eight years alone, JD has expanded from a 50-personnel company to an 110,000-employee powerhouse. I am aware of no large company in the world that has expanded so fast in such a short a period of time, especially when the task involves the complex integration of large white-collar and blue-collar workforces into one cohesive, high-performing unit.

A picture speaks a thousand words…

 

• Track Record: Strategy and Capital Allocation

Up until this point, Richard has largely made all the right long-term strategic decisions for JD, despite some of these decisions not being very easy to make, or even against the view of major investors. Here’s a summary of some of the key events/decisions made by Richard throughout JD’s history:

-The decision to shift the entire business online in 2004. This was done in spite of the fact that 95% of the revenue of JD at that time were in brick & mortar electronics wholesale. I think the decision to forgo all that short-term profitability and have the vision to see where retailing was ultimately going to is incredibly impressive.

-The decision to invest heavily in logistics starting in 2007. This decision was against the advice of a major investor, but Richard saw the need to own an in-house logistics network in order to provide a higher-quality delivery service to customers. The logistics business has turned out to become a great asset and a key competitive differentiator.

-The decision to expand JD’s product categories beyond electronics in 2008. This was also against the advice of a major investor, likely because of the executional risk of holding new inventory in additional categories that have non-standardized SKUs.[68] In retrospect, diversifying the overall product sales mix away from electronics was a very wise decision, and this shift remains on-going.

-The Strategic Partnership with Tencent completed in 2014. I will discuss this deal in greater detail in the valuation section. In general this was a fantastic deal that just made all the right sense in the world, and was brought up originally by one of JD’s large investors.

 

“Over a decade since the inception of the company, Liu Qiangdong’s most correct strategy was to increase stock keeping units (“SKU”). Particularly, selling books was a very shrewd move, which cut down the average transaction value (“ATV”) at not too much cost, and thus lowered the threshold for the first shopping experience of a new customer to JD.com. The ATV for IT product sales is around RMB 800, which makes a new customer hesitate as he might doubt the authenticity of the product. However, if the customer buys a book at about RMB 80, he faces a lower threshold. Besides, if he feels highly satisfied with the extremely fast delivery of the book, he will immediately make his second purchase.

When increasing SKUs, we worried about the adequacy of our capital. However, Liu Qiangdong stuck to the strategy rather determinedly. At that time, although I agreed with him, I was still afraid that our capital chain might break, because our money was not that much and a loss was to be initially suffered for each SKU added. Finally, Liu Qiangdong insisted on increasing SKUs before we ran out of money. The second correct strategy was Liu Qiangdong’s inception of warehousing logistics business when the company received its second investment. At the time, Ma Yun, Executive Chairman of Alibaba Group, was not willing to be engaged in any capital-intensive asset business like warehousing logistics. Therefore, JD.com embraced a three-year non-competition period. Liu Qiangdong implemented this strategy very persistently, because 70% customers were not satisfied with delivery services. At the beginning (of the company’s warehousing logistics business), we were suffering huge pressures, because a delivery center was to be set up for each city newly covered by our network. As a matter of fact, the company was suffering losses for only 20 orders per day in a city. It would not break even until 2,000 orders were received per day in a city. Nevertheless, it took a long time from 20 to 2,000 orders per day in a city. Being suffered for six months in some cities and for a couple of years in some others, the losses totaled a tremendous amount when 30 cities were covered. Liu Qiangdong, with firm conviction and really far sight, has realized the necessity of warehousing since very early.”

-Kathy Xu, Capital Today

 

I think these decisions indicate that Liu is open-minded and willing to listen to the advice of JD’s long-term investors, yet he is also intellectually independent in being able to exercise his own judgement when making the right decisions for the business despite when at times hearing differing views from his investors. In my view, this is a rare combination of traits in the business world.

 

• Compensation Structure / Incentives:

Richard’s incentives are properly aligned with shareholders and for long-term value creation. He founded the company and is an owner-operator who holds around a 20% stake of the equity (valued at ~$6.7bn). Richard has sold very little stock since the IPO in 2014.

In 2015, Richard was granted 13mm ADR options at a $33.40 strike price, subject to a 10-year vesting schedule with 10% of the option values vesting every year. A 10-year vesting schedule is quite a long time-horizon in the realm of typical executive compensation, and indicates that the CEO and the board, like they have been, are focused on long-term value creation. In addition to this option grant, Richard virtually gave up all his cash compensation for the next 10 years. He now takes an Rmb1.0 annual cash salary with no annual bonus. Employee compensation is also heavily tied to the long-term performance of JD shares.

Interestingly, JD recently introduced two new KPIs for 2016 – operating profit and cash flow days (AP – days inventory days). Prior to these new KPIs, net GMV and total revenue were the main KPIs in which managers were incentivized on as part of their annual compensation package. The new KPIs for 2016 potentially mark a shift from focusing on top-line growth to profitability.

 

Valuation & Key Growth Drivers:

TAM is Massive:

Big picture, the overall macro themes driving this story are simple, powerful and inevitable:

1. Chinese consumption is growing 10%+ per year. Savings represent a whopping 50% of China’s GDP, by far the highest of any major economy in the world. Consumption, which is the inverse of savings, is only 37% of GDP. As was the case with Japan in the early 1970s and Korea in the early 1990s, when middle-income countries start making the transition into developed economies, consumption growth generally accelerates on the back of slower overall GDP growth. China is no exception to that trend. While consumption is less than 40% of total output, incremental consumption growth currently accounts for 60-70% of incremental GDP dollars.

2. Online shopping penetration is increasing. Unlike most developed economies where brick and mortar retail had a 50-100 year development lead over E-commerce, China’s brick and mortar retail industry started at the about the same time as E-commerce (late 1990s vs. early 2000s). Critically, this means offline retailers never had the chance to build up significant scale and supply chain advantages over their online counterparts. This has allowed E-commerce to leapfrog at a speed that far outpaces the West. China also has a number of idiosyncratic characteristics that greatly benefit E-commerce, such as a high urban density (everyone lives in apartments which lowers delivery cost dramatically), urban pollution (discouraging people from shopping outdoors), and infrastructure imbalances (much worse traffic, huge shortage of urban parking space). Over the next 15 – 20 years, I expect the great majority of Chinese retail consumption to move online.

3. Barriers to entry in online retail are much larger than offline. Alibaba and JD on a combined basis control close to 90% of the E-commerce market and are gaining share at the expense of tier 2 players. On top of that, JD is taking share from Alibaba (especially Taobao), having grown its GMV at roughly 2-3x the speed of the larger rival.

 

Internet penetration in China is around 50%, and online shopping penetration is around 60%. With nearly $70bn in reported GMV in 2015, whether you use total online shopping GMV[69] ($640bn in 2015), total retail GMV[70] ($4.6 trillion in 2015), or B2C GMV ($342bn in 2015) as a proxy for JD’s TAM, the growth runway is enormous.

If we take China’s B2C GMV as a proxy for JD’s TAM (most conservative), JD’s current market share is 20%. By 2020 I think total B2C transaction volume can top $1 trillion USD (assuming a mid-20’s 5-year CAGR)[71], and JD with its higher growth profile can increase its total share closer to 27%. At the same time, it should be able to extend its existing massive lead on the direct-sales side.

 

Key Operational Metrics:

Robust annual active customer growth and an increased frequency of annual orders per active customer will be the main drivers of JD’s net GMV growth. I estimate that customer-level IRRs are already well into the triple-digits.

As new customers develop stronger online shopping habits over time, their annual frequency of purchasing online gradually increases. JD’s 2008 cohort of active customers, for example, have ramped-up their annual frequency of orders from 3.7 annual orders in 2008 to 21.8 in 2015. In addition, an expanding selection of products on JD’s platform will likely lead to an increased frequency of purchases. It isn’t difficult to imagine JD’s total active customer base making online purchases at an average of once per month (or 12x per year) by 2020 from 8.1 annual orders today.[72]

Assuming that JD’s annual active customer base grows at a mid-20’s CAGR over the next 5 years, (from 155mm in 2015 to 450mm – 500mm by 2020) JD’s penetration of total internet users and online shoppers in China will remain at relatively modest levels of 45 – 55%.

 

Strategic Partnership with Tencent[73]: Mobile-driven Customer Growth

The strategic partnership with Tencent completed in 2014 has accelerated JD’s GMV growth profile by providing convenient access[74] to JD’s shopping app for Tencent’s large base of WeChat and Mobile QQ users.

Mobile application technology has revolutionized the way people communicate and Tencent owns the premiere online communications/social media properties in China. WeChat in particular is a rapidly growing, mobile-only, ubiquitous social media/communications app with nearly 700mm MAU as of 2015YE. As mobile’s total share of internet usage continues to grow, more time is increasingly spent on “Super Apps” such as WeChat that have considerable consumer mindshare. WeChat has brilliantly integrated a highly frequent[75], high-utility activity (communicating online) with local life services[76] within its own app. In essence, WeChat can be thought of as a portal to the mobile internet since it has its own set of integrated third-party apps on its sticky platform – or an app within an app.[77]

 

I expect JD’s penetration of WeChat and Mobile QQ’s users to continue to increase over time on the back of increasing mobile penetration, which should help drive robust customer growth for JD.[78] In Chinese rural/lower-tier cities, mobile adoption has largely leapfrogged PCs, and these under-penetrated markets will be large growth avenues for JD.[79] Over the past few quarters, WeChat and Mobile QQ accounted for roughly 20%-25% of the incremental growth of JD’s customers.

 

For a summary model of the relevant top-line projections, please see Appendix 8.

 

Valuation Summary:

[80]

At $24.22 per share, JD has a market capitalization of $33bn and a TEV of $28bn with a strong net cash position. If we back out JD Finance’s valuation based on its latest PMV, JD’s TEV is closer to $22bn.[81] JD also holds a portfolio of non-core, hidden growth assets and stakes in publicly-listed equities.

The public cloud infrastructure business remains at a nascent stage. Richard hopes that this unit becomes a meaningful revenue and profit stream in a couple of years. Given the massive economies of scale required, it is possible that JD will eventually form a JV or partnership with Tencent’s much larger cloud service unit. The industry itself is attractive for scale players such as Alibaba, and given its early stage will likely grow at 100-150% per annum over the next several years.

JD Home/Daojia is also an early-stage growth business and has an Uber-like, on-demand business model. Launched in April 2015, JD Daojia is an online-to-offline (O2O) delivery platform that provides consumers with two-hour delivery of goods from local supermarkets with its location-based app. A few weeks ago, Daojia and Dada Nexus (China’s largest crowdsourced delivery network) agreed to merge, which will further increase local economies of scale as the two delivery networks combine assets. JD will hold a 47.4% stake in the new pro-forma company. Please see Appendix 5 for a brief overview of my notes on JD Home/Daojia.

 

Summary of my estimates of the current value of public equity stakes and privately-held “non-core assets”:

 

Model Drivers: Net GMV Growth and EBIT Margin

In 2015, JD’s core business reported $69bn in reported/gross GMV, which equates to roughly $47bn in net GMV assuming a mid-teens combined return and cancellation rate and 15 – 17% VAT taxes. I am modelling a net GMV[82] range of $175 – $225bn by 2020 (assumes a 30 – 37% 5-year CAGR range, with 3P GMV growing faster than 1P).

The great thing about this idea is that as long as I’m directionally correct on the key business drivers, I believe a permanent loss of capital over a 5-year time horizon is a remote possibility; whether JD turns out to be a $100bn or $300bn net GMV business in 2020, the margin of safety afforded by the current valuation is massive. To highlight how ridiculously undervalued the equity currently is, just the total FCF generated over the next 5 years alone could make up more than 120% of the total current enterprise value today. This is a great benefit of owning a business that operates with an increasingly favorable working capital position over time.[83]

Richard Liu has stated that he hopes to achieve a similar margin profile to Walmart long-term. I think a 3 – 5% operating profit margin range as a % of net GMV would be a very realistic margin profile for JD 5 – 7 years from now.

 

Base Case:                                                                                                          

JD is a $200bn net GMV business by 2020, and earns a 5% operating profit margin on net GMV (~$10bn in EBIT). At an 18x EBIT / ~25x maintenance FCF exit multiple[84], along with adding the current value of all the public investment stakes/non-core assets, (with the exception of adding the projected 2020 value of JD Finance) and summing the incremental FCF that will be generated in the interim, JD shares could potentially be worth $160 by 2020, providing a total return of 570% and a 45% IRR over a 5 year period. Note that this valuation assumes that all the FCF generated over the next 5 years (around $26 – 27bn) will accumulate on the balance sheet at a 0% reinvestment rate.

 

Please see Appendix 7 for my detailed base-case modelling assumptions.

 

This target valuation implies an EV / net GMV multiple range of 0.8x – 1.0x in 2020, which appears quite reasonable relative to offline and online retail comps that frequently trade at similar or even higher multiples even though they may be operating in shrinking or very mature growth environments. Post terminal year, JD’s GMV can easily double again over the following 5 successive years given the massive growth runway.

JD’s return on incremental invested capital is also improving over time.[85] If we back out the excess cash that will build on the balance sheet, returns on capital approach infinity.

 

Cyclical risk is also minimal as growing internet and e-tailing penetration will greatly outweigh any short-term economic weakness, along with JD being able to take market share from weaker competitors in a more challenging economic environment. The balance sheet is also very conservatively managed.

These factors alone suggest that a 25x multiple on 2020 earnings power could be severely undervaluing the equity.

 

My Base Case Numbers vs. Street Consensus:

                                                                                               

Grand Slam Scenario:

For a business operating with huge barriers to entry, high returns on invested capital, and a secular growth profile more attractive than all of its relevant publicly-traded peers, I don’t think a 50x multiple on 2020 earnings power is an unreasonable assumption.[86] Assuming a 6% margin on net GMV of $225bn, JD could be earning $10bn in maintenance FCF by 2020. On a 50x multiple or 2% yield ($500bn valuation or 37x 2020E EBIT), JD shares could be worth $400/share by 2020 for a total 5-year return of 1,500%.

Maybe this isn’t a 50% probability, but it’s definitely not zero either.

The highest-quality compounders (led by the top management teams) are typically perpetually undervalued by the market because investors fail to price-in future value creation from leveraging a powerful flywheel or sustainable competitive advantage to expand into untapped and adjacent markets with considerable TAM potential. Customer and transaction data, for example, are typically under-appreciated intangible assets that high-quality compounders use to expand into new markets.

                                                                                                                           

Downside Case:                                                                                                                         

If JD only earns a 3% operating profit margin (low-end of Liu’s target) on $175bn of net GMV, (around $5bn of EBIT by 2020), the stock trades at less than 5x 2020E EBIT. I think JD will still likely generate at least $15bn of FCF over the interim years in such a scenario. As a result, the shares could still compound at 25% per annum on a reasonable 15x exit multiple on EBIT.

 

What can go wrong? / Key risk factors

• Political Risk / Adverse Regulations. JD shares are listed on the NASDAQ as an ADR via the VIE holding structure, which is essentially a legal loophole used by domestic Chinese companies to allow foreign investors to invest in their securities. The concern here is that the Chinese government may potentially nationalize the value of foreign investors’ holdings in these securities.

Mitigant:

First of all, let’s think about what would happen to China if they actually wiped out foreign investors by eliminating the VIE structure and not replacing it with an alternative: 1) It would cause permanent collateral damage to China’s international reputation, 2) All domestic Chinese companies will likely become uninvestable for foreign investors, which means they won’t be able to ever raise any foreign capital (this would likely cause considerable damage to domestic financial markets and the general health of the Chinese economy), 3) Since this is akin to seizing the assets of foreign investors, there will likely be a massive retaliatory response from major economies globally; this could range anywhere from a trade embargo to more serious measures. With such adverse potential outcomes, why would President Xi even consider such a move?

It is also important to note that this structure has been around for well over a decade, which suggests that the Chinese government has de facto endorsed it. So unless you think WW3 is going to happen (which means you probably don’t want to be invested in any Chinese ADRs), I don’t see forced nationalization of foreign capital as a viable solution, and likely an extremely remote possibility.

What’s more likely is that the government will either eventually formalize the legality of the VIE holding structure, or reform it (propose an alternative structure whereby foreigners can legally invest in Chinese ADRs), or simply leave it alone. The reason the VIE structure exists in the first place is because the Chinese government doesn’t allow foreigners to have control over domestic technology companies (the internet sector is deemed critical to national security). Public opinion is currently being gathered regarding the treatment of VIEs, and progress towards a favorable solution to all parties appears promising.

JD’s business is also not a politically-sensitive one. In fact, adhering to a business model of only selling authentic products to consumers seems like a very honorable one, particularly in China. JD’s value proposition to Chinese consumers is massive. Customers in general love the business, and as a result, the company has substantial political capital. In fact, JD could be the perfect role-model for how a business should be run in China from an ethics point of view.

 

• Massive tail-risk event of major Rmb Currency Devaluation. (If your base currency is not Rmb.)

Mitigant: This risk could be easily hedged out (at a relatively low cost) by shorting the entire Rmb exposure proportional to the size of the investment.

 

• Key Man Risk – Richard Liu is very important to the business.

Mitigant: Liu is only 42 years old, which means he can potentially be CEO for a very long time to come (though at 42 he already has more than 20 years of business experience). As such, his youth is a massive advantage, similar to how a young investor has a long runway for compounding knowledge and capital.

 

• The share price is depressed, and insiders know it. There is always the risk of a management buyout to take the company private at a depressed valuation, and then re-list in the A-share market (at a presumably higher valuation) in an arbitrage-style transaction. Competitor Dangdang, for example, is looking to go down this route.

Mitigant: Given his track record, I trust Liu to not screw over minority shareholders. He has stated specifically that he understands the stock may be undervalued from time to time, and that easy money can be made by going-private and engaging in valuation arbitrage, but he rather focus his time on improving the business.

 

“Real entrepreneurs build value by creating real products, not by financial engineering.”

– Richard Liu, JD.com Founder & CEO

 

Event Path / Catalysts:

Timing is always tricky, but I think the set-up looks particularly attractive post the next 6 – 9 months. My numbers are materially higher than Street estimates over the next few years, and the shares should re-rate and compound accordingly over time. Over the very near-term, if you care, the stock will likely trade on reported Revenue/GMV figures, and along with general Chinese equity market volatility, but really, who knows?

Richard has stated that he expects to spin-off at least 2 listed companies in the future (most likely JD Finance and JD Daojia in my view). A good portion of shares in these subsidiaries will be allocated to employees.

• Early 2017 timeframe: IPO of JD Finance in the A-share market. This would provide a clean set of reported financials for investors to value JD Finance independently. Separating JD Finance will also remove its associated losses off JD’s reported earnings and remove the negative drag on working capital.

• By the end of Q2, de-consolidation of the O2O unit JD Home/Daojia post-merger with Dada, which will remove current losses off the reported PnL statement. In the event that this business gets separated from the holdco, it will likely trade at a very high multiple.[87]

• Eventual de-coupling of the performance of share prices between large-cap Chinese internet stories vs. the general Chinese equity market. Recently reported earnings from large-cap, high-quality, internet-based growth stories (eg. JD, Baidu, Tencent) have remained very strong and above Street expectations in light of a slowdown in Chinese economic growth, indicating that the Chinese service economy and consumption spending remains robust. The market may eventually better appreciate the resiliency of these earnings as they continue to roll-in over the next several Qs, and appropriately re-rate Chinese large-cap internet names higher.

• My belief is that one of the best times to generally own a stock (especially one that reports negative earnings) is when margins are on the verge of a major inflection point.[88] Starting in 2017, I believe JD is on the verge of a prodigious multi-year ramp-up in free cash flow generation.

 

Summary Conclusion

JD carries the rare, perfect trifecta of characteristics that are typically highly sought after in an investment idea: a phenomenal CEO/management team, a stock price reflecting severe undervaluation, and a fantastic business model with earnings power growing at an attractive rate over time. As a bonus, it has a patient, long-term fundamentally oriented shareholder base that is able to provide smart strategic advice to management.

I am extremely challenged to find a more attractive long-term investment opportunity in the markets today, and suspect I won’t for a very, very long time.

Buffett has talked about facing the choice of investing only in a handful of opportunities within one’s lifetime. For long-term fundamental investors, I think JD qualifies as a real punch card investment.

 

Appendix:

1. Chinese Online Shopper Survey

 

2. Price Comparison Results

 

3. Third-Party Logistics Customer Satisfaction Score

 

4. Brief Overview of Main 3P Logistics Competitors

 

China Smart Logistics/Cainiao:                                              

Cainiao was established in May 2013 and is a joint venture between Alibaba, Intime Retail, Fosun International and several other 3PL firms. It aims to provide up to 24 hour nationwide delivery once the order is placed online in 2,000 Chinese cities. Cainiao is a bit misunderstood by most investors; the business does not provide any line-haul or last-mile delivery services. Instead, Cainiao is essentially a 4P logistics business: it leverages big data from the Alibaba ecosystem of customers and merchants to improve logistics efficiency with third-party logistics firms.

 

Recently, Cainiao has started investing more heavily into fulfillment centres/warehouses to meet the growing e-commerce demand. On average orders on Tmall can take from 2 days to 1 week to reach the customer.

 

Cainiao assets:

Provinces covered: 31

Delivery stations: 97,000

Delivery personnel: ~1.5mm

Collection points: 25,000

 

Premium Express Operators: SF Express

SF Express dreams to become a Chinese FedEx, trying to build a ‘premium quality’ image. SF Express offers free shipping for any order over Rmb199, for orders below Rmb99, delivery fee of Rmb10 per order is charged.

 

EMS:

EMS has the broadest nationwide logistics coverage; however, due to its state-owned background, it is not very service friendly and is the most expensive.

 

SF Express assets:

Workers: 340,000

Transport vehicles: 12,000

Service centres: 12,000

31 provinces, 900+ cities, 1,900+ counties

2014 express volume (mm): 1,200 (1.2bn orders)

Market share: 9%

Customer satisfaction score: 83.9

-building four cold-chain warehouses in Beijing, Guangzhou, Jiaxing, and Xiamen

 

EMS assets:

All cities and counties covered

45k storefronts, 105,000 employees, 36k vehicles; 2014 express volume (mm): 1,200, 9% market share, customer satisfaction score: 80.1

 

“Four tong one da” – Shentong Express, Yuantong Express, Zhongtong Express, Best Express (Chinese name contains tong) and Yunda Express are a group of second tier express delivery firms with a focus on e-commerce orders. They are similar in scale and strategy and each operator employs 50-200k workers with 7-15k service centres.

 

JD.com logistics assets: (as of Dec 2015)

Fulfillment centers: 7

Nationwide coverage: 31 provinces, 2,356 counties and districts

Delivery / pickup stations: 5,367

Next-day delivery as % of direct-sales: 85%+

Over-the-road vehicles: 58,000

Warehouse GFA: 4mm sqm

Warehouse staff: 15,765

Delivery Staff: 59118

Total Warehouse and Delivery personnel: 74,883

 

5. JD Home/JD Daojia

“In the past, we changed the way our customers shop; in the future, we want to change the way our customers live.”

– Richard Liu, JD.com Founder & CEO

 

Brief Notes on JD Daojia:

-Daojia is a location-based services (LBS) enabled O2O app which provides local services including supermarket, food delivery, flower delivery, laundry and home cleaning services and uses crowd-sourced delivery network

-Daojia serves 12 cities, and its GMV is less than 1% of JD’s total GMV

-This is a high frequency volume generating business, which create cross selling -opportunities as well as provides JD an opportunity to strengthen its big data capabilities

-Valuation proposition for merchants is to help them increase sales via O2O channel

-company will have a revenue sharing model with supermarkets in the future

-JD announced partnership with Yonghui Superstores and have subscribed for ~10% of Yonghui’s shares for Rmb4.3bn

-they also have a small stake in ele.me, a food delivery service

-JD Daojia does not own the products or services provided by 3P merchants, and only handles the fulfilment portion of the service

-JD is currently building its own cold chain supply network

-premium/high-end groceries are sold and fulfilled by 1P/cold chain logistics (similar to Amazon Fresh)

-Google Express is a similar O2O service that partners with large B&M such as Walmart, Target and Costco

-The average Chinese city is quite dense with heavy traffic; for eg. Shanghai has a population of over 20 million, which is greater than the entire population of greater New York

-Dada specializes in last-three-kilometer delivery

 

6. Key Operating Drivers and Unit Economics

 

7. Long-term Financial Model

 

8. Top-down Projections

 

9. Working Capital Schedule

 

 

In the production of this paper I’ve taken either quotes, information, or insights from the following books:

• Kissinger: On China
• The End of Copy Cat China: The Rise of Creativity, Innovation, and Individualism in Asia
• China’s Super Consumers: What 1 Billion Customers want and how to sell it to them
• China’s Disruptors: How Alibaba, Xiaomi, Tencent, and Other Companies are Changing the Rules of Business
• Changing how the world does Business: FedEx’s incredible journey to success
• Leadership Lessons from a UPS Driver
• Alibaba: The House that Jack Ma Built
• Sam Walton: Made in America
• East-Commerce, A Journey Through China E-commerce and the Internet of Things: A Journey Through China E-commerce and the Internet of Things
• The Founding of JD.COM (Liu Qiangdong’s Entrepreneurial Journey)

 

 

[1] A term coined by Jim Collins, think of Amazon as an example

[2] Net GMV is reported/gross GMV net of returns, order cancellations and VAT related charges

[3] General merchandise items such as apparel, baby, cosmetics and home products likely exhibit gross margins closer to the mid-teens range, or at least 2-3x electronics GM

[4] Suppliers/wholesalers tend to purchase branded display ads, whereas third-party merchants tend to purchase performance-based ads; advertising revenues are roughly split 50/50 between merchants and manufacturers/wholesalers/re-sellers

[5] JD Finance also provides online payments services to customers outside JD’s platforms

[6] Average inventory days is for the core e-commerce business, which includes any effects from JD Finance

[7] To ensure product authenticity, stringent background checks are conducted on each 3^rd party merchant or supplier which includes, qualification certificates for products, examining business license and on-site visits

[8] Packages delivered by low-tier third-party logistics firms are generally at greater risk of being damaged or late

[9] According to a recent customer survey conducted by RedTech Advisors, approximately half of Chinese online shoppers have experienced purchasing a fake product

[10] JD started investing in its logistics network in 2007 after Richard Liu learned that 70% of JD’s customers were dissatisfied with subpar quality delivery services from third party logistics firms.

[11] Alibaba has decided to outsource last-mile delivery to third-party logistics firms via their JV Cainiao

[12] JD as an online shopping platform has built substantial consumer mindshare as a trusted site that sells authentic products

[13] RedTech Advisors, a reputable research firm, conducted surveys to weigh the importance of price, product authenticity, delivery service quality and selection in online shopper’s minds

[14] Morgan Stanley also recently conducted a global survey of over 10,000 online shoppers indicating that free shipping is the biggest attraction to shopping online. According to a global survey by PayPal, Chinese online shoppers are among some of the most demanding in terms of delivery time, averaging a “delivery tolerance period” of about 5.5 days

 

 

[15] According to a recent survey conducted by research firm RedTech Advisors, Taobao was the source of nearly 80% of fake products purchased by online shoppers, and the source of 73% of products which were returned

[16] RedTech Advisors recently conducted a survey of Chinese online shoppers showing that Tmall was the source of 19% of fake products

[17] I am aware Alibaba has other businesses outside of e-commerce such as cloud computing services and internet finance

[18] Buffet as stated that “Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

– 1992 Berkshire Hathaway Annual Shareholder Letter

[19] For example, the top 20 B&M retailers in China have a 12% share vs 40% for the US

[20] In fact, e-commerce penetration levels are already higher in China than the US

[21] Suning and GOME have been closing down stores and pushing aggressively into online sales channels

[22] This has allowed TJX to scale a repeatable business model over higher volumes and achieve significant cost efficiencies over time

[23] Richard Liu tweeted on Weibo in late 2012, translated: “Tonight, once again I made the decision to sell big home appliances at 360buy at zero gross margins for the next three years… Within these three years, any employee found to sell at marked-up prices will be fired… I assure you that the prices of large home appliances sold on Jingdong will be at least 10 percent lower than those in the Gome and Suning stores… Starting 9 am tomorrow morning, all big home appliances at 360buy will be sold at cheaper prices than those from Suning, both online and offline. There will be no bottom line. If Suning dares to sell at 1 yuan, then 360buy will surely sell at 0 yuan. To those who plan to buy big home appliances, you will lose money if you don’t follow 360buy.” 

– Richard Liu, JD.com Founder & CEO

[24] JD has a “100-minute policy”: If a customer has any complaints about a product, a delivery person will be back at his doorstep within an hour and 40 minutes after the complaint is lodged.

[25] JD can also hold a greater number of SKUs, and have faster inventory turns than offline competitors; this contributes to JD’s lower cost structure

[26] JD started off primarily selling electronics items online, and now as a more mature category it is growing at a slower rate. Coming off a lower base, home appliances and general merchandise categories have higher growth potential and were introduced to the platform several years after electronics around 2010.

[27] Products with less seasonality and inventory risks such as socks, for example, are sold on the 1P platform and non-standardized, long-tail products[27] are typically sold on the third-party marketplace.

[28] This long-term direct-sales gross margin estimate is in-line with JD CFO’s recent comments; he expects JD’s long-term direct sales gross margins to be in the mid-range between its current levels and the average of offline retailers (~19%).

 

[29] It is not difficult to add an incremental product category to your platform once you have built a sticky customer base

[30] Under Rmb99 per order, delivery fee appears to be Rmb5

[31] Source: Siilu.com, February 12, 2015

[32] In the past, JD’s 1P business priced its products lower than offline competitors and Alibaba’s platforms but this spread has narrowed as price is no longer the most important purchase criteria for shoppers; convenience is now the most important factor.

[33] Third-party marketplace services such as fulfillment (warehousing) and delivery are currently priced around marginal cost in order to drive higher volumes.

[34] If the merchant’s business volume is very small, they may only have fulfillment/warehouses in certain regions, meaning that for fulfillment/delivery JD will have to pick-up a smaller number of SKUs from that merchant, and potentially deliver it cross-region to another regional sortation center, closer to where the final destination is; this adds too many layers of distribution and costs that make the third-party fulfillment business unprofitable for lower volume merchants

[35] CLSA estimates that Amazon earns a 10% contribution margin for its fulfillment services

[36] This long-term gross margin estimate is in-line with JD CFO’s recent comments; he thinks JD’s overall gross margins could eventually improve to 20%

[37] Payment processing fees and customer service center costs are also included in JD’s fulfillment expense line item

[38] According to AT Kearney, and also confirmed by JD’s current fulfilment cost structure

[39] CLSA estimated that the average fulfillment cost per order for large B2C platforms with 1P businesses are typically Rmb20-22 (US$3.2-3.5).

[40] According to CLSA, JD’s average delivery cost is Rmb5.2 (~$0.8) per order in tier-1 cities such as Beijing and Shanghai. For cities with at least 2k+ orders per day, JD’s cost per order would be on par with 3P courier firms.

[41] This expense pool also includes all of JD’s customer service related costs, such as call centers and employees, which is a service not provided by third-party couriers

[42] I estimate the contribution profit margin to be MSD margin as a % of Net 1P GMV per order

[43] For every 8 complaints of online shoppers, one is related to delivery. Labour productivity, in particular, is very low as the average number of parcels delivered by express delivery personnel was 23 per day in 2014 vs >50 in the US.

[44] Some of the delivery franchisees in lower tier cities offer promotions as low as Rmb2-3 per delivery; JD believes these local franchisees either make no profit or incur losses

[45] Based on my knowledge, every Chinese e-commerce firm outsources this part of the value chain. In some remote Western Chinese regions, some logistics processes are outsourced.

[46] Given JD’s growing direct-sales volume and GFA to hold more SKUs, cross-regional line-haul is becoming less common

[47] 30% of JD’s annual active customers still prefer COD services

[48] Pay-for-performance is also used to incentivize delivery staff to meet daily targets.

[49] Local governments rather approve land for non-logistical purposes in order to generate more tax revenues

[50] Alibaba has a modus operandi that adheres to an asset-light approach

[51] Most traditional warehouses (~6k sqm) in China do not meet modern logistics requirements in terms of location, height, spacing, lighting, vehicle accessibility, loading docks and safety standards. Modern warehouses typically have wider column spacing, higher floor to ceiling, larger floor plates and truck docking bays compared to traditional warehouses.

[52] Warehouse personnel can account for nearly 50% of the fulfilment cost of storing inventory. JD’s new Asia 1. FC can sort up to 16K packages per hour

[53] JD has already acquired land use rights to over 3mm sqm in 12 cities

[54] The typical all-in cost for a warehouse in China is Rmb5,000 per sqm in tier 1 cities and Rmb3,000 per sqm in tier 2 cities

[55] Fulfillment costs make up around half of JD’s total cost structure

[56] JD’s inventory days is relatively low at 32 – 33 and they have sufficient transaction to appraise the value of this inventory, helping reduce inventory risk

[57] Rates for merchant financing may be closer to 15%

[58] People’s Bank of China

[59] Alibaba recently launched MYbank, and Tencent has WeBank, which are essentially online banks.

[60] For detailed JD Finance modelling assumptions, please contact the Author directly

[61] 30% of JD’s customers still prefer CoD services

[62] A similar phenomenon occurred between the relationship of PayPal and eBay, for example, when PayPal clearly should be its own independent company. Ant Financial will also likely be fully spun-out of IPO’d out of the Alibaba holding structure

[63] The company can tap the ABS market for more wholesale funding with third party financial institutions. In fact, JD Finance recently offered a 4.7 – 6.9% rate during a Rmb2bn securitization round in Q42015.

[64] JD Finance has an advantage in an attractive customer acquisition cost via online distribution if it needs to build a large customer deposit base

[65] Not counting any cash accumulated on the balance sheet.

[66] Richard Liu said in an interview: “… two other investment groups from Shanghai and Hong Kong travelled to Suqian to propose investing in the company, both at prices that were a third higher than Tiger had offered. Both my CFO and executive assistant were sitting in my office, watching over how I planned on handling the situation. I asked them what ranks first on our company’s set of values? Easy, integrity! If integrity is what we believe in, then we don’t even have to spend time thinking about this. Not just for a 30% premium, even if they had offered 300% higher, we would never entertain their proposal. So overnight we lost over 100 million RMB (in dilution – worth billions at today’s stock price), but I don’t regret that decision once.”

 

[67] Liu said in an interview with the WSJ during JD’s IPO that he would not rest until JD was the most profitable company in China

[68] DangDang, pitched as the “Amazon of China”, has largely failed to meaningfully expand its category mix outside of books

[69] B2C + C2C

[70] Offline + online

[71] CLSA and iResearch, two the most well-respected Asia/China focused research firms are assuming total China B2C market growth of just under 30% per annum over the next several years.

[72] For reference, currently BABA has 50 orders per active customer per annum vs. 8 for JD

[73] In a nutshell, Tencent sold its e-commerce properties to JD, provided level-1 access to Tencent’s online communications/social media properties to JD’s mobile app, and entered an 8-year non-compete agreement with JD. In exchange, Tencent received a ~20% equity stake in JD.

[74] WeChat and QQ users will have Level 1 access to JD’s mobile shopping app; Level 1 access means there will be a link to JD’s app on the app’s homepage so that WeChat or QQ users don’t have to leave the app or directly go on JD’s website or mobile app to shop.

[75] Some would say addictive

[76] Hailing a cab, buying movie tickets, and paying utility bills, for example, are some activities you can perform on WeChat in China

[77] Users can access daily services on WeChat, and make a payment on the app in a closed-loop transaction.

[78] I model JD’s customer penetration of WeChat to be around 46% by 2020

[79] According to Alibaba’s COO, internet penetration is ~60% in urban cities but only 27% in rural villages.  “The future of e-commerce in China is smaller cities” – Richard Liu, JD.com Founder & CEO.

Note that I already model lower a GMV per order based on outsized growth from lower-income, rural-based customers. The net effect to GMV per annual active customer, however, remains positive over time, as purchasing frequency increases.

[80] Acquisition-related amortization of intangibles is added back to non-GAAP EBIT and PE. SBC is fully-expensed. Maintenance FCF assumes 0 capitalizing FCF at a non-growth state, so no cash flow generated from working capital is capitalized; Full CapEx is also assumed

[81] Note that all the USD/Rmb fx rates used in this report are based on 6.4778 rate.

[82] I estimate Net GMV will be 68% of reported/gross GMV

[83] Cash conversion cycle was around (10) days in 2015, which I expect to further decrease to (20) days in 2020

[84] This implies a 4% terminal growth rate and 8% cost of capital

[85] In reality this figure is actually much higher if we subtract the excess cash on the balance sheet

[86] 6% growth into perpetuity with a 8% cost of capital

[87] Uber is a business with a similar business model (local economies of scale, reliant on order density, benefits from network effect, disruptive to traditional large industry, large TAM, etc.)

[88] Amazon is a prime example, pun intended

Amazon and World Domination

“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 Annual Letter to Shareholders

 

Background:

Since the summer is clearly over and it has recently started snowing here in Toronto, I’ve been more in the mood to write about another investment idea. In general I’ve been finding more interesting names to potentially short than go long in the US. I don’t believe I’m a great short seller. In fact I think it’s probably the hardest skill to master in this business, and making money consistently with an absolute return mandate and high risk-adjusted returns is extremely difficult. For now I view it more as an intellectual exercise which should augment my analytical skills until it has become apparent I’ve mastered the art of short selling. In general my view on short selling is that it’s a relative return business, and concentrated positions are not justified unless one believes the idea is more attractive than an idea on the long side; even if that were the case, due the leveraged nature of short selling, the vast majority of positions should always be sized smaller relative to long ideas. Just my 2 cents.

 

Moving on, I think some interesting long opportunities have been developing across the “large-cap information technology/media growth conglomerate” space.[i] I believe that some of these “conglomerates”, if I may call them that, have a dominant existing core business which generates relatively predictable cash flows; however, due to limited financial disclosure, they each also possess extremely valuable, but largely hidden growth assets which I believe have largely been under-appreciated or misunderstood by the market. Some notable examples include Google’s intention to reorganize its various business units into the “Alphabets”, which should provide increased financial disclosure to one of the most valuable assets in all of media – YouTube – or Facebook’s largely under-monetized social media portfolio which include hyper-growth assets such as Instagram, and private messaging apps such as FB Messenger and WhatsApp; did I also mention that Facebook owns one of the leading virtual/augmented reality businesses which could turn out to be a massive home-run investment? It is also worth noting that Google, alongside top VC firms Andreessen Horowitz and Kleiner Perkins have invested in the very secretive augmented reality start-up Magic Leap. It appears that the smartest money in the Valley are betting big on virtual reality as potentially the next major computing platform. One day soon, we could see a Minority Report-like future, and the potential applications of this technology certainly excite me! Even Microsoft stock which has had a largely uninspiring share price performance over the past decade or so, now looks kind of interesting from a sum-of-the-parts basis. Having looked rather closely at some of these names, if I had to buy one mega-cap US stock today, it would likely be Amazon.com. Put simply, Amazon is a collection of two high-growth, excellent businesses, run by a proven value creator and serial monopolist. In its Q1 filing this year, Amazon broke out some of the financials for its cloud computing platform, Amazon Web Services (AWS), which was the catalyst for me to take a deeper into this story. AWS is the undisputed industry leader in public cloud infrastructure services (IaaS) and will benefit from a massive multi-decade shift in IT resource spending from on-premise solutions to the public cloud. I believe it will be very likely that AWS will become the dominant public cloud computing platform of the 21^st century, and we are only in the very first inning of this growth cycle.

 

A Trillion Dollar Valuation?

I believe the purchase of Amazon shares will be very rewarding for investors with a 5 year plus time horizon. My thesis on Amazon is centred around the AWS opportunity so the focus of this write-up will be on that segment; however, I do believe the retail segment is under-appreciated and materially undervalued on a standalone basis as well and I will further discuss this in detail below. In short, I believe the long-term profit opportunity for AWS is vastly under-appreciated by the market and that we are at a major industry inflection point in terms of the adoption of public cloud infrastructure services. My high conviction for this idea stems from my belief that AWS will be a much higher quality and valuable business than Amazon’s retail segment over time. AWS’ moat will only widen over time, and the total addressable market (TAM) that it is tackling is massive at conservatively $300bn+ and growing. In a couple of years, I think AWS’ standalone valuation (~$300bn by my estimate) will easily justify Amazon’s entire market capitalization today. Five years from now, both segments on a standalone basis should be worth well more than the entire current market cap. In fact, by 2020 and on a sum-of-the-parts basis, backing out the retail segment’s enterprise value at 20x 2020e EBIT or $470bn, we are getting paid to own the AWS segment for -5x EBIT and this segment alone could be worth more than $600bn or 2x Amazon’s current market-cap by 2020. The total future value from both segments plus the incremental free cash flow and working capital that will be generated over the next 4 years gives me a base case intrinsic value per share of $2,000 – $2,350 or a 4-year MoM of 3.0x-3.5x.

 

Key Points of Variant Perception

• I believe the market is largely under-estimating AWS’ long-term secular growth profile. According to Gartner, just the cloud infrastructure market alone will be worth around $17bn this year, and I think will likely grow at a 5-year 50% CAGR to nearly $130bn by 2020. AWS is currently a $8bn+ run-rate business with a ~47% share of this market and I expect this business will grow to well over $50bn or 6x larger over the next 5 years; this is well above the majority of Street estimates I’ve come across. But the IaaS market is just the tip of the iceberg. If we look at broader global IT spending across enterprises[ii] which includes platform and application software, we should be closer to at least a $1 trillion+ total addressable market (TAM) which makes AWS’ current market share de minimis; there is no reason for me to believe that AWS will not slowly expand into adjacent IT markets such as PaaS (of which they are already doing, successfully, I might add), and SaaS applications over the next 5-10 years. Very conservatively, I believe somewhere between 40%-50% of total IT spending could shift over to the cloud over the next decade or so, which would translate into a market opportunity of at least half a trillion for AWS. At the same time, enterprise adoption of infrastructure cloud services appears to be at a major inflection point, as AWS storage and computing usage rates are accelerating to near 100% growth rates per annum. This strong operational performance from the clear market leader confirms the stated intentions of an increasing number of Fortune 500 CIOs to shift more IT spending over to the public cloud at an accelerating pace.

• Operating margin ramp-up is vastly under-appreciated. Most of the Street is incorporating significant operational deleveraging assumptions or limited operating margin expansion forecasts for AWS over the next 5 years. My view is that long-term margins will be much higher due to a mix of 1) More muted IaaS pricing decline assumptions relative to expectations; I believe an attractive oligopoly industry structure will translate into pricing cuts being closer to 8%-10% annually on core IaaS computing and storage services instead of the 20%-30% implied by Moore’s Law, 2) A favourable sales mix-shift to faster-growing, higher-margin PaaS such as database application subscription services and most notably 3) Easily realizable benefits from massive economies of scale and fantastic incremental margins which should be much higher than current ~19% GAAP operating profit margins today. Due to its clear first-mover advantage and the massive entry barriers for this business, among the largest “hyper-scale” infrastructure cloud service providers, AWS is likely the only one that is currently profitable at a 25% consolidated segment operating income (CSOI) margins. The business is 10x bigger than the next 14 competitors combined in terms of computing capacity, and in terms of revenue, around 5x the size of the next largest competitor – Microsoft’s cloud computing business Azure. 5 years from now, I believe AWS’ operating margins could be closer to 40%-50%, with EBITDA margins ranging from 60%-65%.

• The retail segment’s normalized profitability remains misunderstood by the majority of investors. Investors appear myopically focussed on the lack of or limited profitability of Amazon’s 1^st party (1P) retail business on what is suppose to be a more efficient retail model than traditional brick & mortars (B&M). On this issue a couple of things come to mind: 1) Continued investments in the fulfillment and distribution network are necessary to support a superior customer service offering which in tern leads to continued share gains in under-penetrated product categories within a gigantic TAM; In the US alone Walmart has retail sales of well over $300bn, which is massive compared to Amazon’s entire 1^st party sales which will likely be under $100bn this year. The highly successful Costco-like retail playbook of sharing scale efficiencies with the customer results in a superior service and a more loyal and valuable customer base, completing the virtuous circle that propels the Amazon Flywheel. Customer service and pricing levels are probably the two most important competitive factors in mass market retailing, and I believe that these universal truths have been overlooked or under-appreciated by investors who study Amazon and arrive at the conclusion that Amazon can simply pass less value to their customers in order earn a higher profit over the short-term without risking erosion of its moat longer-term.[1] In short, I believe that Bezos’ strategy to densify Amazon’s fulfillment and distribution network, in time, will payoff hugely for shareholders and allow them to continue to crush the competition. Although I concede that Bezos might be excessively over-investing in some areas at rather low rates of return such as the Fire phone, I am confident that most of Amazon’s investment programs will be highly accretive over time. Ongoing initiatives such as Kiva Robotics, the Drone program, Prime Now, Prime Fresh, and content investments that support Prime’s subscription video-on-demand (SVOD) service are multi-billion dollar bets that are depressing current profitability. 2) The second thing and undeniable truth is the rapid growth of very high-margin 3^rd party (3P) marketplace sales and a faster growing mix of 3P Gross Merchandise Value (GMV) vs. 1P, along with growth in Amazon Prime membership subscription fees and Fulfillment by Amazon (FBA) services for merchants. I estimate that Amazon’s 3P GMV will grow at 30%+ per annum, and these services are accelerating retail gross profits, expanding gross margins and further propel the Flywheel. Because of these additional services, Amazon is no longer destined to the financial shackles of being a pure low-margin, (although extremely efficient) 1P fulfillment-based retailer. Due to these large investment programs, along with the under-appreciated growth of these higher-margin services, the market has consistently and unfairly accused Amazon of being a low-margin retailer that barely generates any real profits.

 

Why does this opportunity exist?

Amazon broke out revenue and operating profit figures for its AWS division during its Q1 results this year, which revealed a very profitable cloud computing business. After being thought of as a loss-making division, by now AWS’ profitability is well known to most investors. This event, along with a steadily improving margin profile for the retail business has catalyzed a substantial re-rating of Amazon shares year-to-date.

However, I believe Amazon remains largely a misunderstood investment story. Most investors still under-appreciate the magnitude of the AWS opportunity as growth and margin forecasts appear far too low by most sell-side analysts. Bezos’ investment time horizon is longer than most investors, who typically under-price the long-term growth prospects of high-quality compounders. The market also typically does a bad job of valuing divergent cash flow streams such as, in this case, the Retail segment vs. the Public Cloud Infrastructure segment; Most analysts still have not woken up to the fact that AWS is a material value driver and consequently do not value Amazon as a sum-of-the-parts but instead assign a consolidated multiple as their main valuation framework. I believe this has led to grossly conservative implied valuations of AWS, which I believe will become a much more valuable franchise than the Retail business over time. As an industry, public cloud infrastructure services also has a limited reporting history, and investors have assumed that it is a very low-return, unprofitable business. Financial disclosure of hyper-scale cloud infrastructure providers such as AWS, Azure and Google Cloud remains quite limited as Azure and Google currently do not break out their cloud division financials. What’s more, publicly-traded companies with comparable economic characteristics to AWS are not obvious to the casual market observer, making it harder to value. Finally, there is a misunderstanding of Retail’s long-term earnings power due to the different growth initiatives within this segment such as Prime, FBA, and 3P which all have different growth and margin structures – and all at different points of their respective investment cycles – which mean lazy analysis will likely lead to a faulty investment conclusion.

 

AWS – The Fastest Growing Enterprise Technology Company in History

Brief Business Overview

AWS was formed in 2006 to sell excess cloud computing capacity unused mainly by the Amazon.com retail website. Providing cloud infrastructure services is largely a recurring, subscription-based business which can be further broken out into three main service lines: Infrastructure-as-a-Service (IaaS), Platform-as-a-Service (PaaS), and Software-as-a-Service (SaaS). IaaS is the provision of storage, computing power, virtualization and networking services over the cloud. PaaS is the provision of an operating system platform and related services over the cloud, and SaaS is the provision of application software such as Salesforce CRM, for example, over the cloud.

Source: Gartner: Magic Quadrant for Cloud Infrastructure as a Service, Worldwide report

AWS is the clear market leader and should be posting revenues of nearly $8bn this year and well above $12bn next year, making it the fastest growing enterprise technology company in history. For reference, Google is the only other technology company to achieve $10bn in revenues in less than 10 years!

 

Value Proposition

Similar to how households or enterprises can pay for electricity service from a local utility provider, customers can rent computing and storage units over the cloud from an infrastructure cloud service provider on a pay-as-you-go basis. Since companies already outsource their electricity requirements, there is little reason why IT infrastructure shouldn’t be commoditized over the cloud as well. The current shift to public cloud services is reminiscent of a time during the industrial revolution when companies started shifting their power consumption to electric utilities instead of generating their own power source in-house. WRT to alternative IT solutions, traditional IT outsourcing solutions provided by firms such as IBM or HP are typically more expensive, and on-premise solutions require large, upfront investments into in-house IT resources such as software, hardware and consulting services.

 

“No company that we [Andreessen Horowitz] invest in anymore actually ever

buys any hardware” – Marc Andreessen, TechCrunch, January 2013

 

The head of AWS, Andy Jassy, discussed several key reasons why companies are flocking to the cloud.[2]

• Cloud enables a service consumption model that transforms a customer’s fixed capex to variable cost.
• Due to superior capital efficiency, hyper-scalers such as AWS realize far more economies of scale than many enterprises could on their own. Hyper-scalers achieve superior asset utilization vs. customers that may have sub-20% data centre utilization rates in some cases.
• Cloud enables on-demand models to prevent over or under provisioning of storage and computing during peak or low demand periods.
• Companies can outsource IT infrastructure requirements and focus their resources on their core business.
• Pricing is very attractive in comparison to legacy on-premise solutions. As shown below AWS has a huge pricing umbrella over traditional on-premise solutions with pricing for basic computing and storage services ranging from 68%-80% cheaper than comparable on-premise solutions.

Source: Gartner, Deutsche Bank

Because of these reasons and the increasing comfort around the security and reliability of hosting data over the public cloud, adoption is hitting a major inflection point according to CIO surveys. General Electric, for example, is a major customer of AWS and is planning to shut down 90% of their 32 data centers over the next five years.

 

The Moat – it’s very wide, and growing

Economies of scale act as a large entry-barrier as significant capex is required to break-even in this business. AWS truly is the 800-pound gorilla in this space with greater than 10x the computing capacity of the next 14 largest competitors combined. As a result, they are the only current existing player operating at scale. In addition, switching costs are also increasing over time as customers that migrate large data workloads over to a single cloud vender can easily get locked-in. Switching costs also increase as customers purchase incremental value-added services on top of AWS’ basic infrastructure services. One notable example of customer lock-in is Netflix, which relies on AWS for its entire IT infrastructure; Netflix has said that it would be a “significant multi-year effort to switch infrastructure cloud providers.” For AWS this is all great news as they have already reached a critical mass of 1 million plus sticky customers and operate a largely subscription-based business model that benefits from massive scale economies and high barriers to entry. Finally and most importantly, the business will also benefit from a massive network effect of 3^rd party developers/software application vendors as customers will likely stick with only 1-2 cloud provider platforms with the largest breadth of IT services.

 

With respect to pricing, unlike what many investors believe, the business of providing public cloud infrastructure services is not a pure commodity-like business. Yes, at the basic core the business is about renting out uniform storage capacity and computing power units. But other competitive factors such as security, reliability, speed and a broad set of features are critical for large, sophisticated, enterprise-grade customers who are beginning to shift an increasing amount of mission-critical data to the public cloud. Some of AWS’ competitors with businesses tied to traditional on-premise solutions have argued that AWS is only suitable for start-ups and is not an “enterprise-grade” service. This is clearly not the case if we take a quick look at AWS’ customer base, which includes large enterprises such as General Electric, Comcast, Vodafone, Unilever and the CIA. The lucrative CIA contract was won by AWS over IBM Softlayer, despite Softlayer’s lower quote, because according to the CIA, AWS had a “superior technical solution”. If this is not the smoking gun that attests to AWS’ “enterprise-grade” quality, which helped the company win over a contract from an organization with one of the strictest security standards in the world, then I don’t know what is.

 

Attractive Industry Structure and Economics Developing

Gartner projects the IaaS market will be worth $17bn in 2015 and will double over the next 3 years. I believe Gartner’s CAGR’s estimates are too low and I have modelled an industry CAGR closer to 50% over the next five years. Why? Well, AWS’ compute and storage services’ usage rates are growing at 90%+ YoY, (Revenue is growing nearly 80% YoY) Microsoft recently disclosed that its Azure business is growing revenues 135% YoY, and Google Cloud is likely growing at triple-digits as well. So with the market leaders currently growing at 3x-4x the rate that Gartner projects, and with the industry conservatively at less than 5% of the TAM and rapidly growing due to a major multi-decade shift in IT spending, do we really think that industry growth will be just 30% per annum over the next few years? Even assuming 50% per annum growth over the next 5 years, the size of the cloud infrastructure market will still be ~13%-26% of the TAM, implying plenty of growth well beyond 2020.

 

In terms of competition, simply due to the massive economies of scale required, I see the majority of share in the IaaS market split between AWS, Microsoft Azure, and Google Cloud over the next several years. The current market setup is a 2-horse race between AWS and Azure, with Google at a distant third and not in the minds of most large enterprises. AWS has been steadily gaining market share and is now nearly 5x larger than Azure with a ~47% share; Azure will likely generate run-rate revenues of ~$1.6bn this year and according to my industry due diligence Google Cloud is likely a sub-$1bn business. The rest of the industry is mostly comprised of the traditional enterprise IT incumbents such as HP[3], IBM, and Oracle who have an incentive to protect their legacy businesses which will likely be cannibalized.[4] As a result, they emphasize more of a hybrid-cloud approach, and unlike Microsoft’s Nadella, were very late in the game in pursuing a “cloud-first” strategy. Due to the high entry barriers, these sub-scale players will likely operate a niche cloud business without any significant market presence. For reference, the Goldman Sachs analyst thinks that even Azure is likely operating on negative gross margins and is not expected to break even until the second half of 2016 or early 2017 despite being the clear #2 player with a $1.6bn business!

 

“While many companies are developing commercial cloud offerings, there are only two driving enterprise cloud platform innovation at massive scale: Amazon and Microsoft.” – Microsoft CEO Satya Nadella, Microsoft Q1 2016 Conference Call

 

There appears to be some sort of consensus that, longer-term, the market will eventually develop into a duopoly between AWS and Azure. Although a possibility, I have to disagree. I think Google is currently being underestimated and could potentially be a very large player in this space. I believe Google’s limited traction thus far in the cloud infrastructure market has largely been 1) a lack of focus, especially in developing a rich feature set such as the one available on AWS, 2) very limited marketing to enterprises, and 3) limited time in market, as their cloud business only launched 2 years ago. The first issue shouldn’t be a problem for Google longer-term given their technical prowess. The recently announced hiring of VMware cofounder Diane Green to head Google’s Cloud business, to me, signals that Google is willing to tackle the enterprise market more aggressively.

 

Google’s 8^th employee and SVP of technical infrastructure, Urs Holzle, recently stated that he thinks in 5 years Google’s Cloud business could be larger than its entire Search Advertising business! I think Google’s advertising business will likely top $100bn in revenue by 2020. So what he is basically saying is that Google Cloud will grow by over 100x in 5 years! For reference, I am only projecting AWS to grow to ~$54bn in revenues by 2020. At first I thought Mr. Holzle was being delusional. However, the more I thought about it the more I see a bit of truth in his statement. Although Google Cloud is subscale now, I believe the conditions are present for them to compete very effectively. Firstly, they likely have one of the largest existing datacentre footprints available that power their heavy-traffic, security-sensitive, consumer-oriented cloud apps such as YouTube, Google Maps, Drive, and Gmail; with that also comes the expertise required to host extremely large data sets. As such, because of their existing scale I believe they are likely already operating at gross margins higher than Azure, or at the very least have the infrastructure in place to scale up very quickly. Secondly, unlike the traditional IT incumbents, Google doesn’t have a highly profitable legacy business to protect, and they are willing to tolerate large losses for a long time in order to scale up. Obviously having a war chest of nearly $80bn also helps. Thirdly, unlike Azure but like AWS, Google intends to build its cloud OS platform with open source technologies. Similar to their rather successful strategy in mobile by using Android to develop an open ecosystem of 3^rd party developers and customers, I believe this strategy will play out well in the cloud infrastructure world as well. The fact of the matter is that despite being able to work with other technologies, Azure’s cloud platform is built with very Microsoft-centric technologies, which is not friendly to the modern day developer who doesn’t code in the .NET Framework. Instead, Azure appears built for Microsoft’s existing enterprise customer base, which they hope to protect from AWS and Google. Finally, Mr. Holzle has said that only ~1% of total storage capacity in the world is on the public cloud (implying a more aggressive TAM estimate than my own), meaning that we are still on the 1^st pitch of the first inning in this game. In my view, Google has plenty of time to catch up.

 

With that said, it’s difficult to imagine AWS not maintaining its current share or even increasing it over time as they far along in the learning curve, are considered the clear industry leader by enterprises with the most robust and sophisticated features, and already have the largest 3^rd party marketplace of applications on their platform. To be conservative and due to potential volatile changes in market share within a hyper-growth market, I model for AWS a 5-year top-line CAGR in-line with the cloud IaaS industry.

 

With respect to industry pricing, prices for basic IT infrastructure services are largely driven by Moore’s Law.[5] AWS has cut its prices nearly 50 times for basic IaaS storage and compute offerings over the course of the past 6 years, and Azure and Google have cut prices in-line to keep up. Google announced deep pricing cuts in April 2014, thereby effectively resetting IaaS prices for the industry, stating that AWS was over-earning by not passing on the full Moore’s Law cost savings to customers. Google cited that public cloud infrastructure providers such as AWS and Azure were cutting IaaS prices closer to 6%-8% per annum, which is a sign that industry pricing was already starting to firm up in true duopoly fashion. Due to the risk of more competitive pricing – mainly from Google – I am modelling a conservative base case scenario of IaaS pricing falling by 10%-20% per annum, which should be roughly in line with hardware cost savings from Moore’s Law and scale efficiencies from increased bargaining power. I believe the risk of a pricing war will decrease over time since share will mainly be allocated to a small handful of rational players. Azure has historically not been aggressive on pricing, and has a large installed base of customers to harvest cash flows from and to transition into the cloud. For Google, I believe their priority now is to dramatically improve their platform, such as launching additional features and services for their PaaS offering. I believe my industry pricing assumptions could potentially be a very conservative, especially if Google figures out that destroying the industry value pool alone will not win them share. The dream bull case would be if Google fails to gain any real traction, and the market evolves into a duopoly/quasi-monopoly between Azure and AWS with AWS having a dominating 60%-70% market share; pricing power of course would be much stronger.

 

Expansion into Adjacent Markets and the OS Ecosystem/Network Effect

Although an important component of the AWS investment story, I believe that the market has largely overlooked AWS’ expansion into the adjacent PaaS market, which should lead to a stickier, higher-margin business profile for AWS and a wider moat over time. PaaS offerings are higher value-added than basic IT infrastructure services with better pricing power and terrific incremental margins. These services encompass areas such as the Internet of Things, Mobile, Big Data Analytics, Email, and Desktop Virtualization that make up the foundation of a modern operating system (OS) platform over the public cloud. I think everyone in the industry has now woken up to the fact that the PaaS layer will be the most important public cloud battleground of the future; however, few have a leading, profitable IaaS business such as AWS’ with the customer base to cross-sell into.

 

One notable example of AWS’ success in growing their PaaS platform is their recently launched Amazon Aurora service. Aurora is a MySQL-compatible database engine with 5x better performance than the typical MySQL database and at one-tenth the cost of high-end commercial database offerings. Barely 2 years old, Aurora is already a $1bn+ business growing 127% YoY and is actually the fastest growing service line in Amazon company history. The database market is one of the largest sub-segments of platform software at around $40bn and Gartner thinks that cloud database services can grow at 45% CAGRs over the next several years. Clearly, Aurora is stealing massive market share away from database incumbents Microsoft and Oracle who have the leading on-premise solutions in this space; my due diligence suggests that Oracle’s database cloud product is growing closer to under 40% per annum. Aurora’s success gives me great confidence that AWS has the capability to build a leading PaaS offering amongst incumbents who have been in this space for decades.

 

Due to the favourable mix-shift of a faster growing PaaS business with better pricing power than IaaS, I believe AWS’ operating profit margins have more upside risk than what the Street anticipates. However, there are no good comparable publicly-traded businesses that can give us a clue on how AWS’ long-term margins can potentially look like. For this issue, I have to give credit a brilliant friend of mine who pointed out to Intel’s PC division as perhaps a relevant comparable.[6] How are these two businesses similar? Well, Intel’s PC business is another Moore’s Law type of business with high fixed costs, it benefits from tremendous R&D scale efficiencies, and is a dominant market share leader in PC processors with an 80%+ share. For reference, Intel’s PC segment reported ~$35bn in revenues and generated 42% operating margins in 2014. With the exception of perhaps a larger enterprise sales force, I believe AWS’ IaaS business shares quite a similar financial profile to Intel’s now mature PC business. However, as I already noted, AWS’ expansion into PaaS offerings with higher contribution margins vs. its more commoditized IaaS offering should lead to even greater margin expansion over time. This leads me to believe that eventually AWS could become an even more profitable business than Intel’s PC division ever was.

 

Growing on the back of a vast installed base of customers, AWS’ cloud computing platform Elastic Beanstalk will likely have a massive ecosystem of 3^rd party developers/software vendors; Intel never had this type of network effect advantage. But what other technology company had a similar advantage? Off the top of my head, one business I can think of that benefitted from a similar type of ecosystem and thus had an overwhelming market share lead was Microsoft’s Windows OS for PCs. This was a phenomenal business that sold pre-packaged software at 100% incremental margins into an enormous open-ended growth market which propelled Microsoft stock to be one of the most valuable companies in the world at the turn of the 21^st century. Just like how Windows was the dominant OS of the PC era, and iOS and Android are the dominant OS of the Mobile era, my belief is that AWS will likely be among one of the very few dominant OS platforms of the public cloud era. Already having achieved a critical mass of having the largest marketplace of 3^rd party application software for 1 million+ sticky customers, and the most robust set of features (over 1,000 features have been introduced since inception), and with a business multiple times the size of the rest of the industry, I do not think this prediction is unrealistic. Also worth noting is that AWS should be able to easily leverage its R&D scale efficiencies to expand even further up the cloud stack into higher-margin application software such as SaaS over time, which will further expand its TAM. This is additional free upside not baked into Street estimates in my view. Now I can clearly see why Bezos wrote that AWS is market-size unconstrained.

 

In summary, I think AWS’ long-term economics will look like something in between Intel’s PC division and Microsoft’s Windows OS for PCs when they were nearing a mature growth phase, but with the added benefit of having a much larger TAM, and possessing the best combination of competitive advantages a business can have in my view – the network effect and massive economies of scale. By 2020, I believe AWS can grow revenues closer to $54bn (much larger than Intel’s PC segment), and generate operating profit margins somewhere between 40%-50% and EBITDA margins north of 60%-65%.[7]

 

Retail Segment – The Bezos Flywheel

As mentioned in my thesis the growth of FBA, Amazon Prime and 3P marketplace sales should drive general margin expansion for the retail segment over time, and further propel Bezos’ flywheel. Some analysts have pointed to Amazon’s slowing reported retail sales growth, but fail to appreciate the fact that faster growing 3^rd party sales understates total retail sales to an extent, due to the fact that this is a commission-based business that earns a take-rate off of 3P GMV. The more important driver here is the growth in 3P GMV, which should remain very strong; this is due to the Amazon customer wallet being relatively under-penetrated in certain areas such as apparel, along with a massive remaining growth runway in retail sales. For reference, total US retail sales was ~$4.53 trillion in 2013, and is likely growing at a nominal GDP-like rate. I estimate that Amazon’s total global GMV (including 1P and 3P) will still be less than $1 trillion by 2020.

 

3P Marketplace, Amazon Prime and FBA – Trying to Decipher the Genius of Bezos 

Amazon Prime is a very high-quality, fast growing business that generates annuity-like, subscription-based revenue streams. Prime membership numbers aren’t disclosed, but estimates based on surveys suggest that there may be up to 60-80 million members worldwide. Prime members tend to make more frequent purchases on Amazon (up to 2x-3x more in value than non-members).

 

Initially I was quite skeptical of the launch of a SVOD service for Prime members due to the multi-billion dollar content investments necessary to build a compelling offering, but over time I have come to see the attractiveness of such a business. One strategy a Pay-TV distributor can use to differentiate itself from the competition is to have differentiated content. Traditional Pay-TV distributors have licensed rights to exclusive sports content in order to protect the Pay-TV bundle. Another type of content strategy that appears to provide differentiation for a cable network or SVOD is to invest in exclusive original content. Over the past several years, we have seen distributors such as AMC networks, Starz, and Netflix pursue a strategy of investing in exclusive original content to some success. Amazon is now pursuing a similar strategy by producing, for example, three new seasons of Top Gear that will be exclusive on Amazon Prime. I believe Amazon is probably spending a couple of billion dollars on content streaming rights and production presently, and this expense pool will likely peak at around $3-$5bn over the next few years. For reference, Amazon’s largest OTT competitor, Netflix, spent ~$3bn+ on content in 2014, and is expected to spend between $4bn – $5bn this year.[8]

 

I think the economics of producing content appear much more attractive when it is paired with a global SVOD distributor which has access to a global pool of potential subscribers. Perhaps this is the main reason why John Malone recently built an equity stake in Lions Gate: I could be wrong, but the end game thesis could be to unleash some synergies by leveraging Discovery and Starz’ brand equity and global base of customer relationships to eventually build a high-quality, global subscription-based streaming service. With Lions Gate’s existing content streaming library and scale in content production, this business is currently experiencing a positive tailwind of high-quality content being re-priced higher due to steadily growing incremental demand from OTT players who are experiencing rapid growth in global markets. Maybe the legend John Malone sees this same inflection point in the economics of content production assets. With that said, I see the economics for Amazon’s streaming service particularly attractive over time since Amazon already has a global customer base that they can leverage for Prime subscription growth. Some analysts forecast that Netflix can eventually reach 200 million subscribers globally. Given Amazon’s global presence, I don’t see why they can’t get there eventually. This business will eventually throw off great incremental margins once it reaches a critical mass, as largely fixed content expenses will be amortized over a growing base of Prime subscribers. Based on Netflix’s per-subscriber valuations, I am extremely bullish on this business.

 

The genius of FBA is that it completes the virtuous cycle of more Prime eligible SKUs, better control of the customer experience, leveraging incremental fulfillment scale efficiencies, lower prices, and more Prime members. Long-term, this is superior model to e-commerce competitors who lack the breadth of SKUs and a high-quality, uniform customer experience. Credit to Andreessen Horowitz’ blog for this great image below which illustrates the Amazon Flywheel.

Source: A16Z Blog

Amazon reminds me of the successful Costco model of sharing scale efficiencies with customers, and maintaining a low mark-up pricing policy. The market consensus on Costco 10-20 years ago was that it was a low-margin retailer and expensive stock. Now the business is better understood as one of the most successful retailers in history.

 

Retail Segment Long-Term Economics

Quite detailed analysis is required in order to come up with an informed view of how consolidated margins may look like for the retail segment long-term. After discovering all these moving parts in the retail business which greatly complicates the story, it is no wonder that the sell-side has consistently for a long period of time under-estimated Amazon Retail’s margin upside.

 

Amazon’s Retail business can be separated into 1P and 3P sales. Because 3P sales (which are 100% gross margin) are based off a commission of 3P merchandise sold, I think the best way to think about how the retail segment’s long-term operating margins might evolve into is to start with Amazon’s GMV. GMV is an important metric for analyzing e-commerce models such as Amazon’s since the business derives total revenue from a mix of 1^st party (1P) and 3P (marketplace) sales. Currently Amazon doesn’t disclose their GMV (what a surprise), but some analysts estimate that it might have been ~$180bn in 2014 or slightly 2x Amazon’s total retail sales. I believe this estimate is quite reasonable. If we assume that 60% of Retail’s GMV was 3P, and given Amazon’s take-rate of ~12% (this figure is based off of merchandise category), 2014 3P sales should be ~$13bn. Add $72bn for 1P sales and we arrive at around $85bn in total retail sales, which is around what reported Retail sales were for Amazon in 2014. There should also be a few billion of revenues in the mix from Prime subscription fees and FBA but for the sake of simplicity I will ignore these businesses for this analysis.

 

Now, let’s further split our analysis between North America (NA) and International. First off let me say that I am working on the general premise that Amazon has a much more efficient retail model compared to B&M, and current investments are obscuring the true profitability of this business. To summarize, items that are obscuring the “core” profitability of the retail business include R&D spending on the Drone program, investments in Kiva Robotics, the Fire Phone, TV and Tablet, Amazon Prime Now, Amazon Fresh, content streaming licenses and production, incrementally moving delivery services in-house and general growth investments into building additional fulfillment infrastructure closer to end markets. A few of these investments such as the Fire Phone may have a questionable return on investment profile, but I believe that most of these initiatives will turn out to be quite accretive to shareholder value. Ultimately, if you believe that Amazon doesn’t have a more efficient model than B&M, then I can’t help you here. For reference, the Bernstein internet analyst “gets it”, and has published an excellent note covering this topic.

 

North America 1P & 3P Operating Margins

For the more mature NA segment, if Amazon has a more efficient retail model, its 1P business should be able to earn operating profit margins higher than the most efficient B&M retailers at comparable sizes. I think Costco and Walmart are pretty good benchmarks. Costco is a $117bn business and generates ~3% operating margins; Walmart is a 5% operating margin business. From a product mix perspective, Amazon’s 1P gross margins are likely in the mid-teens, compared to Costco’s at around 10%-11%. Given what we know here, I’m confident that over time Amazon’s NA 1P business should be able to earn at least mid-single digit operating margins and potentially much higher. Note also that higher-margin categories such as CPG are still relatively under-penetrated by Amazon, and there should be a 1P sales mix-shift towards these categories.

 

In terms of GMV, the 3P business is likely growing much faster than 1P sales due to the growth of 3^rd party merchants, FBA sellers and Prime users. By 2020, I estimate that 3P GMV could closer to 75% of total Retail GMV of ~$955bn or above $700bn. WRT the long-term 3P operating margin forecast, eBay’s marketplace segment is probably the best reference here. Despite eBay losing massive e-commerce share and underinvesting on its marketplace platform, it sports 30%+ EBIT margins with a GMV of $83bn in 2014. After taking into account payment processing expense differences from the PayPal segment, and differences between take rates (12-13% for Amazon vs. 8.5% for eBay), Amazon’s 3P operating margins should be conservatively at least ~30%-35% by 2020. I think this could potentially be a very conservative guess because I think eBay in general is not the most well-run business, and by 2020, Amazon’s NA 3P GMV should be at least multiple times larger than eBay’s GMV, providing much more scale efficiencies. Note that I am not adjusting for Amazon’s fulfillment expenses for 3^rd party merchants here given that I am not sure what FBA’s contribution margins are. I would say that FBA strengthens the Bezos flywheel further and this business leverages scale efficiencies by utilizing fulfillment infrastructure that supports the 1P business. In addition, when the Kiva Robotics program is fully implemented, this initiative could easily lead to upside of a few hundred basis points of margin expansion which I am not capturing in my model.[9]

 

By 2020 I am modelling a 3P sales mix of 28% out of total retail sales. On that retail mix of 72%/28% of 1P/3P sales at 5%/30% operating margins, respectively, consolidated GAAP NA margins should be around low double-digits.

 

International

The largest criticism I have about this business is the company’s massive loses in China and the lack of any real traction in that market. Amazon entered China in 2004 and at one point not too long ago had the same amount of fulfillment space as JD.com (which I think is a pretty cheap stock btw). This is despite the fact that they currently have a 1% market share in direct-selling B2C marketplace sales compared to JD’s ~47% share. I think it’s time for an exit, and a sale of this business for an equity stake in JD.com could be the most attractive option at this point.

 

Within International Amazon has more mature businesses in markets such as the UK, France, Germany and Japan, and ones that are still subscale in China, India, Mexico, Spain and Italy. The growth opportunity in International remains enormous, but it will likely take a very long time before any large profits are realized. Thankfully, the International segment will likely remain a less valuable piece than NA for a very long time, and as such, is less of a key driver.

 

I am modelling 0%-5% GAAP EBIT margins for International by 2020, which I think prices in the risk of capitalizing losses permanently in failed markets such as China. When combined with low double-digit NA EBIT margins, Amazon Retail’s consolidated “core” operating profit margins should be within the HSD to LDD range by 2020. Note that this is still quite a rough guess and I have tried to be very conservative with my assumptions here, and have allowed some space in my analysis for potential low-return investments.[10] Due to the huge operating leverage in fulfillment, I see potential upside risk to this estimate.

 

Concerns – It’s all about the “Long-Term”

The most common argument I hear from the bears is something along the lines that Jeff Bezos is an empire builder who doesn’t care about profits or shareholder value.[11] Some also believe that Amazon is a de facto charity disguised as a for-profit company, run purely for the benefit of consumers at the expense of shareholders; I think this is almost akin to calling Amazon stock a Ponzi scheme. These are pretty ridiculous assertions in my view.

 

Is Jeff Bezos an empire builder? Probably. Does that make Amazon a bad investment? I don’t think so. When you are growing so quickly and reinvesting most of your profits in two of the largest markets in the world there is risk that you look like an empire builder and want to grow at any price. Bezos is obsessed about creative destruction and his investment time horizon of 5-10 years is longer than most CEOs and public market investors. In general his investment philosophy appears very flexible where he is willing to invest in lots of different projects where the risk/reward profiles range from substantial downside, but also a lot of upside optionality. When the inevitable failed project becomes apparent, the investment community are quick to scrutinize these low-returns.

 

In the grander scheme of things, I don’t believe a genius capital allocator has to head Amazon in order to make a lot of money here. Let’s take Amazon Prime for a quick example. If Amazon Prime raises its annual subscription price by 20% tomorrow, membership growth would likely remain very strong, implying that this would be a very wise decision in light of the goal to maximize shareholder value. Bezos won’t do this often, which might suggest that he is not a rational actor or shareholder friendly CEO. Perhaps this is the truth, yet I honestly think that this will eventually look like a rounding error in a DCF model. In my view, this is one case where the business is so wonderful it overrides the management factor in the investment thesis. I also think that critiques haven’t given Bezos enough credit for his successful investments and start-ups such as AWS.

 

For the record let’s take a brief look at some of Jeff Bezos’ capital allocation decisions:

-Acquired Twitch for around $1bn in 2014. Twitch is a hyper-growth, online live video streaming service with a niche audience. I think this media property has a very attractive platform for pursuing either an advertising heavy or subscription-based revenue model. In general I am quite bullish on the future of e-sports gaming and think this purchase could potentially be a home-run.

-Acquired Kiva Systems for $775 million in 2012. I think this was a pretty good investment as the Kiva robots can take out a lot of labour costs in Amazon’s fulfillment centers.

-Acquired Zappos for $1.2bn in 2009. All I know about this purchase is that Zappos was a very customer-centric shoe retailer that seemed pretty well-run and by 2008 was doing more than $1bn in GMV.

-Started AWS in 2006. I think this business alone makes up for all the losses and failed investments that Amazon will ever incur. If you own an asset that can be worth over $1 trillion within the next 10 years, I highly doubt you’re a value destroyer. The logic that Bezos doesn’t care about profits simply falls apart here when this business is at the cusp of one of the greatest technology growth cycles of our generation and is already reporting run-rate 19% GAAP operating profit margins. If Bezos is an irrational empire builder then why would he not operate AWS at 0% margins? Instead, industry prices for cloud infrastructure services are already firming up. So unless you think there are some serious sketchy accounting games going on here with the segment reporting, the “profitless forever” argument simply does not hold for AWS.

-The Fire phone has been an absolute disaster. In general it seems like Bezos’ strategy in consumer hardware is to sell products at a loss in order to drive incremental sales on the core retail platform.

-China has obviously been a disaster; nothing much needed to be said here. India, on the other hand, is a huge potential market and looks very promising.

-Amazon Now, AmazonFresh, Amazon Prime, and the Drone program. With the exception of Prime, these are all pretty large investment programs where the long-term pay-off may be questionable. Need a bit more time to judge these fairly.

 

Overall, I think his batting average is not perfect, but pretty damn good when you actually look at the record, and certainly better than most CEOs. Share dilution has also been quite limited over time. He writes that his job is to maximize long-term FCF per share in his shareholder letters. I just find it hard to believe that he is bullshitting in every letter just to trick shareholders into believing the Amazon story. It’s clear that Bezos thinks reinvesting all of Amazon’s profits into long-term projects is a more attractive use of capital then returning it to shareholders or reporting a healthy GAAP profit for Wall Street. What’s most important here is that Amazon’s earnings power has consistently increased over time, not what the company is reporting in GAAP profits.

 

Valuation – The Most Valuable Company in the World

On near-term valuation multiples, Amazon looks very expensive. It trades at ~42x 2016e EBIT[12] by my numbers, but this multiple will rapidly shrink in my outer projections years as AWS grows its profits significantly. By 2019 and 2020, backing out the Retail segment’s value, I believe we are getting the AWS business for 1x and -5x EBIT! On a fully consolidated basis, Amazon trades at just under 7x my 2020e EBIT projection. Even if we assign 0 value to the Retail business, we are paying 13.5x 2020e EBIT for AWS, which is still way too cheap in my view.

 

Base case, I am valuing the Retail segment on 20x 2020e EBIT, or ~$470bn ($961 per share), which translates into a GMV multiple of 0.5x. This is a large discount compared to Amazon’s historical GMV trading multiples of between 0.8x-1.0x, but reasonable I think, given the more mature future growth profile. For reference, large-scale US-based retailers with slower growth and without a high-margin marketplace business have typically traded between 0.6x-1.0x GMV. Worst case scenario, in 5 years this segment should be worth at least the current market-cap today.

 

I feel AWS deserves a higher multiple than Retail, and I am valuing this business at 25x 2020e EBIT or ~$600bn ($1,240 per share or nearly 2x Amazon’s entire current market-cap). This translates into ~11x 2020e sales and ~19x 2020e EBITDA. These multiples may look aggressive but I believe are well justified. Post-2020, AWS will still likely grow operating profits at 20%-30% per annum or higher on the back of massive ongoing cloud services growth. The business will also throw off increasingly predictable cash flow streams as enterprises are locked-in to a single cloud platform provider with most of their mission-critical IT workloads. Benefitting from a long-term secular industry tailwind, the business is also relatively non-cyclical; in fact I think it will be quite recession resilient and perhaps even counter-cyclical as enterprises have a greater incentive to cut costs by moving workloads over to the public cloud during a recession. If we take publicly-traded enterprise horizontal SaaS venders with near-infinite growth horizons as a set of comparables, I think AWS is a much better business than most of these names that trade at 8x-11x forward revenues with non-existent earnings, greater competition, lower switching costs, and smaller TAMs.

 

With the addition of the total incremental FCF and working capital that will be generated over the next 4 years, I think Amazon shares are worth between $2,000 – $2,350 by 2020 which should provide a 4-year annually compounded internal rate of return of 31%-37%. Worst case scenario, I think the stock trades at 19x my consolidated 2020e bear case operating profit numbers, which means shares are still worth $1,300 or 94% higher than where it trades today. This gives us about a mid-teens IRR. The stock would have to trade at a sub-10x 2020e EBIT multiple in order to be worth less than where it is today. This seems like a pretty good risk/reward.

 

The Bigger Picture: My Margin of Safety in Quality & Growth

Stepping back a bit, my former blog mate predicted here that Alibaba will become the most valuable company in the world in 10 years. I’d have to respectfully disagree with him. 7 to 10 years from now AWS alone could be worth well over a trillion dollars[13] and I’d bet that Amazon will be the first company with a trillion dollar market-cap. I love high-quality compounders with near-infinite/open ended growth horizons that are evolving into monopoly-like businesses, and I think the chances of me being wrong on both the prospects of AWS and Retail is much smaller than me being independently wrong on either one of them.[14] As such, I feel comfortable with the probability that either one of these businesses can more than justify the entire Amazon market-cap today, giving me my desired margin of safety.

 

Catalysts – Warning: Long-Term Time Horizon Required[iii]

I do not think this is a great holding for traditional hedge fund-like strategies that focus on shorter-term, event-driven trading opportunities. But make no mistake, I believe the timing for this investment is generally good and my suspicion is that AWS will continue to blow away Street consensus over the next several quarters. Therefore, I think the stock will continue to re-rate as growth-oriented investors pile in.

Catalysts may include:

• Additional AWS financial disclosure such as volume, pricing, cost structure and PaaS and SaaS business lines; A spin-off of AWS since there are virtually no synergies with the Retail segment (this move would be very unlikely, since Bezos would likely lose control); I believe if this segment were to be spun out today, shares could trade 50%+ higher. I would be very impressed with Bezos if he did this.

• Retail consolidated operating margin expansion from mix-shift to faster growing 3P operating profits, Prime subscription fees, current heavy investment phase rolling-off and greater operating leverage from fulfillment.

• Time: “The indefinite continued progress of existence and events in the past, present, and future regarded as a whole”.

 

Epilogue

In general studying Amazon was a very challenging and intellectually stimulating exercise. What I love about this idea is that it isn’t a hedge fund hotel or a consensus trade. I still think there are a lot of skeptics out there that love to hate the stock and criticize the lack of reported profits. I would not be surprised to receive a lot of push back from my readership base this time, even from the well-informed, very smart crowd.

 

Other potential ways to play the public cloud computing megatrend:

• Alphabet/Google: Could be an interesting backdoor play on the public cloud if their business begins to take off. Not a guarantee but I don’t think this is priced in at all.

• Microsoft: Thinking about this company makes me bored. But in all seriousness I think they will do OK.

• Chinese Internet Companies: According to some sources Alibaba’s IaaS has 1.4 million customers. Other major Chinese internet firms such as Baidu, JD, or Tencent may eventually get into this space.

• Short IBM/Oracle:

IBM is again on its death bed, and has to reinvent itself in order to remain relevant. Honestly I think their business is going to shrink a lot, and I don’t think there’s room for another major IaaS/PaaS player in the market. Commoditization of IT services is going to absolutely kill them. No one’s going to use their consultants or outsource their IT infrastructure to these guys if they can do it on the public cloud for much cheaper with a superior technical service. Even industries with tons of customer and regulatory sensitive data such as the Public sector, Financials, Insurance and Healthcare will all eventually move the vast majority of their IT workloads to the Public Cloud.

 

Oracle is another potentially interesting short. The issue for these guys isn’t that they won’t successfully transition into a cloud vender, but that it’s a much less profitable business than on-premise. When you earn 95% gross margins on your application maintenance fee streams and have to replace those with SaaS subscription fees at closer to 60%-70% gross margins, your business is going to get hurt. Also it appears that Amazon Aurora is gaining much more traction in the market compared to Oracle’s existing cloud database service.

 

[1] I think people under-estimate how price-sensitive consumers are to purchasing commoditized products

[2] Personally, after developing a web application myself, I know it would have been extremely inconvenient, very slow and more costly to purchase the servers to host my app over the internet instead of using a public cloud provider such as AWS.

[3] In fact, HP has already given up its Cloud Helion business and has recently announced a new partnership with Microsoft

[4] Just like how the Salesforces and Workdays of the world continue to disrupt the application software market, I see the same phenomenon playing out in the infrastructure services world

[5] Between October 2013 and December 2014, Amazon’s average monthly cost per GB RAM fell from $42 to $25, while Google’s dropped from $52 to $32. Increased bargaining power with hardware suppliers could also mean lower capex per unit going forward.

[6] Sometimes we have to use our imaginations to produce great analysis

[7] Assuming maintenance capex in the mid-teens

[8] I am a large bull on Netflix’ prospects as well but have not been able to find an attractive entry-point.

[9] Kiva Robots are estimated to replace 1.5 human workers in fulfillment centers and cost $25k a piece with an economic life of roughly 5 years

[10] My thesis is also not based on a bet that current large investments will roll-off by 2020, and thus margins will lift-off and shares will see a re-rating. I am just trying to come up with an educated guess about how margins may look like if we back out these investments by 2020.  I am all for value accretive investments if they present themselves and if they are the best use of capital. So reported GAAP EBIT margins may never reach this EBIT margin range this decade, which is OK with me as long as I’m confident that capital is being allocated wisely. Honestly Amazon’s Retail business was one of the most difficult businesses I’ve ever analyzed, and I’ve never been a proponent of using precise calculations to drive an investment thesis/valuation.

[11] Amazon in fact recorded GAAP operating margins in the MSD during the mid-2,000’s

[12] I believe operating income will be the key driver of shares going forward. Street tends to focus on CSOI. I focus on GAAP EBIT because I think stock-based comp should be capitalized going forward

[13] Just assume 50% share in a TAM of $500bn and 40% operating margins = annual operating profits of $100bn; A modest 10x multiple would mean a $1 trillion dollar valuation!

[14] Risk is increased if you don’t know what you are doing.

[i] As a side note, part of the reason why I believe excessive diversification is overrated is because the intrinsic value of certain stocks held in a concentrated portfolio are the summation of multiple businesses that are potentially diverse across customer base, geography and product lines etc. Of course, certain single-stock/idiosyncratic risks still apply, such as value destructive capital allocation.

[ii] which comprises of spending on hardware, software, and services across the entire software stack

[iii] And when I mean “long-term” I mean 5-10 years!

Charter Communications / Time Warner Cable – Betting Big on the US Cable Industry

 

“I have said in an inflationary world that a toll bridge would be a great thing to own if it was unregulated … you have laid out the capital costs. You build the bridge in old dollars and you don’t have to keep replacing it.” – Buffett

 

Overview – Merger Arbitrage is Very Profitable Again:

I like Charter here @ $170 per share. I believe heavy selling pressure from arbitrageurs and the complexity of the proposed merger with TWC and Bright House Networks has created a very attractive entry-point. A long-term investment in Charter shares today could potentially generate a very attractive 31% – 39% multi-year annually compounded internal rate of return.

As some of you that regularly read this blog might know by now, I have been a cable bull for quite some time and I still think the industry’s long-term prospects are very attractive both in the US and in most of Europe. I love analyzing and investing in cable equities in general and I love rapidly growing levered equities.

I also like investment theses where the underlying target company is a very good one but is operating within an industry clouded by uncertainty. Despite all the naysayers and the extreme negativity in the mainstream media towards US cable operators – from my perspective it seems like the major papers absolutely love to hate the cable industry – cable is a very attractive business. To gain a better perspective on the negativity, simply take a look at the cover or business section of the Wall Street Journal every other week or so, and you will likely find some article focussed on cord-cutting or cord-shaving (subscribers migrating to less expensive programming packages), the demise of the Pay-TV bundle, some type of major programming dispute a MVPD has with a cable network, or profiles of newly emerging streaming services that will change the face of content consumption. I believe major news reporters have a misinformed view of the economic implications of cord-cutting for cable operators, and that fears are overblown. I think most of the market and the Street still under-appreciate the likely future improving economics of the cable business and are instead overly focussed on the sustainability of their Pay-TV profits streams, programming cost pressures, and regulatory uncertainty. Over the next 7 – 10 years, I expect cable operators in mature markets will continue to transition into very high-margin, less capital-intensive cash cows with a de facto monopoly or duopoly on the high-speed broadband market; moreover, there is ample opportunity to continue to expand into adjacent growing markets such as enterprise/SMB, out-of-home WiFi, and advanced home security/automation services. The industry is also in a rapid final wave of consolidation which should greatly improve economies of scale for aggressive acquirers such as Charter Communications.

The thesis is very simple: Bet on Malone and his legendary capital allocation, bet on Rutledge and his operational prowess, and bet on a growing broadband business.

 

The Deal:

Charter is acquiring TWC for $195.70 per share in cash and stock and TWC’s shareholders can elect to either receive $100 or $115 per share in cash for the consideration. Based on my numbers, “New Charter” should be able to compound FCF per share at a higher rate if more TWC shareholders elect to receive less cash and more Charter stock – assuming Charter stock stays above current trading levels at the deal closing date.

Nearly every analyst on the Street came up with different purchase multiples based on various adjustments to TWC’s yearend expected balance sheet and free cash flow generation. On my numbers, Charter is paying around 9.3x 2015 EBITDA for TWC. The headline purchase multiple appears optically high relative to prior cable industry deals; however, due to M&A speculation a large chunk of the consideration is comprised of relatively inflated Charter stock, and also with the benefits of massive easily realizable tax, operating cost, capex and financing synergies, I believe the deal is likely free cash flow per share accretive to Charter on a near-term and longer-term basis.

Time Warner Cable: The Sleeping Giant

The deal expands upon the Charter roll-up thesis; TWC’s management will be able to cash out in a huge golden parachute and Rutledge and his highly capable team will better manage TWC’s systems and improve per-subscriber unit economics by investing in long overdue high IRR projects across the entire HFC network. Adhering to the same operating model that has accelerated Charter’s own free cash flow growth, they will: 1) convert legacy analog systems to digital across TWC’s entire footprint (like they have for Charter’s footprint already), which should reduce churn, accelerate ARPU growth, and extend average subscriber lives by offering a higher quality service, 2) greatly improve customer service, 3) up-sell advanced/incremental video services, 4) free up spectrum capacity in the pipe to offer much faster minimum data speeds than most competing broadband services which should allow them to continue growing their broadband share and 5) offer attractive triple-play (and future quad-play) bundles with superior value propositions to existing Telco fiber/copper and direct-to-home Satellite offerings. These initiatives should, along with a management team and board laser focussed on shareholder returns, greatly improve TWC’s fixed asset utilization across their network and accelerate growth in the key EBITDA per homes passed metric.

The bottom line is that Time Warner Cable is a very attractive cable asset with a highly clustered set of systems across America and has reasonable Telco fiber competitive overlap within its existing footprint. The company is managed by a mediocre executive team and had a passive shareholder base focused on near-term shareholder returns over aggressively growing long-term equity value. I believe the market has yet to price in the upside of a growing TWC business.

Altice’s surprise entry into the US cable industry provided TWC with an extra bargaining chip and likely forced Charter to pay ~$15 per share more with less advantageous terms than otherwise. Originally I was expecting a purchase price per share closer to $175 – $185. I feel like the Charter idea was almost a no-brainer prior to Altice’s entry. Mr. Drahi likely ruined the dream bull case scenario for Charter longs now that he will be fiercely competing to buy US cable assets, and consequently inflate industry trading multiples. Aside from the potential minor anti-trust concerns, my previous long-term outlook on Charter was that it would have likely rolled-up the balance of the US cable industry accretively and eventually match or even exceed Comcast’s size. Despite this, I believe Charter remains a very attractive idea and I don’t believe Dr. Malone and Mr. Rutledge would have pursued this deal if they didn’t think it was accretive to Charter. This is also likely Dr. Malone’s final opportunity to come full circle in his career to build a powerhouse cable company in the US where he was a pioneer.

Interestingly enough, the Bright House portion of the deal is the exact same one that that was agreed upon contingent on the consummation of the failed TWC/Comcast/Charter transactions. In my view, the Brighthouse portion of the deal is another example of brilliant financial engineering by Dr. Malone in order to shore up Charter’s balance sheet to make a large cash consideration for TWC. The total consideration is $10.4B comprised of $2B in cash, $5.9B in common stock and $2.5B in preferred stock units that will have a 40% conversion premium to New Charter’s stock price. I think it goes without saying that by preferring to receive such a large portion of the consideration in New Charter equity, the Newhouse family are quite bullish on Charter’s future prospects. And I think they should be. The Newhouse family are long-time successful US cable entrepreneurs and industry veterans and have invested alongside Dr. Malone in the past, partnering in deals such as investing in Discovery Communications when it was nearly bankrupt. I find it interesting that the “smartest money” in the business are all betting big on the US cable industry; three very successful cable entrepreneurs and investors (Malone, Drahi, the Newhouse family) with some of the best value creation track records in the industry are bullish and directly putting their money where their mouth is. Great investors typically see what the market is largely missing several years down the road and bet big when the odds are heavily stacked in their favour.

From Charter’s most recent 14A, Charter’s largest shareholders are some of the greatest value investors and capital allocators of the 20^th century.

 

Capitalization:

On the leverage front Charter management stated in the merger deck that they plan to deleverage to the “lower end of their target leverage range” of between 4.0x – 4.5x post transaction. Given that Dr. Malone is the de facto strategic capital allocator/investor behind Charter, I highly doubt that they’re going to deleverage anywhere close to 4.0x, especially if rates stay this low. My bet and part of my thesis is that they’re going to maintain a continuously levered capital structure around 4.5x over my projection period and aggressively shrink the equity. And I don’t see why this leverage ratio is not unreasonable for New Charter. Liberty Global and Altice are similar cable roll-up growth equities with similar risk profiles and are typically levered closer to 5.0 and frequently go above this level. I target a comfortable EBITDA/Interest coverage ratio above 3.5x for New Charter which should provide ample EBITDA cushion.

I think when we have a great proven operator in place that is disciplined in allocating capital and a business which is essentially a non-cyclical, lightly regulated monopoly/duopoly that sells an essential service and generates very predictable utility-like cash flows, a high leverage ratio is appropriate. This is compounded by my view that New Charter’s EBITDA will likely grow in the high single-digit range, supporting an aggressive but appropriately leveraged equity shrink playbook.

Management also confirmed that Charter and TWC should be able to retain their separate lending silos and TWC will likely retain their investment grade rating post-deal closure. I conservatively assume that total transaction debt will be issued at a blended 5.85% rate, and will of course be mostly long-dated, fixed with a staggered maturity profile in separate non-recourse holdcos. Based on precedent high-yield bond and cable debt offerings with similar equity growth profiles (Altice, DirecTV, Charter, Liberty Global etc) along with the current attractive credit market environment, I think the inability to secure adequate financing will be quite low. On future rates, my assumption is that they will likely increase slowly over time and I model the cost of debt creeping up 50 bps higher per annum. If the yield curve flattens on the back of a rising Feds funds rate the long end of the curve should remain attractive for burrowers such as Charter. I also think that there’s a possibility that we may be living in a zero interest rate environment for the next 5-10 years or potentially even longer. There is very little visibility in this future probability distribution curve and the range of possible future outcomes can potentially be very wide.

 

New Charter Pro-Forma Model:

The numbers above are for my base case and assumes the deal is accretive on a FCF per share basis by nearly 20% in year 1. How I prefer to model is to reverse engineer the projections necessary to arrive at my target return profile, and then assess if these projections are reasonable. Originally I was projecting around $30 per share in fully-taxed free cash flow for Charter by 2019/2020 under the failed Comcast/TWC/Charter proposed transactions. I think that under my base case New Charter should be able to comfortably achieve this same number by 2019 under the new transaction.

 

Key Drivers:

Aside from the operating cost synergy upside and aggressive deployment of capital into further M&A and share buybacks, I think a key driver of New Charter’s stock will be whether Rutledge and his team can accelerate TWC’s revenue growth. Most of the Street appears to modelling quite steep video sub declines for both Charter and TWC past 2015. I think continued video sub declines are likely but my decline rates are much softer than most analysts. Given the inherent sizable operating leverage in this business, I believe a return to video revenue growth or at the very least measured, small declines in net video subscribers is likely required for this thesis to play out. The good news is that I believe future cord-cutting is a measurable risk, and in the severe downside scenario of accelerated cord-cutting and shaving, I believe there are 3 major mitigants:

• For consumers that choose to consume their content purely over-the-top instead of part of a traditional cable TV bundle, high-speed broadband has become a ubiquitous service. To the extent that additional OTT competition continues to enter the video streaming market and disrupts the traditional bundle, cable has the ultimate hedge by owning the critical last-mile infrastructure or pipe that efficiently transports high-speed data (HSD) and video services to the customer; cable operators can easily price discriminate with a tiered pricing strategy as higher-speeds and capacity are demanded to stream content online. Cable’s dominant HSD service will only become more valuable over time as data speeds and bandwidth capacity demands continue to grow exponentially. In essence, I view the cable business as a collection of lightly regulated local toll-booths on inevitable, growing data consumption.

• Due to high programming cost pressures over the past decade and promotional pricing strategies in an increasingly competitive video marketplace, Charter’s video business gross margins have been squeezed to around 35% today, and is quickly becoming a loss leader within the cable triple-play bundle. So the net effect of any further declines in video subscriber losses will increasingly become negligible over the next several years. Charter’s Spectrum package currently offers an attractive triple-play bundle at an entry-level promotional price-point of ~$90 that ramps up over 1-2 years. Since pro-forma programming costs per sub per month are projected to be in the mid-$40’s range in 2016 for New Charter, Charter is already selling the video service at near break-even levels. At this point in the video business’ product life cycle, I believe it is more of an “add-on” service for potential cord-cutters, and is used by cable operators to help preserve the customer relationship by enticing consumers to pay around $10-$20 more per month for a competitive triple-play bundle. As long as the entire customer relationship (selling either a data, video, or telephony service) is not lost the hit to an operator’s gross profits and cash flows will not be as severe as standalone broadband services can be priced higher as opposed to within a bundle. For subscribers that purchase pricier pay-TV packages which include more premium content, I believe these customers are typically an older demographic, wealthier, and consequently less likely to “cut the cord”.

• For the growing 12 million or so US homes that will never subscribe to a traditional cable bundle, I see no reason why cable operators or any MVPD for that matter can’t offer their own competitive over-the-top skinny TV bundle to chase this market to help offset the shrinking video business. Despite having roughly 14 million Pay-TV subscribers, DISH has already launched a direct-to-customer online streaming product called Sling which is likely a 10% net margin business at a $20 per month price-point. There is certainly risk of increased cannibalization of their traditional TV revenue streams but I believe these packages are designed, priced and marketed squarely to broadband-only homes. Given the shifting economics of content distribution from the distributor to the cable networks and producers within the traditional Pay-TV ecosystem, I believe ultimately the cable networks that monetize their content through wholesale channels have more to lose than the distributors if more customers elect to replace traditional bundles with skinny ones.

Stepping back from these strong mitigants in a crash case scenario, my view on cord-cutting hasn’t really changed over the years. I think 1) A basic Pay-TV package still provides a great and unparalleled value proposition for consumers looking for basic entertainment, especially considering the fact that Americans on average watch 4-5 hours of television per day 2) US cable networks remain unwilling to aggressively license their “must have” and most valuable content outside the lucrative Pay-TV bundle as they are not willing to cannibalize their existing revenue streams over the short-term, 3) Due to inertia cord-cutting is likely to be a slow, and measured decline as it has been, 4) Operators are now more focussed on improving customer service, 5) Operators are stepping it up on the technology front by offering sleek next generation cloud-based user interfaces[1] that they previously never did, 6) Growth in OTT services such as Netflix have far exceeded the growth in broadband-only homes; Netflix has around 40 million US subscribers which is around 3.5x as many broadband-only homes, indicating that an OTT streaming service is still a complementary service, not a complete substitute, for many consumers. 6) US household formation is ticking up and could potentially provide an additional tailwind for Pay-TV subscription growth, blah, blah, blah… The cord-cutting trend is real but is blown out of proportion by the media.

So the video business is likely a melting ice cube in secular decline, but an upside driver to this thesis is for New Charter to regain lost market share, mainly from the direct-to-home satellite distributors that were able to undercut cable operators in video pricing and were competing against a largely inferior analog cable product throughout the past 2 decades.[2] With the video product becoming increasingly commoditized across all MVPDs with little differentiation now that cable operators are upgrading to an all-digital network, with the right execution, I am confident that cable can regain lost video share. I am particularly confident in Rutledge and his team’s ability to up-sell and cross-sell incremental and advanced video and broadband services at high incremental margins to TWC’s subscriber base, drive up TWC’s existing low ~33% triple-play penetration and ARPU and add more value and better customer service to the customer relationship which should ultimately reduce churn. And Rutledge’s team already have a proven track record of doing just that.

Rutledge left New York-based Cablevision which currently leads the cable industry in EBITDA per homes passing at ~$450 and penetration rates and took the helm at Charter in late 2011. Since then 1) Charter’s video sub base has stabilized as they have nearly stopped bleeding video subs and can potentially start growing positive net subs again over the next several years, 2) Charter’s EBITDA per homes passing has started growing steadily again since the turnaround that began in 2012; it has grown by ~15% since then. Further industry-wide evidence that support the view of an improving cable video business include TWC’s recently reported quarterly numbers showing ~3% yoy net video sub losses; a decent improvement over heavy losses in 2013. Unfortunately, the cable and telco operators don’t disclose their churn and subscriber acquisition costs (SAC) metrics like the DBS operators do – which is really a shame for the purposes of our analysis of a subscription-based revenue model. However, my bet is that New Charter’s greater scale should drive lower churn and SAC as CPE and network-related hardware costs decline over time. Most importantly, Mr. Rutledge has nearly 35 years of industry experience, with a proven track record as COO of Cablevision from 2004 – 2011, and a strong familiarity with TWC’s systems as former president of TWC. So I think if there’s anyone that’s best suited for this job, it’s undoubtedly him.

“During his tenure at Cablevision, Mr. Rutledge met Mr. Malone, a larger-than-life figure who was one of the industry’s pioneers. Mr. Malone tried to recruit Mr. Rutledge to run DirecTV, the satellite operator he controlled at the time.

Mr. Rutledge was not interested, but agreed to meet Mr. Malone for a dinner at the University Club in New York.

“I thought the idea of sitting in a room and telling him why I didn’t want to go to DirecTV would be fascinating,” Mr. Rutledge said. “He is a frictionless thinker. By the end of the conversation, we were talking about how great cable is.”

–The New York Times

At the time, DirecTV was Dr. Malone’s largest personal holding, and he was likely looking for a great operator to replace Chase Carey. One final comment on Rutledge is that I like the fact he’s a very long-term oriented operator who sees the need for cable operators to sacrifice near-term profitability in order to maximize shareholder value longer-term. He has done this by adhering to a proven operating model by investing heavily in the fixed network infrastructure and customer service capabilities necessary to better compete long-term.

 

The Future: High Speed Data

I am modelling high-single digit residential broadband revenue growth on the back of 1) Increasing broadband penetration from a 40% pro-forma footprint penetration today, to closer to 50%-60% 5 – 7 years from now, and 2) Mid-single digit growth in data ARPU, driven by a mix-shift towards higher speed tiers and modest inflationary pricing increases. Broadband sells for near 100% incremental EBITDA margins excluding subscriber acquisition costs and is a much more attractive business than video as there are no programming expenses. The commercial business also continues to take market share from ILECs and this business is growing top-line at a mid-to-high teens rates, driven by all 3 service lines.

In terms of the outlook for future broadband internet penetration rates, there are a few references. Cablevision is already at an industry-leading 55% penetration in its New York-centred footprint despite competing against Verizon’s superior fiber-to-the-home (FTTH) FioS product which overlaps nearly 70% of its footprint. Yes, New York is a wealthier demographic, but the competition is also fierce. Comcast is currently at around 40% penetration despite having around 55% – 60% telco-based fiber overlap. Another comparable is Telenet which is a Belgium-based cable operator that currently has broadband penetration rates above 55% and has fiber overlap from Belgacom across the majority of its footprint. Other European peers operating in developed countries such as Virgin Media, Ziggo, Numericable Group, Kabel Deutschland and the Scandinavian cable-based operators are still steadily increasing their broadband penetration. Right now I estimate that New Charter has around 38% – 40% fiber-based overlap with U-verse and to a smaller extent FioS which is relatively low compared to its other large, US-based peers.

So I see no reason why over that over the long-term penetration levels will not reach my target.

On pricing, the Federal Communications Commission (FCC) actively monitors broadband and video pricing and it would probably not be wise for cable operators to abuse their market power in “uncompetitive markets”. The big bet here is on data demand growth. Some of us may have read the Cisco reports that forecast rapidly growing data-usage demand (~30%-40% compounded annually) over the next 5 years or so. Personally growing up being enamoured as part the “digital age”, this is one of those few secular trends where I have a very high conviction. It’s not like data services are new – we all remember the crappy dial-up services in the “old days” – the application of the technology just hasn’t accelerated until the recent explosion of bandwidth-intensive applications. With the proliferation of multiple devices outside and within the home, and the increasing amount of time spent on applications on these devices, (an increasing number of two-way interactive, customer-facing applications such as Facebook/Instagram/Snapchat/Tinder/WhatsApp, and streaming HD quality shows/movies) demand for these services will likely grow exponentially from here.

In terms of broadband competition, in a scale business the key question is really who can meet the growing demand for data the most cost effectively. The simple answer is that only cable with its fiber-to-the-node HFC[3] network can. Cable’s current DOCSIS 3.0 technology is capable of providing downstream speeds of up to 1 gbps. The technology roadmap to higher speeds is also clear. DOCSIS 3.1 is already being field tested by Cox Communications and Comcast in select markets and this technology will be able to offer downstream speeds of up to 10 gbps. Most importantly, the incremental cost of capital per home for upgrading to DOCSIS 3.1 is attractive at only $70-$75 or less. Right now only about a third of Comcast’s current HSD customers purchase a broadband service above 25 Mbps – the threshold that was arbitrary defined by the FCC as “high-speed broadband”. But as speed demands increase it will be clearer that cable has a natural monopoly on speeds above this level across parts of their footprint.

The main reason why cable has such a huge competitive advantage today is that operators have already invested the tens of billions of dollars in building out their massive fixed network infrastructure[4] in the 90’s and early 2000’s; these major infrastructure costs have been laid out in old dollars and never have to get replaced. I estimate that both Charter and TWC currently earn a mid-20’s pre-tax return on net tangible capital, and future incremental returns on capital should continue to improve as HSD profits increasingly become a larger piece of company-wide profits. It will likely be another 15 – 20 years before cable operators have to even consider overbuilding a FTTH product to maintain their competitive advantage. Until then cable should continue to take the large majority of incremental new broadband subs – especially from regional incumbent local exchange carriers (ILEC) that offer an inferior DSL service.

Partly due to regulatory uncertainty, the major telcos have basically stopped their fiber roll-outs. AT&T has upgraded parts of its legacy DSL-based twisted pair copper wire network to offer a VDSL product by overbuilding fiber optic cable to the node. Through vectoring and bonding the last-mile copper-to-the-home they can only boost max headline download speeds of up to 100 – 250 mbps depending on the length of the local loop. Verizon’s FTTH FioS service and Google Fiber are the only available products right now that can match and exceed cable’s downstream speeds, but building a FTTH network is extremely capital-intensive[5] and for now the economics only make sense for the highest-density population cities.

Due to the laws of physics, data over wireless spectrum can’t be transported as efficiently over the air than within a pipe, and the price of licensed spectrum is soaring due to shortages across major wireless operators. Right now wireless data demand is far outstripping available spectrum capacity and there is an increasing need to use WiFi offload as a solution. In order to provide seamless mobile-fixed connectivity to customers, convergence has been a hot topic lately in the cable world. The cable WiFi consortium in the US already has over 300K WiFi hotspots deployed across the country using unlicensed spectrum. There is an additional growth avenue by leasing additional wireless network capacity from AT&T and/or Verizon and as a mobile virtual network operator (MVNO) bundle an out-of-home WiFi service. Quad-play bundles typically further reduce churn and improve subscriber economics.

 

Synergy Upside:             

Management have provided a very conservative guidance of $800 million in run-rate cost synergies. I think precedent cable M&A deals where scale efficiencies were sizable and obvious such as Liberty Global/Virgin Media and Liberty Global/Ziggo have demonstrated the massive potential upside in conservative synergy estimates. In both these cases, the actual synergies actually doubled the initial estimates.

New Charter Synergy Assumptions:

• Assuming no revenue synergies.
• Programming synergies
  • I estimate ~$775 million in total run-rate programming cost synergies based on a pro-forma affiliate rate card slightly lower than TWC’s 2016 projected monthly rate of $46.60; I conservatively project that these run-rate synergies will be gradually layered into years 1 to 3 by 25%, 50%, and 75%, respectively, as expired affiliate fee agreements are renegotiated over the next several years. It won’t be until 2019 that New Charter will capture the full run-rate programming cost synergies.

Programming cost synergy estimate

• OpEx synergies (excl. programming costs)
  • I assume 3.5% of the pro-forma cost base or ~$636 million in full run-rate operating cost synergies by 2018, again gradually layering this into years 1- 3. Most of these cost savings should come from higher efficiencies in local economies of scale in marketing, advertising, and customer service, etc. As you can see on this map below there will definitely be incremental benefits of servicing subscribers in a continuous footprint for New Charter where the 3 companies merging currently overlap (in markets such as Texas, California, etc). The clustering effect of systems will help the new company easily achieve greater economies of scale in local markets.

New Charter’s footprint

• CapEx Synergies and Projected Capital Spending:
  • The low hanging fruit here is definitely the increased bargaining power in the procurement of customer premise equipment and other network-related hardware with a larger subscriber base. In Europe, Altice and Liberty Global’s capital spending plans for upgrading their network to DOCSIS 3.1 have cost them ~50-60 Euros per subscriber relationship. If we conservatively assume New Charter spends $75 per sub upgrading the balance of TWC and Bright House’s network to digital[6] (~8-10 million subs I estimate), they will likely spend around $600 – $750 million over 2-3 years for this capex cycle. Remember, this is mostly success-based capex spending where incremental revenues per sub are received for every upgraded home/business, and churn will likely be reduced as well. Upgraded subs are more likely to purchase bundled and advanced/premium services; even if we assume a $5 per month per sub revenue uplift, the payback period for this capex project is less than 1.5 years
  • TWC has already begun a 3-year investment cycle upgrading its systems that was initiated in 2014 (the following year after the company suffered a disastrous year with nearly 7% net video subscriber losses), rolling out its Maxx service to select high population density markets. Charter will accelerate this roll-out, along with digitalizing Bright House’s systems and brand the combined company’s service under Charter Spectrum, offering minimum data speeds of 60 mbps, hundreds of HD channels and advanced video services, at-home WiFi, an improved cloud-based user interface, digital DOCSIS 3.0 enabled modems and improved customer service. By year 3 I expect the majority of the network upgrades to be completed, and capital intensity will decline rapidly from there. Charter has already completed upgrading its network to all-digital and on a standalone basis their capital intensity is set to decline. There should also be some capex savings from the increased clustering of systems and less truck rolls from an improved TWC customer service.

• Tax synergies: Very easily realizable. There will be a higher intangible asset base that can be amortized from purchase accounting. On the higher tax basis, I project the company will start paying full cash taxes in 2018 as Charter’s NOL runs out and assume no further M&A.

Integration and execution risk are likely not considerable here due to nature of the assets and the business (human capital is not the most critical resource and company cultural factors are not as important), and given Rutledge’s past track record in integrating cable systems successfully. Overall, I project New Charter can potentially achieve ~$1.4B in full run-rate synergies out of the pro-forma operating cost base by 2019, or 75% higher than management’s initial estimates. TWC should be run much more efficiently under Rutledge and his team.

 

EBITDA or “Operating Cash Flow” margins and growth, leveraged share buybacks and accelerating free cash flow per share growth

Core Charter is already growing revenue and EBITDA at high-single to low-double digits driven by its operational turnaround. New Charter’s EBITDA and EBITDA per passing should be growing at similar high-single digits. I’m targeting nearly $19B of EBITDA at a 38.5% margin and roughly $375 of EBITDA per passing by 2019. Pro-forma EBITDA per passing is around $270 for 2015, which is still considerably below the industry average. My operating model implies that Charter should be able to partially close the gap with its peers; EBITDA per passing should grow to around $370 by 2019, which would still be a nearly 20% discount to Cablevison today.  For reference, Comcast’s cable division generated ~$330 of EBITDA per home passed and ~41% EBITDA margins in FY2014. Despite being larger, Comcast has a much more balkanized footprint largely due to past inorganic growth and a higher % fiber overlap across its footprint than New Charter.

I differ from the Street on the key operating model projections on a longer-term basis (I believe operational gearing, EBITDA and FCF margins will kick in on the backend of my projection period and by 2019/2020 should converge closer to Comcast’s current levels).

 

Levered Equity Shrink:

I also differ from the Street on New Charter’s capital allocation policy. After reading over at least a dozen of the analyst reports that were released related to the merger, almost none of them (except for one who I won’t mention) modelled future share repurchases. Some of the bulge-bracket investment bank research analysts such as Citi, Goldman and Morgan Stanley have ceased their coverage of Charter and TWC since they are advising on the merger. Still, I find it very typical that after studying the Street’s under-appreciation of potential future buybacks in previous similar situations, most analysts are just assuming that New Charter will use the bulk of its FCF to de-lever the balance sheet. Do we really think that management will just de-lever substantially if tax-sheltered FCFs are growing at mid-20’s percent?

“I used to say in the cable industry that if your interest rate was lower than your growth rate, your present value is infinite. That’s why the cable industry created so many rich guys. It was the combination of tax-sheltered cash-flow growth that was, in effect, growing faster than the interest rate under which you could borrow money. If you do any arithmetic at all, the present value calculation tends toward infinity under that thesis.” – Dr. Malone

It is always difficult trying to predict Malone’s end game strategy, and it’s near impossible trying to stay one step ahead. But one thing I’ve learned from closely studying his opportunistic investment style and past major holdings is that he really likes obscurity and complexity in his deals and investments. This typically leads to mis-pricing, but savvy management eventually unlocks substantial value with hidden catalysts that the market doesn’t anticipate. So my bet is that as long as Charter’s free cash flows are steadily growing, management will aggressively buy back the stock at a 4.5x leverage ratio. Also, if more of TWC’s shareholders decide to receive more Charter stock and less cash, then New Charter should be able to start buying back stock within the first year; I assume that half of them do under my base case and Charter will de-lever by 0.2x in year 1. By 2019 New Charter can potentially retire around 35% of its pro-forma float if management maintains a continuously levered capital structure and uses all available FCF to buy back shares.

 

Additional M&A Optionality:

Like what Altice’s CEO Dexter Goei has said, everything below Comcast is effectively in consolidation mode right now. I think if the current Charter/TWC/BH deal is approved by regulators as contemplated it will already be a great result for all shareholders, but any additional acquisitions of smaller cable systems is free upside to my thesis. Despite Altice’s intention to grow their US-based revenues, I think it is very likely that New Charter will aggressively compete for smaller cable systems post-merger. In judging the attractiveness of a potential M&A target, I believe the two most important factors to take into account are the competitive fiber overlap and high-speed data penetration. Obviously the smaller both of these are the better. Other considerations include any continuous system overlap in a hypothetical pro-forma company, potential triple-play penetration upside and the percentage of systems that have been upgraded to digital. Suddenlink is an example of a very attractive rural-based operator with a ~12% fiber overlap and a 37% HSD penetration that Altice recently acquired a 70% stake of.

There are a couple of future potential attractive M&A targets:

Mediacom is an incumbent rural cable operator with ~900K basic video subs, an estimated 38% HSD penetration and an attractive ~12% Fiber-to-the-node (FTTN) overbuild within its footprint. Mediacom was taken private by its founder Rocco Commisso a few years ago but he is now 65 and may be looking to cash out soon in the current wave of cable consolidation.

Cable One is an incumbent rural cable system with about 680K total customer relationships and 500K data subs with a total 25% VDSL overlap and 1% FioS overlap in its footprint. This stub will likely get spun out of Graham Holdings Corp. (formerly the Washington Post) over the next 45 – 60 days. On my numbers, I think Cable One is likely worth around $2.8 – $3.0 billion or 9x – 10x 2015 EBITDA / ~$4,000 per customer relationship to a strategic acquirer. Given their lack of scale, Cable One has been shedding basic video subs at 15% – 20% run-rates due to management’s decision to delay upgrading their analog systems. Out of all potential cable M&A targets, I think this asset likely has the highest probability of being rolled-up into a larger player. I place a 95%+ probability that Cable One will get bought out by either Altice or New Charter. Since Charter/TWC will be waiting for the current proposed deal to be approved by regulators, I think it is more likely that Altice will make a bid for Cable One when it gets spun out in the next little while. Altice is basically a well-run, publicly-traded portfolio of globally diversified cable assets run by a management team with private equity-like targeted returns.

Two family controlled and larger operators that are more of a wild card are Cox Communications and Cablevision. Cox is a privately-held operator with a little over 4.1 million basic video subs and a very attractive rural-based footprint. Cox was taken private several years ago and I believe the company is very well run, but it doesn’t appear like the Cox family are in a hurry to cash out. Cablevision is controlled by the Dolan family and its footprint is mainly in the highly competitive New York area market. CEO James Dolan basically put up the company for sale at the Television and Internet Expo 2015. Despite the Dolan’s openness to a sale, I believe they will not be the first in line to get acquired given that the more attractive assets mentioned above will likely get rolled-up first.

Other potential smaller targets include WideOpenWest (WOW) holdings which has ~900K customer relationships and RCN. The common theme among these smaller systems is that they’ve all likely been bleeding basic video subs, typically in the 10%-15% range yoy. As programming costs continue to escalate and these smaller operators delay upgrading their systems, becoming part of a larger company with additional scale benefits remains the end game.

 

Valuation Summary:

New Charter Base Case: Assuming a $210 YE Charter share price

Malone recently said at the Liberty annual meeting that he is targeting high-teens to low-20’s annually compounded equity returns for Charter. I believe this is a very conservative projection but it is my downside case nonetheless assuming the deal closes.

Unlike the majority of media investors, I do not value cable firms on an EV / EBITDA multiple. I think this metric is relevant for evaluating potential M&A targets but aside from that this metric is misleading because 1) Not all debt is created equal, 2) Future capital intensity should be taken into account, and 3) Cash taxes have to be taken into account to adjust for potential large tax assets such as NOLs.

“It’s not about earnings, it’s about wealth creation and levered cash-flow growth. Tell them you don’t care about earnings.” – Dr. Malone

I think a levered FCF per share multiple is the most relevant metric, and this is another differentiated view I have from the Street that likes to value cable operators on an EV / EBITDA basis. Assuming we back out the present value of Charter’s NOL at $24 per share, currently standalone Charter trades for around 15x 2016 fully-taxed FCF per share. Assuming no further M&A, and all incremental FCF generated will be used to repurchase shares at reasonable multiples, New Charter can potentially earn above $30 per share in fully-taxed FCF ex-growth capex by 2019. I am conservatively assuming a post-merger, pro-forma multiple re-rating to 18x FCF per share or 3 turns higher over a 4-year period, potentially providing compounded annual returns of 35%. On these numbers, Charter shares can potentially be worth $507 – $634 by 2019, providing a huge margin of safety today. I think this is a very reasonable exit multiple given the predictability and non-cyclicality of Charter’s cash flows, future returns on capital, and its growth profile.

Pro-Forma Charter Communications 4-year Target Return Profile:

Unlevered FCF Valuation:  

Target multiples on an unlevered basis:

On an unlevered basis we are within the same valuation ballpark assuming we apply similar multiple valuation ranges.

On a side note, I know there are some who consider themselves value investors who would typically avoid investing in any company with a lot of debt. Well, to them I say this: To a man with a hammer, everything looks like a nail, 2) There’s something very powerful called the levered cash-on-cash return on equity model.

In my view, it is quite dangerous to always act within a confined set of hard rules or to be forever chained towards one type of thinking. The best way to negate this inherent bias is to relentlessly seek the truth. Elon Musk who I highly admire often talks about this principal. I think the truth behind appropriately levered equities is that they can potentially yield higher risk-adjusted rates of return than otherwise. Any leveraged equity will always face the probability of an impairment of capital for the equity holders. For a largely subscription-based, recurring revenue business model that sells a basic essential service to an extremely diversified customer base I just think the probability here is very, very low.

 

Nightmare Case: The Deal Breaks and Charter Standalone Valuation

I place a 10% probability that the deal will get blocked by regulators and no additional M&A event materializes.

Standalone Charter should be earning around $10 of FCF per share by 2016. Assigning a 16x – 20x FCF per share valuation range and adding the present value of its NOL should yield a 1-year target intrinsic value range of $181 – $220 per share. However, there is also the $2 billion break-up fee to consider should the deal break. This would subtract about $20 per share to our valuation so our max downside could be anywhere from $160-$200 per share.

 

 

The Setup:

At the core, this is an event-driven / merger-arbitrage type idea, so I think there are a few ways to play the thesis.

• Long TWC @ $176. Capture full deal spread assuming deal closes and roll TWC stock into New Charter to play long-term growth equity thesis. If deal breaks TWC stock will likely fall over the short-term, however, Altice will be waiting just around the corner. I think the probability that TWC remains an independent company regardless of whether the deal breaks or not is very slim. In the absolute worst-case scenario that no other bid materializes, TWC’s core business has shown early signs of improvement and my bet is that this operating momentum will continue.

• Long Charter @ $170. Charter’s FCF growth is already at an inflection point so if the deal gets blocked the max downside should be minimal as I highlighted above.

• Long both TWC and Charter. Both shares will collapse into New Charter at deal close and subsequently long-term growth equity thesis will take hold. I liked TWC @ around the mid $150’s as I placed a very high probability of a Charter bid materializing at around $175 – $185. Like most situations I like, having a longer-term time horizon is a huge edge here.

• Merger Arbitrage Trade: Long TWC @ $176, Short 0.475 Charter shares @ $170 to lock in deal spread, receive $115 of cash per TWC share at deal closing. Trade duration: 6 – 9 months.

 

Catalysts / Event-Path: Next 12 – 36 months

• Deal expected to close by year end or Q1 of 2016.

• Post-merger re-rating with Street and investors focussed on pro-forma growth numbers and stabilizing TWC video business.

• Post-deal closure synergy estimate revision upside by management and adjusted EBITDA margins and FCF ramp-up; Charter’s standalone free cash flow growth is already at an inflection point.

• De-leveraging post deal close to target leverage ratio and announcement of massive share buybacks by year 2.

• Additional accretive M&A of smaller systems (Cable One, Mediacom, WOW, RCN, etc) and/or system swaps with Comcast, Cox, or Cablevision to drive greater system clustering efficiencies.

• TWC’s video business begins to stabilize and standalone revenue accelerates throughout the rest of 2015 driven by the roll-out of its Maxx service.

• Easing of market concerns over potential increased broadband pricing regulation post-deal.

 

Risks to Thesis:

Key man risk – Dr. Malone. There is always key man risk when investing behind one of Malone’s holdings, and this is just the reality of betting behind any superstar capital allocator. Based on reading his biography Cable Cowboy, Malone ate “a lot” of steak and drank a lot of whisky with Bob Magness and the TCI team when he was president of TCI. I don’t know what his health habits are now but he looks pretty healthy to me. And for some reason, I have a sense that media moguls live pretty long lives. The legendary cable cowboy is now 74, and certainly appears at the top of his game being actively involved in many large, ongoing complex deals. If he is near the end of his career he will likely be going out in a “bang”, and I don’t mind going along for the ride.

 

Regulatory risk – As part of their net neutrality/open internet goals, the FCC has recently reclassified broadband from an “Information Service” to a “Telecommunications Service” under Title II regulation of the Telecommunications Act. Title II has raised investors’ concerns about potential increased future regulations on ISPs such as cable/broadband operators like Charter/TWC. If you want more background on the net neutrality debate, I highly recommend the Master Switch by Timothy Wu.

If the FCC just wanted to prevent ISPs from blocking, throttling or allowing paid prioritization of internet traffic, reclassifying broadband to Title II seems quite overkill in my view. Due to forbearance on pricing and forced last-mile unbundling, the medium-term implications on the economics of the cable business are negligible (maybe there will be some increased legal fees), but the real concern is that longer-term, as cable’s market dominance at higher broadband speeds in uncompetitive markets becomes more evident, regulators may impose pricing controls on broadband. I do think that this is the single biggest risk to the thesis. Given the unpredictable actions of regulators at times, it is more difficult to come up with a range of likely possible future outcomes within a defined timeline.

I believe in what appears to be a move framed to protect internet users from the potential abuses of ISPs will ironically cost internet users more over the long-run. Think of an ISP’s broadband pipe as a highway with data from various internet companies such as Netflix, Google and Amazon being transported along the highway to the end user. The open internet/net neutrality principles were designed so that ISPs can’t further monetize parts of their pipe, or sell a “fast lane” to an interested party like Netflix, for example, that wants priority traffic, or alternatively block or throttle a lane when traffic becomes congested during peak hours/usage. What this means is that the FCC has basically decided that internet consumers will basically foot the bill for their higher broadband usage instead of the content/internet companies.

Another irony of Title II is that is has created a more uncertain regulatory environment for ISPs looking to potentially invest in or expand their networks, which is the exact opposite of what the FCC would like to see in the broadband market – increased competition. Title II is most akin to utility-style regulation that has been used for services such as fixed voice networks, electricity and water providers. Due to pricing regulations, companies operating within these industries have barely invested the capital necessary to maintain or upgrade their infrastructure given the regulated returns on capital. That’s why we see deteriorating landlines and poor service quality across these services in America today. But broadband services are much more dynamic. As speed and capacity demands continue to increase, ISPs have to continue upgrading their networks to service the market.

Regarding competition and market power, like most local newspapers in many rural towns and lower tier cities in America today, the business of providing broadband service remains a natural monopoly. The scale requirements to connect every home in a local market provides the incumbent with a substantial entry barrier, and being first to market is a major advantage. It is difficult for any private operator to justify overbuilding a fully upgraded fiber-optic cable network in a poorer, low population density area with an incumbent operator already present. I think as long as incumbent ISPs such as cable operators continue to upgrade their networks to provide faster speeds and more capacity for consumers at “reasonable” prices, they will less likely draw future additional regulatory scrutiny. In addition, as high-speed broadband becomes more ubiquitous over time, and as the economics of providing the service continue to improve, continued overbuilding by the telco competitors can potentially stem regulator’s concerns about competition. Obviously this is a very sensitive topic right now given what appears to be a more hostile regulatory environment. Thinking about this issue reminds me of a great quote from Peter Thiel: “Monopolies like to downplay their dominance to avoid getting regulated, and companies operating in perfect competition pretend to be doing something unique to stand out or raise capital.”

On pricing, the main issue with imposing any future pricing caps on high-speed brand services is that less active users would basically be subsidizing the service for heavy users. Nonetheless, the severity and form of any potential future pricing caps is very uncertain. It could range anywhere from pricing caps for providing speed tiers up to a certain level such 25 mbps in markets that are deemed uncompetitive (which is a type of regulation similar to how prices for basic video services are capped today in “uncompetitive markets”) to regulated returns on capital across the entire industry for all ISPs. I must admit that the probability distribution here is very wide.

One final thought on this is that regulations can change over time, and a new pro-business FCC can easily reverse bad regulation. After reading parts of the ~400 page FCC document / ruling on Title II, I must say that it reads like a crock of shit. A lot of the motivation behind Title II and the blocking of the TWC/Comcast merger seems very politically-driven given the President’s stance on this issue. I can’t help but think that the FCC arbitrary defined high-speed broadband as 25 mbps or above intentionally just to fuck over Comcast. As a reference, I think there are market models in other parts of the world such as the Netherlands that make a lot of sense where there is a single lightly regulated cable company (Ziggo / UPC Netherlands) providing very high-quality, high-speed broadband service across virtually all homes in the country at very reasonable prices.

 

Increasing broadband competition – Google Fiber expansion, subsidized local municipalities building fiber, and increased Telco fiber overbuilds. Google fiber is only available in a few US cities with plans to expand to a few additional tier 2 cities. This service is currently priced at only ~$70 per month for up to 1 Gigabytes per second. At this price-point it doesn’t appear like the project is earning its cost of capital given the huge initial capital outlay, the existing incumbent competition, and the markets targeted are not particularly attractive. Given that we have a controlled company with a management team that doesn’t prioritize return on capital and has interests not fully aligned with shareholders, it appears that Google Fiber remains just one of many of Google’s pet science projects.

AT&T may look to further expand their U-verse project to more cities after the merger with DirecTV closes. I believe any additional competition from future U-verse expansion plans would emerge slowly. Ironically, Title II and net neutrality goals have created a more uncertain business environment for both AT&T and Verizon in terms of investing in fixed infrastructure, and is one of the reasons why they’ve largely stopped expanding their fiber overbuilds. Aren’t regulators/anti-trust authorities suppose to help maintain/encourage a more competitive market environment instead of hindering one?

 

Deal risk – I place a 10% probability that the deal will get blocked by regulators. Another potential regulatory concern are concessions that will require asset divestitures. I think this deal has a higher likelihood of passing regulatory approval than the proposed Comcast/TWC merger mainly given that 1) New Charter will have a 30% market share of the FCC defined high-speed broadband market at 25 mbps or higher vs a pro-forma ~57% share for Comcast/TWC and 2) A combined TWC/Charter/Bright House will be a much smaller entity than a combined Comcast/TWC. I also think Charter’s capital plans to upgrade the balance of TWC and BH’s systems to provide higher capacity and 60 mbps minimum downstream speeds to customers and to insource call centre jobs from overseas will be looked upon favourably by regulators. Management and Malone said that they are very confident that the deal will withstand regulatory scrutiny and were willing to provide a $2 billion break-up fee. Most importantly, even in the unlikely event that the deal gets blocked by regulators, the max downside risk I’ve quantified in my standalone Charter valuation is very limited.

 

Blog Update:

There is a cheaper derivative play on Charter, and I think it is quite obvious what it is. Due to an emerging pattern of unusual and/or above average trading volumes on smaller ideas shortly after they have been posted on this blog, I am no longer posting ideas of smaller-cap or illiquid ideas. I’m certainly flattered by Mr. Market now that I’m starting to influence stock prices with an obscure value investing blog but I don’t think it’s worth it to risk looking like a stock pumper or promoter and potentially encourage a portion of my readers to engage in short-term speculation without doing their own proper due diligence. I know that there are many hedge funds and fund managers subscribed to this blog, and I think that it is quite obvious that some of these guys are very short-term oriented traders. As a long-term, concentrated value investor that likes to accumulate shares on weakness, I think it is wise to keep my best ideas a secret from now on, or post them somewhere else anonymously. Given that there are likely close to zero attractive US large caps right now that match my hurdle rate, it may be a very long time before I post anything attractive again.

 

Cable All over the World:

In general I’m bullish on the entire industry. Other cable names I like include Liberty Global, Altice, Televisa and Comcast.

I like event-driven ideas and I think a potential Global and Vodafone deal looks very interesting. The best outcome for Global shareholders would likely be that Global acquires Vodafone while Vodafone’s non-European/emerging markets segment are spun-out in a separate entity. This way Malone’s team would maintain control over the newly merged entity, maintain an aggressive leverage ratio of 5x and use the bulk of FCF and cheap debt to repurchase shares. Due to the considerable overlap of operations between Vodafone’s European segment and Global’s cable assets, especially in the UK, Holland and Germany, the synergies would be massive. From a high level, I think the FCF per share accretion from such a deal would be very impressive.

Comcast to me just looks undervalued right now and is a more conservative way to bet on the US cable industry.

Of course, I don’t think any of these names are likely cheaper than a potential Charter/TWC. Charter is not one of my top ideas anymore but if I had to compare and reverse engineer a past media investment, I would have to say that I like this idea more than DirecTV when it was @ $50 per share on a 10 p/e.

Does anyone else use Tinder by the way?

 

 

Some house cleaning:

Sold out of QVCA, AutoCanada, and AIG warrants. I think these are all still attractive ideas but on a longer-term time horizon not as good as my current holdings. I think Fiat-Chrysler Automotive looks attractive here, and an aggressive actavist investor might be able to force GM to seriously consider a merger with FCA. Idea tracker is now also updated.

“The great personal fortunes in the country weren’t built on a portfolio of fifty companies. They were built by someone who identified one wonderful business. With each investment you make, you should have the courage and conviction to place at least 10 per cent of your net worth in that stock” – Buffett

 

Appendix:

 

Media and Telecommunications Information Sources:

Books:

• Cable Cowboy: John Malone and the Rise of the Modern Cable Business
• The Master Switch: The Rise and Fall of Information Empires
• Rupert Murdoch: The Untold Story of the World’s Greatest Media Wizard
• A Curious Discovery: An Entrepreneur’s Story
• Call me Ted
• Netflixed: The Epic Battle for America’s Eyeballs
  
• Comcasted: How Ralph and Brian Roberts Took Over America’s TV, One Deal at a Time
• Blue Skies: A History of Cable Television
• Cutthroat: High Stakes & Killer Moves on the Electronic Frontier
  
• Captive Audience: The Telecom Industry and Monopoly Power in the New Gilded Age
• The Curse of the Mogul: What’s Wrong with the World’s Leading Media Companies
• The Billionaire Shell Game: How Cable Baron John Malone and Assorted Corporate Titans Created a Future Nobody Wanted

Industry Sources:

• Light Reading – http://www.lightreading.com/
• CableLabs – http://www.cablelabs.com/
• FCC – https://www.fcc.gov/
• NCTA – https://www.ncta.com/
• http://www.broadcastingcable.com/
• http://www.hollywoodreporter.com/business

[1] Comcast’s X1 platform appears pretty impressive

[2] Eg. In 2007, DBS video offerings of up to 100 channels were priced at $35 compared to Charter’s most comparable offering priced at $50, or a 30% discount

[3] Hybrid fiber-coaxial

[4] Building fiber optic cable to the node

[5] A FTTH build-out can cost several thousand dollars per home

[6] This capital spending will mostly consist of replacing some electronic equipment in the cable plants/headends, purchasing DOCSIS 3.0 enabled modems for digital services, and the labor installation/maintenance cost

Idea Tracker Update, Part 4: Interactive Brokers

I’ve slowed down the updates since it’s my favorite time of year in Toronto – when it gets warmer.

Interactive Brokers reported their q1 results today and I believe the brokerage business remains on track to generate just under $1B in pre-tax earnings power by 2016.

They say bulls make money, bears make money, and pigs get slaughtered.

I guess I’m a bull on Interactive Brokers…

IDEA TRACKER UPDATE, PART 3: LIBERTY INTERACTIVE

Liberty Interactive – Tracking Share Discount

In light of the stock price appreciation over the past few years, the original thesis hasn’t really changed. Maffei has said that despite the higher QVC trading multiples, leveraged share repurchases will continue. Now with the e-commerce businesses shifted to the Ventures Group, the QVC Group has become “much cleaner” to analyze. I believe the fact that this is still a relatively obscure tracking stock with hidden equity investments and irrelevant consolidated GAAP reported financials is the main reason behind the mis-pricing. Very few tracking shares exist in the market today, and due to the inherent complexity in managing additional business groups with their own stock currencies, many corporate management teams simply shy away from them. In fact there have only been a few opportunistic capital allocators that have really used them in the past including Dr. Malone and Charlie Ergen.

The main asset remains QVC. This was a business that was run by media mogul Barry Diller for a while, was owned in a joint-venture between the Robert’s and Malone’s Liberty Media until Malone acquired Comcast’s ~57% stake at quite a high transaction multiple. Like virtually almost all of Dr. Malone’s related companies, QVC is extremely well-managed. I also believe that if cord-cutting were to accelerate, the effect on QVC would be minimal. Unlike the cable networks’ lucrative affiliate and advertising fees that are at risk from unbundling and over-the-top, home shopping networks like QVC have a different model; they pay carriage fees (which I will go over in further detail below) to the Pay-TV operators that are net of gross sales. So even if their customers slowly transition to consuming their content online either through an existing bundle with “TV-Everywhere”, a skinny bundle or maybe even perhaps directly from QVC’s website, their revenue model will not be at risk. Essentially their model resembles more of a retailer than of a cable network, except they generate superior free cash flow compared to brick & motors. Finally, they have an attractive core customer base that are middle-aged women from wealthier households that are less likely to “cut the cord”.

QVC earned ~$960 million in levered free cash flow in 2014. They’ve been hit over the past few years by the weakness in the Yen from their Japanese business. I think this year they will earn ~$1,000 million in fcf, and afterwards this will grow at 5% per annum over the next 3 years, driven by 2%-2.5% top-line growth and a bit of operating and financial leverage. The business doesn’t have much operating leverage since most of the cost structure is captured in COGS, but the business is very predictable, has a favourable customer base with near 90% repeat purchases and operates in a virtual duopoly with HSN in the home shopping network category. I basically view this business as a steady long-term GDP+ grower.

On the capital allocation front, Maffei has said that he’s going to continue to shrink the equity. Backing out the other pieces of the QVC Group tracker, QVC’s implied fcf multiple is currently slightly less than 14x. Assuming the share price continues to appreciate, they should be able to buy back ~17% of the float over the next few years at a 2.5x leverage ratio. So their levered fcf per share growth should be a little over 10% per year over the next few years. On 2017 numbers QVC should be earning around $2.80 fcf per share. I would value QVC at 16x-18x this number or a 5.5%-6.25% yield; so the QVC piece alone is worth $45-$50 per share by 2017. For such a high-quality business with predictable growth across the entire cycle and really high returns on tangible capital, I think these multiples are justified. For reference, they’ve recently issued a 10-year note at slightly less than 4.5%. I think QVC’s equity will very likely grow at a faster rate than 4.5% over the next 7-10 years. Also, I think QVC is a better business than some of these comparable large-cap consumer staple stocks that trade at less than 5% earnings yields but generate a lower return on capital with similar or lower growth prospects. So I think a 16x-18x multiple is very reasonable for this business.

For HSN, it’s also a decent business and I think it’s slightly undervalued given their under-levered capital structure. It currently trades at roughly 9x this year’s EBITDA, and they have almost no net debt. Management recently distributed a $200 million special dividend and I think they should be on the cusp of a material capital return plan in the near future. On the more aggressive side, if they leverage up closer to QVC’s leverage ratio of 2.5x, they can easily return nearly $1B of cash to equity holders. If they choose to reduce the float, they can buy back up to nearly 30% of all shares outstanding at today’s market value. For our purposes I’ll conservatively value HSN at current market values, so at their 38% stake it’s roughly worth $3.50 in per share value.

I assume that the value of the Group’s Chinese JV will offset the minority interest from their 60% stake in QVC Japan. There are currently more than a dozen competitors in the China, and the Chinese JV hasn’t reached minimum efficient scale yet. These 2 pieces really don’t move the needle on valuation, and if the Chinese JV really takes off, that’s just additional free upside.

In terms of eventually combining HSN and QVC, Maffei has said that there won’t be much cost synergies from leveraging the combined production studios. The only large cost synergies that I can think of is increased scale from combining their distribution networks and bargaining power with logistics firms, and potentially reducing the carriage fees they pay to the multi-channel video programming distributors (MVPDs); basically guys like Comcast and DirecTV. Currently QVC pays 5% of their gross retail sales as a carriage fee to the local MVPDs that distribute their channels to their subscribers, and (I think) HSN pays this rate as well. If by combining the companies they can potentially negotiate a lower carriage, and take back some of that gross margin. Just this cost synergy alone can create quite a bit of value without any execution risk. The combined companies’ US businesses generated ~$9.6B in total revenues for 2014, so even a 100 bps of gross margin savings would equate to $96 million which will flow straight to pre-tax income and be ~10% accretive to fcf per share. But I think for now Maffei will be content if HSN continues to return excess capital to shareholders with share buybacks and dividends. Whatever they decide to do with their HSN stake, you can be rest assured that it will be done extremely tax-efficiently. Knowing Dr. Malone’s deep hatred for paying taxes, this is a given.

If we add up all the prices – HSN’s equity value based on today’s market price, and QVC’s value – Liberty Interactive is worth $48-$54 by 2017. At the mid-point of this valuation range, the stock should generate a 2-year IRR of 35% if you can buy the shares around $28. I’ve noticed that sometimes that the more illiquid B shares trade at a discount to the A shares, which they shouldn’t as these are the super-voting shares. So much for efficient markets.

IDEA TRACKER UPDATE, PART 2: SOFTBANK

Softbank – A great capital allocator and sum of the parts

The long thesis here is basically that Softbank is run by an excellent capital allocator and is trading at a deep discount to its sum-of-the-parts or break-up value. I largely agree, however I want to have greater clarity on how Mr. Son is going to unlock shareholder value over the near-term. Any eminent catalysts over the next 2-3 years would be great for closing the holdco discount gap and consequently increasing the IRR on this investment. But I also wouldn’t worry too much if the stock stays flat in a trading range for a little while. Given Son’s exceptional track record, (I believe Softbank has been able to compound intrinsic value per share at 20%+ since it went public) I think it’s a very high probability that Softbank will continue to compound intrinsic value per share at superior rate of return for a very long time. If we analyze all of Softbank’s major investments since inception, the compounded rate of return has been roughly in the mid 40’s%, driven largely by the investment in Alibaba; Son invested $20MM in Alibaba when the business will still being run out of Jack Ma’s apartment. Talk about a visionary. Even if we exclude Alibaba from the return figures, I believe his track record is still in the low 20’s%. I think how Son runs Softbank is actually quite similar to how Buffet grew Berkshire – intelligently investing all the cash flow from existing cash cow businesses into opportunistic, very long-term investments. I guess for Buffett it was more like investing the low-cost float received upfront from his insurance businesses. For Son his Japanese telecom business is basically the cash cow. I really like how Son is building Softbank’s ecosystem to prosper in the “mobile revolution”. He’s investing in the infrastructure (Sprint), the content via mobile games (Gungho, Supercell), and in the services (Alibaba).

Aside from the typical complex holdco discount, I believe that investors’ worries over the outlook for Sprint and the negative short-term sentiment for Alibaba is why Softbank’s shares are still trading at such a large discount to intrinsic value. But for the enterprising, opportunistic value investor that’s willing to dig through all the moving parts, I believe Softbank is quite cheap.

Domestic Telecom Business: The Japanese wireless industry is basically a 3-player market and although Softbank continues gain incremental market share, it remains third behind its competitors DOCOMO and KDDI. Apparently Son was able to convince Steve Jobs to give him exclusivity in bundling the original iPhone models with wireless plans when they were first released. Along with his foresight in betting on the iPhone, Softbank was able to undercut industry pricing by a large margin which led to huge market share gains. Some analysts were expecting Apple’s iPhone’s handset margins to come down as competitors would eventually catch up and pressure pricing in an increasingly commoditized product; if this were to occur then the telcos would be able to pass on some of these device cost savings to consumers. Despite the increasing competition, the iPhone product lifecycle doesn’t seem to be ending anytime soon and pricing hasn’t been pressured at all. I’m not sure if Apple’s ecosystem will allow them to earn above-average profits for the long-term but what I do know is that Softbank’s customers continue to buy lots of expensive iPhones among all the alternatives. So overall the business remains healthy today. They’re currently #1 in terms of networks speeds and they’ve recently completed a major CapEx upgrade cycle to 4G, so I expect their free cash flow to materially ramp-up over the next several years. Moreover, the industry players have each recently shown signs of ending aggressive promotional pricing, which should further support healthy long-term ARPU growth, or at the very least support stable pricing. I value their wireless business in-line with comps at 6x EBITDA.

Sprint: Sprint definitely has its problems. The US wireless industry remains an extremely competitive 4-player market as T-Mobile and Sprint continue to invest large amounts of capital on upgrading their networks and hurting the overall industry profitability with their deep pricing cuts. I’m not an expert on the US wireless industry so I don’t think I have a huge edge here. Some analysts even believe that Sprint’s equity could be worth $0. Fair enough. Let’s assume Sprint’s equity is worth 0. Worst case scenario, Softbank would inject a little bit more equity capital in a cash-hemorrhaging Sprint. Even under this scenario, my break-up analysis suggests that Softbank’s shares are still worth nearly 15,000 YEN 2 years from now. So whether or not Sprint is successful in reaching minimum efficient scale doesn’t make or break the thesis.

Alibaba: I believe Alibaba’s value is worth much more than the current market cap of Softbank today. I value this business at 25x 2017E EBITDA of $12B, or $300B. As they continue to scale their marketplaces, their operating margins should continue to ramp-up, along with an increasing incremental return on capital. With such a large fixed-cost base, I don’t see how their incremental margins on transaction growth won’t hold up despite the monetization concerns. I also think the fake product concern is short-term in nature. On top, they have a huge payments processing arm in AliPay, an infrastructure-as-a-service (IAAS) business that sells excess cloud capacity, and a logistics joint-venture; this is a monster of a business and likely one of the highest-quality in the world. These guys were basically a start-up that drove eBay’s business out of China. Their end market growth runway is huge, they’re in a net-cash position, and for a monopolistic, asset-light, toll-booth business on China’s growing e-commerce market, I think $120 per share is reasonable. Since Mr. Son is also the largest shareholder of Softbank, I doubt that he would want to incur a large tax hit should he decide to monetize the Alibaba stake with the huge tax basis. I assume, like Yahoo!, that their stake will eventually be spun-off in a tax-efficient transaction, so I apply no after-tax value. I also think the domestic regulatory or currency risk is quite limited. Longer-term I think as the market better appreciates Alibaba’s value it will be a driving force in lifting Softbank’s shares.

If Softbank shares can close 90% of the holdco discount in 2 years, the IRR on this investment will be ~38%. Like most other major non-US currencies, the Yen has been getting annihilated. In terms of structuring this position, I think I’m going to fully hedge out the Yen, and I might even short the proportional Sprint stub. Based on the proportional values of each piece, you can create your own stub if you like.

Idea Tracker Update, Part 1: EBAY

I’ve been looking for some garbage to short in this market. I think it’s been increasingly difficult to find attractive long opportunities in larger companies that meet my hurdle rate. The only real opportunities I see right now are special situations where the underlying company is undergoing some type of corporate event and coincidentally these are in industries I think I understand best. I don’t think the market is overly expensive nor cheap by the way. Over the next little while I’m going to post a mini marathon set of posts that will update some of the ideas recently mentioned on this blog.

First up is eBay.

 

eBay – Revisiting the spin-off thesis

The stock has done quite well over the short-term since Steven recommended it. I original liked the idea as well, but now that I have a much higher hurdle rate, it simply doesn’t meet my return requirements unless I structure a long position in combination with more leveraged instruments such as derivatives which I’m unwilling to do at these trading levels.

The original thesis was focussed on the pending spin-off of the PayPal unit from the Marketplaces unit which would unlock substantial shareholder value mainly through improved capital allocation, better corporate governance, operational focus, cost rationalization and in general just getting rid of a rather idiotic CEO. I think the CFO needs to go as well.

I think the opportunity still exists partly because of everyone’s frustrations with the mediocre operating performance and the subpar capital allocation.  But I also think investors are increasingly fixated on faster-growth opportunities in the general tech space. Ebay is sort of becoming a “dinosaur” compared to some of the more newly emerging, sexy, rapidly growing technology-based industries such as enterprise SaaS and social media. Moreover, from an event-driven angle there was also little guidance given from management (at the time of the spin-off announcement) for how each business would get capitalized, the complexity of where to allocate the corporate overhead, D&A, etc and the typical failure of most market participants in properly valuing 2 divergent earnings streams.

The thesis for the marketplaces segment is based primarily on financial engineering and returning capital to shareholders via leveraged share buybacks. I had modelled ~$4.1B in EBITDA for marketplaces by 2017, which is actually on the back of low single-digits top-line growth and ~300 bps in EBIT margin compression. I’m actually quite bearish relative to consensus on the long-term prospects of the marketplaces business given what I think is a few emerging structural challenges that this business will face in a changing e-commerce competitive landscape. I think the two large concerns I have is the slowing organic growth and the additional marketing and R&D spend that I think will need to be incurred in order to even sustain positive long-term revenue growth rates. The recent security failure might have also turned off a lot of users and damaged brand equity for the long-term; I know I would be pissed if my account and password got hacked. 1) In the recent full conference call, management projected 0%-5% fx neutral top line growth for marketplaces which I think is pretty ridiculous in light of the fact that US and global e-commerce is still growing at around high-single to low double-digits. This tells me that management have mismanaged the business to such an extent that they’re now losing massive market share. Given the international exposure, I think there’s even a possibility for reported revenue growth to go negative, especially if the US dollar continues to surge against major international markets. Given the operating leverage and rather concentrated US cost base of this segment, the downside won’t look pretty. For a typical dominant network, winner-take-all marketplaces business model that should be taking incremental market share this is just a very worrisome possibility. But honestly, after going over some of management’s bullish forecasts in previous analyst days (that have badly missed or have been revised down), 0%-5% could potentially be very realistic. On the margin side I think larger incremental spending will be required since this business increasingly looks outdated (doesn’t seem to be attracting millennials) and irrelevant.

So I feel like there’s quite a bit of execution risk going forward to revitalize this business and better compete against Amazon. I think going forward the only real value proposition for this platform will be for existing “power sellers” that have a long merchant track record and have less of an incentive to move their business. The major business lesson here: Despite having a business with superior economics on the surface: an asset-light, cash-generative toll-booth business (with ~40% operating margins) vs. Amazon’s fulfilment model (with ~1% operating margins), a dominant network effect doesn’t automatically off-set an inferior service. In Tony Hsieh’s book, Delivering Happiness, he talks about the great lengths Zappos went to continually improve their customer service even if it sacrificed near-term profitability; this included things like free shipping for customers, free returns, and an exceptionally trained, passionate customer service team. Zappos was eventually acquired by Amazon and I feel like even in this new information age economy, the level of customer service remains a critical factor to the success of these e-commerce service platforms.

I assume the new marketplaces management will increase the pace of buybacks and leverage up to 2.5x net debt to EBITDA by 2017. Working from EBITDA to FCF per share, I modeled out nearly $2B in fully-capex’d FCF by 2017. If marketplace can raise debt over the next 3 years at an average after-tax cost of 3.5%-4%, leverage up to 2.5x by 2017, and assuming they pay full repatriation taxes on existing foreign cash, I think they can repurchase ~22% of the total current float over the next 3 years. They should be over a comfortable interest coverage ratio of over 5x as well. Originally I expected closer to 30% of the float to be repurchased but since they’ve announced that they’re capitalizing PayPal with $5B in cash, I think this is less likely. Given the number of large actavist funds in this name (Jana, Third Point, Glenview, Icahn), and the leveraged share buybacks that have already taken place over the past year (~$4.6B in share buybacks) I’m rather confident that they will shrink the equity accretively in this low rate environment – I just don’t know to what degree (2.5x is what I’m assuming or 4x that some have suggested). For a still rather high-margin, cash generative business with a network effect moat, (although structurally challenged I believe) I value marketplaces at a range of multiples of 14x-16x (or a ~6%-7% fcf yield) my estimate for $2 per share by 2017. On these numbers, marketplaces is basically worth $28-$32 per share 3 years from now. Unlike most of the Street that values marketplaces on an EBITDA multiple, I believe we have to take into account a more efficient capital structure that involves leveraged share buybacks.

However, if top-line growth rates dip to negative territory and FCF growth decelerates even faster, the entire leveraged buyback thesis falls apart. On the upside case, it’s very possible that Alibaba will eventually acquire eBay and fix its problems. I think Jack Ma has real ambitions to expand outside of China. I would just assign a 0 value on the GSI segment (which is now getting sold) since it’s immaterial and was a horrible acquisition. On a side note, Donahoe has repeatedly said that it was a great acquisition – I wonder why the sudden change of heart?

 

For the PayPal unit, here’s an excerpt from my last letter to my investors:

“… Although we acknowledge that Apple Pay can potentially become a major contender in the payments industry, we remain skeptical of a wide spread merchant and consumer adoption of Near Field Communication (NFC) technologies, along with the issues of convenience and security being adequately addressed. Apple Pay is currently only in ~220,000 merchants in the US, which is ~2% of the total addressable market. Furthermore, we believe that their competitive focus will remain in the offline, mobile Point-of-Sales (PoS) space which is currently a miniscule part of PayPal’s existing business. In fact many market players, including PayPal, have failed to gain much market traction in the mobile offline payments industry over the past several years. This is partly due to the high barriers of entry including scale and security requirements, but more challengingly the need to get the different parties with differing economic incentives in the payments ecosystem including customers, merchants, financial regulators, banks, and the payment networks to facilitate wider spread adoption of PoS mobile payments.  If Apple Pay can indeed generate considerable traction and wider spread adoption of PoS mobile payments[1], we actually believe that this will ironically be a net positive for an independent PayPal; it can it open up a large offline payments opportunity as a free option, currently not being priced into shares, in our view. As per the unit economics, Apple Pay currently takes $0.15 for an average $100 PoS transaction versus PayPal’s ~$1 – a stark differential. Although PayPal may have to sacrifice some existing unit economics in order to create substantial value in PoS mobile payments, we believe given PayPal’s strong brand equity and franchise value, PayPal can eventually generate sufficient scale to participate in this opportunity.

 

PayPal’s ~$216 billion in Total Payments Volume (TPV) is currently ~20% of the $1 trillion online commerce total volume – second to only AliPay – and only ~2% of $10 trillion in the total commerce opportunity. The online eCommerce market is a long-term secular growth market and should continue to grow faster than brick-and-mortar TPV. We believe that post-spin, independent PayPal will have ample strategic options to aggressively pursue the total eCommerce opportunity – both online and offline. PayPal can position itself as either platform agnostic like it has for the most part historically, or it could potentially form strategic partnerships with either Apple, Google, Facebook, Samsung or even Amazon, among other large market players once it is separate from core eBay. We believe there was likely internal conflict and misaligned incentives between past PayPal executives and the C-suite, leading to poor strategic decisions for PayPal’s positioning in the marketplace. An independent PayPal will likely become a more nimble, focussed, disruptive “Silicon Valley-like” entity, with future business performance properly aligned between management and employees. The bottom line is that we believe spinning-off PayPal is the right strategic decision and will better position PayPal to tackle a rapidly changing global payments competitive landscape.”

 

In sum, I think an independent PayPal makes a lot of sense. In order to attract some of the brightest talent needed in Silicon Valley today, I think an independent stock currency is required for stock-based compensation. Base Case: PayPal earns nearly $3B in operating income by 2017. I assume a bit of margin compression (~200 bps) if they go after the offline payments opportunity and continue to deploy large amounts of R&D spending. So net-net the lower incremental margins from the offline opportunity should outweigh their existing scale benefits. I also think there’s a bit of risk from PayPal’s projected ~20% top-line growth rate – if we assume eBay’s top-line is slowing down to LSD-MSD, then by default PayPal’s related transactions on the eBay platform (around one third of PayPal’s business) should be slowing down dramatically as well.

On a 25x-30x net operating profit after-tax (NOPAT) multiple, PayPal is basically worth $50-$60 per share 3 years from now, or nearly double eBay’s value. I’m not quite sure what management plans to do with the $6.3B in incremental fcf that they’ll generate over the interim years so I very conservatively assume that it just builds up on their balance sheet. There’s definitely a bit of upside if the actavists push new PayPal management for better capital allocation as well. PayPal will be capitalized with no debt and $5B in cash to help fund the credit part of their business but I think realistically they’ll just need half of that amount. PayPal’s $9B in excess cash by 2017 will be basically worth ~$7.5 per share.

So let’s add all the pieces up to arrive at intrinsic value: 1) eBay marketplaces: $28-$32, 2) PayPal: $50-$60, 3) PayPal’s excess cash: $7.5, and 4) a 9x multiple on corporate overhead’s negative after-tax income: ($13.5). If we add it all up the stock is worth $72 – $86 by 2017. If we take the mid-point of the intrinsic value range and if the post-spin catalysts materialize as expected, the stock should generate a near 18% 2-year IRR under my base case from today’s $57 price tag. Unfortunately this is way below my hurdle rate, so I’m officially closing this position for the blog. How I’m going to play this situation out is to observe the stock up to the spin-off event and see if I can get more clarity on post-spin capital allocation and if there’s any post-spin forced selling. I’m not long now, but at least I’ve done the necessary work should Mr. Market present an opportunity. I’m also much more interested in the PayPal piece. For bigger funds that have a lower hurdle rate, the opportunity might be worth it if you’re confident that capital will be adequately allocated in both pieces and if you think marketplaces isn’t in a long-term structural decline.

One last note on management that I want to get out of my system. These guys (management) are honestly amateurs when it comes to capital allocation and corporate governance. If I were to grade them alongside the management teams that run my portfolio companies on a relative scale from 1-10, these guys would be sitting on a negative digit. I have absolutely zero confidence in existing management to execute on what is necessary to build long-term shareholder value. I recall reading a transcript with the CFO basically saying in like a proud way that the ~$15B of cash that they’re holding on their balance sheet is generating a lot of interest income. Well, no shit. If you give me $15B I can sit on my ass and buy long-term US treasuries too! These guys seriously need to go. The high executive turnover, constant flip-flopping on major strategic issues and operational missteps is suffice evidence. Next time don’t hire a management consultant to run a once leading, global technology company.

[1] NFC only works on the newest iPhone 6 models, which is ~70 million users as of the end of 2014; Apple has large existing installed base of ~500 million iPhones