Category Archives: 2020

Q1’2020 Investment Commentary: Building a Bridge to Normal

Dear Client,

We hope you all are staying safe and well through these challenging times. COVID-19 is something personal and scary for us all. Our team and most of our clients live in the tri-state area, our nation’s most frightening hot spot. We have clients on the front lines, heroically fighting this virus in the emergency rooms of the region. Irrespective of geography every one of us likely lost or knows someone who lost a loved one to COVID-19 already. These are sad, hard times, but we as a family, a group, a country, a society, and a world will get through this. Crises have a way of bringing people together, even if we must temporarily stay apart. While there are emerging rifts over whether the economy should open up, or lockdowns should remain in place, this is truly one of those rare moments in history where every human on Earth is in a unified battle against a singular and common enemy. Such situations bring out the best in people and while a quicker healthcare policy response would have helped lessen the blow, the economic policy response has been powerful and swift evidence of the communal spirit in action.

It seems like once a decade, significant events of global consequence occur that immediately change the contour and trajectory of history. COVID-19 is this decade’s 9/11. From 2020 onward, the world will look very different than it has in the recent past. Some things will not change, much change will occur from acceleration of events already underway and some change will be more temporal in nature. Eventually, this epoch will be a major chapter in history books and the conclusions remain undrawn today.

March was an exceptionally volatile month. Two of the ten largest percentage losses in the history of the Dow Jones Industrial Average and one of the ten largest gains occurred in the month.[1] One day on each side of the ledger narrowly missed cracking the top ten. The VIX hit levels unseen since the Great Financial Crisis (GFC), registering its highest close ever along the way.[2] In our March letter, we expressed our belief that a “return to normalcy will be swift.” We have revisited and quickly backtracked from that assumption, though we do believe the right policy measures are in place to mitigate worst case economic scenarios.

At the time, we took comfort in how China, South Korea and Taiwan showed the world a playbook to react and adapt to a world threated by COVID-19. While our leadership was starting to grasp the magnitude of the situation, by and large, the reaction was far slower than we hoped for. New York City was especially slow to react, taking an extra five days after our letter to announce school closures. This has proven to be a costly mistake and consequently, New York City has since emerged as one of the globe’s most vulnerable hot spots. With the extent of community spread in the US, the idea of a quick one-month lockdown with ramped testing facilitating a “test and trace” reopening thereafter was entirely precluded. Not only will reopening take a long time, but “normal” from here on after will be incredibly different than what we knew before.

Building a bridge to “normal”:

Markets reacted swiftly to the harsh realities of prolonged lockdowns in the US. Businesses are simply not built to withstand zero revenues for short, let alone prolonged periods of time. Since our March letter, we became especially concerned about the potential ripple effects in commercial real estate. Consider landlords who rents space to retailers and restaurants, all of which were forced to close as “non-essential businesses.” The retailers and restaurants earning $0 revenue have no money to pay rent. Landlords meanwhile still have overhead including property taxes and mortgages of their own (leverage is beyond merely common; it is the natural state in commercial real estate). Landlords thus have little cash flow to cover mortgage payments. The lenders behind these mortgages are either banks or shadow banks, each of which deploy leverage. Lenders who cannot pay now leave the banks behind the mortgages without cash flow. Effectively, the entire edifice of running a business in a property owned by a landlord with a loan from a bank looks like a Ponzi scheme when the cash stops flowing, with a cascading pyramid of obligations that snowballs as you climb the ladder. How does the system work and get through to the other side? There are three important constituencies and their respective responses we must consider.

First, there is a human element. Were the landlord to evict the restaurant or store who cannot pay right now, there is no chance they can fill that space anytime soon. For the landlord’s lender, were they to foreclose on the landlord, there is little chance they could sell the property for a reasonable price and recoup their costs in doing so. This is a non-zero-sum situation and a prisoner’s dilemma with real consequences. Effectively, everyone in the system has incentive to work out a solution with one another in order to survive these tough times. In speaking with people and businesses involved in all layers of this situation, we have seen strong evidence that the players are all attempting to forge mutually beneficial postponements and, in some cases, outright reductions in future obligations. The willingness to work together and build a bridge to normalcy is extremely optimistic and helpful and we are presenting this story because it is specifically relevant and in a general way sets the backdrop for the extent of the support the Federal Reserve Bank and the government stimulus are providing for the economy.

Second, the moves from the Federal Reserve Bank came with unprecedented speed and scale. The Fed started by digging into its Great Financial Crisis toolkit: cutting rates to zero, recommencing quantitative easing and buying commercial paper to support money markets. Next, the Fed went even further with support for municipal debt markets, a program to lend to banks standing behind the government’s Paycheck Protection Program loan program (PPP) and a special bond buying program aimed at easing corporate credit through direct purchases of corporate debt. The sum total of these Fed measures will inject over $6 trillion into the financial system.[3]

Third, is the government stimulus program. Society is undergoing the ultimate stress test-no company was built to survive a prolonged period of $0 in revenue. For many, especially small businesses, there is no way to have built a balance sheet to weather this kind of storm. In effect, society has an obligation to pay people and businesses not to operate and not to work, because everyone is better off with that. The CARES Act is being called a $2.2 trillion stimulus package, though some aspects of the disbursed expenditures likely overstate the total cost.[4] Following 9/11, our country underwrote two wars at what is in hindsight estimated to be a $6.4 trillion total cost.[5] In war, price tags are perceived differently than in economic crises; however, we think the response to COVID-19 should be treated as a massive war-like effort. This simple reframing of the debate from stimulus to a war-like effort will stop people from wondering “how do we afford this?” today and focusing on actually building the bridge. We can worry about paying for it all once we are on the other side. Right now, we need mobilization of healthcare and productive capacity geared towards this situation in rapid fashion, much like we would in war, alongside massive economic support to counteract job loss and business closures.

The $2 trillion CARES Act is a well-designed starting point in waging the economic battle against cCOVID-19. The unemployment insurance offered by the act is well designed and well targeted towards, though likely needs to be extended farther into the future. The PPP is well thought out; however, at $349 billion, it is proving to be far too small given the scale of the problems small businesses are dealing with.

One important factor that must be addressed is how much better capitalized our banking system is in today compared to 2008. U.S. banks in aggregate boast strong balance sheets, high liquidity, and are in a position to lend into the crisis instead of retrenching. The inability of banks to lend in 2008 is what amplified the magnitude of the GFC. Stated another way, bank behavior was procyclical in the GFC, while here it has the potential to be countercyclical and help build that bridge for the economy to the other side of the virus.

One of the more interesting wrinkles on the economic policy side emerged when some Europeans who had formerly been resistant to the idea of a Eurobond spoke in ways that opened the door to its possibility.[6] This would be a powerful step forward in John Monnet’s vision for a “United States of Europe.” Much in the spirit of Monnet’s architecture, crises spearhead further cohesion and unification. We certainly do not view Eurobonds as an inevitability; however, the softening of former stances is how something formerly impossible becomes possible. Crisis has a way of bringing people closer together and building the bridge to normalcy requires a greater degree of cooperation and sacrifice from everyone in every community around the world.

What the other side of the bridge looks like (it’s not normal):

COVID-19 will kick off one of the most profound reshaping of our world any of us will see in our lifetime. We have spoken with people young and old who already grasp that this is the most significant global event many of us have ever and possibly will ever experience. Below we address ten big changes that we expect to see. There are common threads to many on this list, though each line is unique. Some of the changes we are contemplating are different than the obvious ones, though others are likely things that have crossed your mind in the past month.

  1. A greater societal focus on hygiene and cleanliness—with those most vulnerable dealt the harshest COVID-19 outcomes, people will do more to be less “vulnerable” in the health sense. Behavior changes that are forged over weeks and months tend to persist. Restaurants and other service establishments will be expected to maintain a higher level of cleanliness. New jobs will be created and industries that have been relatively consistent but lacking in growth will need to scale capacities in order to supply the needs of these new, cleaner industries. We also expect some kind of national sick leave program which changes the incentive for hourly workers in particular, who in the recent past would work when sick in order to make ends meet, but now owe it to society to stay home.
  2. A move from cities to the burbs—dense, highly urban cities like New York are especially tough to be in right now. The per capita infection rate is higher than in non-city environments and the challenges of locking down in a small apartment, accessible only by elevator, with limited outdoors space are especially daunting. The appeal of a single-family residence with green space will grow for many young urbanites.
  3. Everyone who can afford to will want to own a car—remember just a few months ago when popular Silicon Valley lore believed everyone would ditch their car for Uber? That story is ancient history. As people move out of cities into the suburbs, they will need cars. Car sales in China, particularly Wuhan, are recovering quicker than anyone expected as people are reluctant to take mass transit and the government, dealers and OEMs are handing out incentives to sell more cars.[7]
  4. Experiential spending > things—this trend will gain speed once a new normalcy emerges as people will be craving doing what could not be done in lockdown. Some elements of experiential living, like going to concerts, will be on pause for the foreseeable future; however, other elements, like experiencing the great outdoors will likely accelerate quickly. Outdoors are largely free (aside for the equipment we need to experience them) and are a natural formal of social distancing.
  5. All content viewing will start in an OS. Without sports, the demise of the linear bundle will accelerate, and ad budgets will shift even quicker to digital channels. Alongside this reality, we expect AVOD to continue its emergence as a way to view and monetize content. This is already becoming evident just one month into the widespread lockdowns.[8]
  6. Buy online, pick up in store—PayPal had been trying to stoke this trend for years, to no avail. Now it is being offered across the retail landscape from groceries, to electronics to microbreweries and beyond. The experience is great for consumers and simple. This will require new kinds of employment and a rethinking of some parking lot space, but once behaviors are shaped, there is no going back.
  7. Contactless payments—this is a cousin of buy online, pick up in store and boasts its own broad ramifications. Cash itself is a means through which the virus can spread, as is the handoff of a credit card for a swipe. The infrastructure for contactless has been in place for a little time, though a catalyst for change had been lacking.
  8. Infusing technology into more of our lives—virtual education, work from home tools and telemedicine have been seeing slow-rolling adoption in recent years that has now accelerated beyond the point of no return.
  9. Biotech—for much of the past decade, biotech has been a popular political punching bag with both parties scoring points complaining about the high price of some modern drugs. With society having this great need for a vaccine, biotech will likely reemerge as a revered industry.
  10. Leaders stepping aside—from the first days of the lockdowns, our email alerts were flooded with board members and c-suiters stepping aside to “spend time with family” or something like it. We think this could accelerate the passing of the torch from the Boomer to Millennial generation in corporations around the world.

What will not change?

  • Travel will go on and come back. After 9/11 it was flying itself that was perceived as unsafe, today flying itself is safer than ever on multiple fronts. Flying will come back in stages. Some will resume limited travel once we get to a looser phase of social distancing. Once we have a vaccine, we think desire to travel will re-accelerate to pre-COVID levels.
  • Events will eventually resume to much fanfare. We expect a return of sports sometime soon with fanless competition, but longer-term, people still crave the communal nature of big live events from sports to music to industry tradeshows. When these events resume will be on the virus’ schedule, not our own; however, they WILL resume.
  • Work from home will not be widely embraced. While those who can work from home are doing so right now and initial reports suggest there is no productivity loss associated with doing so, the long-term desirability of such arrangements will lose some of its luster over time.[9] We do think there will be more flexible work from home time in the jobs that can afford it; however, people need personal contact, the capacity to take non-verbal social cues and make group communications far more productive than they can be on Zoom, and the boundaries that a home vs office divide offer psychologically. In a work from home world, the reality of David Foster Wallace’s “videography” would evolve far too quickly: “…it turned out that consumers’ instinctively skewed self-perception, plus vanity-related stress, meant that they began preferring and then outright demanding videophone masks that were really quite a lot better-looking than they themselves were in person.”[10]
  • Kids will still go to school. Education is simply better in person, especially for little kids. Socialization is extremely important in development and kids rely on leadership from teachers alongside social cues from their peers to hone in on their work and eventually unwind when it is time to play.

As for markets:

Right now, it is obvious that there will be hard economic times ahead. For opportunity, you must be willing and able to look out several years and you cannot anchor to 2019, nor can you anchor to where things are today. We expect high dispersion from here, with some large winners and losers emerging.  The obvious losers from COVID-19 are already down considerably in the stock market, consequently, some of the biggest losers from here will be companies where the impact of covid-19 related shutdowns is non-obvious. Far too many people are assuming all kinds of software are safe. One way we will see the risks to these non-obvious companies emerge is a growing divide between revenue and receivables. These companies might still be billing their customers, but their customers will be increasingly unable or unwilling to pay.

When the Fed cut rates back to zero, we sold all our financial stock positions. While we are generally sanguine on the sector and its ability to withstand the crisis, the earnings outlook will be under pressure from the dual forces of rising defaults and low net interest margins. We reallocated some of the sale proceeds to new positions and left the rest in cash. With our expectation for high dispersion over the next few months, we think it is prudent to carry extra cash in order to have dry powder to deploy into some of the inevitable hiccups along the path towards normalization and ultimately recovery.

We stress-tested every single portfolio company we own for their ability to withstand a prolonged period of lockdowns, social-distancing thereafter and a slumping economy. Resilience is of the utmost importance today. Beyond testing for resilience, we are keenly focused on earnings power both during this bridge period and after. You will also notice that as you look through your portfolios, the companies are positioned to benefit from the areas that we do and do not see changing. Companies with the right combination of resilience and earnings power will emerge from this period much stronger than when it began. In fact, this might be one epoch in time where the strong get stronger at a faster rate than ever before. This has consequences and inevitably there will be backlash, but it also portends great opportunity in the investing world.

The Dragon in the Medical Exam Room

Early in the first quarter, we made a new investment in Nuance Communications. Nuance provides conversational artificial intelligence to healthcare (two thirds of revenue) and enterprise end markets. Within healthcare, in addition to owning a functional monopoly in radiology documentation with PowerScribe, the company has a strong suite of products powering the digitization of the industry. Nuance is best known for its Dragon medical dictation product, used by 55% of doctors in the United States.[11] They are currently transitioning Dragon medical dictation into a high margin, recurring revenue, cloud-based product called Dragon Medical One. Dragon Medical One grew revenue 54% last quarter, showing clear progress in the transformation.

Beyond Dragon Medical One, Nuance is developing a more disruptive product to evolve and enhance the dictation industry—Dragon Ambient eXperience (commonly referred to as “ACI”), built in partnership with Microsoft.[12] ACI “uses ambient sensing technology to securely listen to clinician-patient encounter conversations while offering workflow and knowledge automation to complement the Electronic Health Record (“EHR”)”.[13] ACI is compatible with all major EHR and telehealth platforms, but has an especially promising relationship with Epic Health Services. Epic, who boasts 80% market share amongst the largest hospital networks in the US and has partnered with Nuance to bundle ACI as an add-on to all its EHR customers. This has effectively unburdened Nuance of distribution to a huge installed base. Based on conversations with industry experts, ACI is revolutionary, possesses capabilities far beyond competing software, and is expected to have high levels of physician demand. These sources validate Nuance’s estimated serviceable addressable market for ACI of at least $6.6 billion in the United States.[14] For context, this is over four times larger than FY 2019 sales for the entire company (excluding discontinued operations).

The world has drastically changed since we initiated our position in Nuance early in the first quarter. Despite COVID-19, the company affirmed that it had “not experienced any significant changes in our business” as a result of the environment.[15] Nuance is well positioned to continue avoiding significant negative impacts as it provides mission critical software to busy healthcare professionals and Fortune 100 enterprises. Although cCOVID-19 could delay uptake of Nuance’s products by new customers, it could accelerate the adoption of ACI by existing ones when physicians and hospitals get past peak resource utilization from COVID-19. Accelerated uptake of ACI would fuel faster revenue growth and a better margin profile for Nuance and most importantly, for clients, ACI helps solve two major problems exacerbated by this present crisis: physician burnout and large patient backlogs.  The COVID-19 crisis has undoubtedly increased physician burnout. ACI measurably decreases the time physicians spend on documentation, while improving patient throughput. In beta mode, a major orthopedic clinic reported “their providers were not only happier and more focused, they were also able to see 24% more patients and brought in an additional $1.35 million in revenue during one quarter”.[16] Helping clinics meaningfully grow revenue is another positive side effect from ACI.

Mark Benjamin has demonstrated strong strategic vision and execution since he joined the company as CEO in April 2018, and we expect that to continue with the ACI rollout. Strong execution will be critical for realizing the full potential of ACI. In his first two years, Benjamin has revitalized the culture by simplifying the company’s business and strategy around a few core verticals. He improved the capital structure while aggressively repurchasing shares and investing in research and development. He divested and spun off non-core business.  Benjamin has built a reputation for providing conservative projections, best evidenced by the 2019 Investor Day guidance through 2023 which ignores all potential ACI revenue streams. Nuance currently trades at a 5% FCF yield and a 30% discount to a DCF based on Benjamin’s guidance. It is not unreasonable to argue investors are getting potential upside from ACI for free at current prices.

[1] https://en.wikipedia.org/wiki/List_of_largest_daily_changes_in_the_Dow_Jones_Industrial_Average

[2] https://www.cnbc.com/2020/03/16/wall-streets-fear-gauge-hits-highest-level-ever.html

[3] https://www.cnbc.com/2020/04/13/coronavirus-update-here-is-everything-the-fed-has-done-to-save-the-economy.html

[4] https://thehill.com/policy/finance/economy/493218-cbo-projects-cares-act-will-cost-176-trillion-not-22-trillion

[5] https://www.cnbc.com/2019/11/20/us-spent-6point4-trillion-on-middle-east-wars-since-2001-study.html

[6] https://www.ft.com/content/8da39299-b257-4e8f-9b83-a84a8930f1c1

[7] https://www.japantimes.co.jp/news/2020/04/09/business/car-boom-wuhan-lockdown-recovery/#.Xp2wXshKiUk

[8] https://adage.com/article/video/rokus-scott-rosenberg-breaks-down-covid-19-viewership-trends-ad-age-remotely/2251446

[9] https://www.brookings.edu/blog/up-front/2020/04/06/telecommuting-will-likely-continue-long-after-the-pandemic/

[10] Foster Wallace, David. Infinite Jest. New York, Back Bay Books, 1996, page 148.

[11] Nuance Communications Inc at Leerink Global Healthcare Conference

[12] https://news.microsoft.com/2019/10/17/nuance-and-microsoft-partner-to-transform-the-doctor-patient-experience/

[13] https://www.nuance.com/healthcare/ambient-clinical-intelligence.html

[14] Nuance Communications Inc 2019 Investor Day Presentation

[15] Nuance Communications Inc Form 8K dated March 20, 2020

[16] https://www.healthcareitnews.com/news/epic-debut-ambient-voice-technology-assistant-himss20

March 2020 Investor Letter

March 12, 2020

Dear Client,

Many prognosticators call a 20% drawdown from peak to trough in markets a bear market. The week that started March 9, 2020, exactly 11 years to the day from the Great Recession’s bottom now officially marks the end of the bull market that began on that day and the start of a bear market. One fundamental reality of investing is that all bull markets eventually end. Unfortunately, a second truth holds that “markets go up on an escalator and down on an elevator.” This 20% decline has been especially swift. According to Michael Batnick at Ritholtz Wealth Management, this is “the fastest bear market ever.”[1]

Bear markets are an inescapable element of investing. Bear markets are the cost of owning assets that over the long run return considerably more than inflation. Stated another way, the equity risk premium (the excess return in equities) exists because there are these moments in time where everything looks terrible and the pain of owning assets makes everyone question why they own anything in the first place. Typically, since World War II, stocks have entered bear market territory (a 20% drawdown from peak to trough) once every six years. We have gone 11 years without an official bear market though we experienced periods in 2011, 2015-16 and December of 2018 with the market retreating by 19% only to find support and not cross the bearish 20% threshold.  What’s the fundamental difference between those downturns and today? Very little aside for the swiftness and extra pain on paper.

One thing that has been especially tough to manage through all this is that before coronavirus set in, the market was making highs and companies that we follow were reporting meaningful accelerations in their business from the prior reporting period. The economy was on the brink of re-acceleration, right as the external shock hit. This is no ordinary shock like an earthquake or a hurricane where the pain is acute and the path to recovery hard but obvious. Instead, we have an uncertain amount of time until the acute phase is over. Leadership in this country has been slow to act and the window to set us up for the quicker path to recovery is rapidly closing. As we see it, if the leaders were to order all schools and gatherings closed and ended for the next month, we would be on our way to normal much quicker than if we let this virus get out of control. The market knows this and is expressing its concern at the lack of a steady hand delivering meaningful action to set us on the less damaging path.

China and South Korea have shown the world that aggressive testing and social-isolation provably work to stem the coronavirus’ tide. It looks increasingly likely that this novel coronavirus will be endemic around the world from here on out, though there are considerable benefits to slowing its aggressive tide. If we can “flatten the curve” and decrease the case load at any one time, we can help our healthcare system avoid becoming overburdened like Italy. [2]

According to noted Harvard epidemiologist Marc Lipsitch, once 60 percent of adults become infected, “the spread can stop permanently.”[3] There are two paths to getting to that permanent stop: the quick way or the slow way. The quick way would have the virus spreading like wildfire and overburdening our health system with considerable damage along the way. In contrast, the slow way would involve self-isolation and about one to two months of really tough medicine for society to swallow in order to drive a more manageable case load for hospitals to treat patients who are more vulnerable to coronavirus. In the fast path, far more people will die, as is happening in Italy. In the slow path, far fewer people will die and we can get back to normal life much quicker.

Once the worst dangers of the virus are past (and it will happen one way or another), the return to normalcy  will be swift. We own shares in companies that will certainly be impacted in a meaningful way. Disney, for example, will experience a steep drop in park visitors—they will likely have to shut their US parks as they did in China. With the suspension of the NBA season and other leagues likely to follow, Kambi will have fewer events on which to offer their services to their sports book customers. Revenues will certainly be hurt in the near-term. If you fast forward two years however, there is no path dependency on future revenues tied to today. In other words, today’s hit will not change the actual earnings power of the respective businesses two years forward. People will eventually return to Disney’s parks and Disney Plus might even stand to benefit with people in self-isolation signing up sooner than they otherwise might have. For Kambi, in two years, more states in the US will have legalized and regulated sports gaming. Sports games will go on and people will indulge in sports gaming, which is an entertaining accompaniment to the games themselves.

When we build a discounted cash flow analysis for any of the businesses we watch or invest in, one year itself is worth no more than 4% of the total value of a company. In other words, were we to write one year of a company’s life to zero, as people are expecting right now, the overall hit to long-term value is much smaller than the amount of pain the market is pricing in today. That does not mean things cannot get worse before they get better; however, it does mean that when the environment returns to one in which people value the earnings power of a business, the recovery will be swift. Importantly, every company we own has the balance sheet to withstand a prolonged period of business contraction. All of these companies have little debt relative to their debt capacity, considerable actual cash liquidity, in addition to credit line access.

We place great emphasis on the management teams behind which we invest. In tough times, great management teams step up to create value in unforeseen ways. A company like IAC, who has remained highly liquid, will have incredible opportunities to deploy their large cash stash and add value that could not be modeled in a mere two weeks ago. ANGI Homeservices (which is majority owned by IAC) just this week authorized a repurchase equal to 25% of its public float—this will be massively accretive to long-term value. Twitter initiated a $2 billion share repurchase program, the first in its history, and appointed some outstanding investment-minded board members. We know there are more tools in the playbooks of the management teams we have invested behind and we expect that somewhere down the line these companies come out of this bear market more, not less valuable than our initial assessment.

Today, March 12th, will be a bad day for markets. There was some hope that the President’s evening address on the 11th would 1) finally take this issue seriously; 2) offer a plan for how we stop the spread of the coronavirus, given a proven playbook exists; and, 3) offer a plan for mitigating the harm for those who are economically vulnerable because of this unforeseen situation. There is some solace insofar as the President finally showed he understands the seriousness of the situation, but unfortunately, little was given on the most important issues related to point 2) above. The market has its way of forcing situations, as it did in late September 2008 when Congress voted down TARP.[4] Given this President is as sensitive to the market as any in our recent history and given the gravity of the situation, we do expect leadership in this country to come together and deploy the right kind of plan to get us through this.  There are five key points that need to be addressed:  1) this won’t be easy; 2) we must deploy a roadmap to follow for what provably gets this virus under control 3) we must do whatever it takes to make sure we protect our community; 4) we will get through this together; and, 5) and with leadership and cooperation at all levels of our society things will be fine through this tumult as we get back to normal faster than you can imagine in the eye of the storm.

In six months, this insult will be a painful, though increasingly distant memory. Within two years, our companies will once again be valued on their earnings power and in the case of every company we own today, that earnings power will be considerably greater than at the start of this mess. We spent some time searching for historical analogies to today. Two come to mind as especially appropriate: natural disasters and General Strikes. Natural disasters, as we mentioned above, are far more acute and quick in the pain, though they offer a template for what recovery looks like. People, even those in pain, have an urge to get back to normal things in life and to do activities that are necessary and activities that create joy. General Strikes are relevant analogs for what it looks like when economies shut down for extended periods of time.

Two French examples from modern history are highly relevant. In May of 1968, France experienced a General Strike that saw two-thirds of the French population strike and thus skip work. This included nearly all key public and private sector workers. The chaos resulted in Charles de Gaulle fleeing the country, and the government was on the brink of collapse. There were riots and people were anxious about what the world would look like going forward. GDP continued growing with hardly a blip. Similarly, in 1995, France saw a General Strike of the entire public sector with virtually all of the country’s transportation and other key services entirely shut down. Both of these enormous disruptions could have been expected to cause significant recessions; however, in neither case did GDP actually turn negative. In 1995, GDP was close to zero but a recession was avoided. Why is this so? We suspect that for many, amidst really tough circumstances, work offers an escape, despite the inability to do some of the everyday life things that we want to do. Neither are perfect analogies; however, both shed light on what the actual economic harm of major disruptions cause. A recession today might be unavoidable, but a recession caused by an external shock in a strong economy should cause less long-term harm than a recession caused by excesses in an economy that have to be wrung out. In that crucial respect, this is not and will not be like 2008. The economic harm will be considerably less than in 2008-09 and the recovery will almost certainly be quicker.

One other key point must be emphasized here: the entire Treasury curve heading out to 30 years is now at under 1%. We did not even get to these yields in the worst of the Great Recession, when deflation was truly on the table. Yes, this is an economic shock; however, deflation is not the risk we face here. Liquidity will be essential for small businesses in weathering this storm, but our balance sheets need not be pared down in the same way they were a decade ago. Further, the market is giving the government considerable firepower to draw on fiscal policy as a palliative here. Lastly, and perhaps most importantly for us, with rates over the long-term under 1%, and opportunity cost an important consideration, stocks as an asset class look increasingly compelling. Sure, stocks have volatility, but if your timeframe is long enough (and we all are in that camp), then the frustrations of the volatility are worth the extra yield that will be picked up over a decade. We have largely refrained from quoting Warren Buffett because of our emphasis on independent thought; however, doing so now is justified. Buffett often speaks in nuanced ways, though he was as close to emphatic as he gets in asserting that: “If something close to current rates should prevail over the coming decades and if corporate tax rates also remain near the low level businesses now enjoy, it is almost certain that equities will over time perform far better than long-term, fixed-rate debt instruments.”[5] Rates are even lower today than when he said this on February 22nd. Think about that! Now look at it in visual form:

We talked about how frequently bear markets happen at the start of this letter. If we take that timeframe back to 1900 instead of post-WWII, they happen far more frequently— once every 3.5 years. How long do they last? The typical bear market lasts for 367 days-just over a year.[6] We think that timeframe seems reasonable in this case, with the stages set for perhaps an even swifter recovery in this case. Balance sheets in our financial and household sectors are incredibly strong. This stands in stark contrast to 2008 where it took years to work off balance sheet excesses. If we as investors do our job appropriately, and we are working hard to do as much, we will find the best investment opportunities we have ever seen in our relatively young history.

We are happy to discuss this in further detail with you and encourage you to reach out directly.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Partner, President
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Partner, Chief Investment Officer
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] https://theirrelevantinvestor.com/2020/03/09/the-fastest-bear-market-ever/

[2] https://twitter.com/CT_Bergstrom/status/1236426968444235777

[3] https://www.spiegel.de/international/world/i-don-t-think-the-virus-can-be-stopped-anymore-a-03d404e6-762b-42fb-ac48-e4a8f03a2f2b

[4] https://money.cnn.com/2008/09/29/news/economy/bailout/

[5] https://www.cnbc.com/2020/02/22/buffett-says-its-almost-certain-stocks-will-beat-bonds-over-long-term-if-rates-taxes-stay-low.html

[6] https://www.thebalance.com/u-s-stock-bear-markets-and-their-subsequent-recoveries-2388520

#WeBackJack – Our Open Letter to Elliott Management About Twitter

March 4, 2020

Dear Elliott Management,

As long-term shareholders of Twitter, we think efforts to oust co-founder Jack Dorsey from the CEO role again would be as detrimental to Twitter’s evolution and growth today as it was in 2008. We think we are well positioned to opine on this issue for the investment world given our auspicious entry into Twitter’s stock in the early days of the Jack-led turnaround and our large positions in both Twitter (our single largest investment at RGAIA) and Square.[1] We are writing this letter to explain our thinking.

One of the big contentions about Jack as CEO seems to be a about Twitter’s slow path to reaccelerating monetization. We think this narrative misses a few key points. Jack was right to focus on user experience ahead of monetization, because had Twitter not proven its seriousness about brand safety to top of funnel advertisers, considerable budget would have been lost. Protecting revenue at that point was more important than creating new revenue streams. Further, improving the user experience was crucial for reaccelerating user growth and cementing Twitter’s role as the modern Associated Press for the 21st Century.

We think it’s clear that Jack learned from his shortcomings the first time around and that he has been a distinctly different kind of leader and manager since returning as CEO in 2015. While some point to the flat stock returns during Jack’s second tenure as evidence of a job done poorly, we think two mitigating factors should be considered:

  1. The base rate of investing in a stock at 10x P/S is historically a bad bet.
  2. Twitter had stepped into a series of challenges that would take considerable time to sort out.

When we first bought shares of Twitter in 2017, we identified Twitter’s overt Facebook-envy and its inability to define its own essence in the social media landscape as distinct negatives. We felt Twitter should be seen as an information, not a social network, and that defining its role in what was seemingly a crowded space would be crucial for creating a culture and driving product development around a vision. Jack was explicit about this problem in saying “we saw hundreds of use cases over the 10 years and we tried to do all of them. And that just didn’t work.”[2] It was Jack who uniquely owned the mandate to redefine Twitter around a core essence and recalibrate its entire existence to fulfill that mission.

Jack also noted that Twitter “lacked the sense of ‘ownership’ needed from employees to follow through on a shared roadmap.” In his return to the CEO role, Jack gave back $200 million of his own money to the employee bonus pool. How many CEOs have ever so literally “put their money where their mouth is” and helped their employees to their own detriment? Since returning to the CEO role in 2015, Jack has declined any base salary and nearly all compensation other than relatively small covered expenses for “residential security and protective detail.” This is what leadership looks like! No wonder Twitter employees love Jack, are inspired by him and are leading the #WeBackJack hashtag in the wake of Elliott’s efforts becoming public.

Importantly, we believe that Twitter today is on the right track. The true reacceleration in user growth began in earnest in the beginning of 2019 and accelerated throughout the year:

Unfortunately, problems with revenue product limited the capacity for the user growth to flow through in the form of higher revenue. We are confident faster growth is near. Twitter has made rebuilding its entire core ad server a top priority for this year. The task will be completed at some point during the first half of the year. Twitter has called it “foundational and transformational work” that will “increase development velocity” and build a platform to add incrementally new revenue products, including the capability for native commerce and experiments in microtipping. The improvements will meaningfully enhance Twitter’s relevance as a demand response platform, which would then open up more self-serve opportunities for smaller advertisers. At the very least, we think anyone eager to judge Jack should afford the company the opportunity to complete what we think of as the second phase in the turnaround that began in 2015 with this enhanced effort at building revenue product.

While we do not think firing Jack is the right move for Twitter, we do think there is room for Elliott (the investment firm with two T’s, not our Elliot with one T) to oversee some improvements at Twitter. In our conversations with investor relations, the company at first was somewhat warm and since has been resistant to the idea of subscription feeds. This is a big mistake. Twitter historically has been highly attuned to how active users are using the platform and adapting the product accordingly. While Twitter has reservations about a product that preferences private over public conversation, this is a change that is happening across all kinds of platforms and will continue happening irrespective of Twitter’s hopes.[3] Meanwhile Twitter is incredibly well positioned for subscription feeds given its role as an “information network” and it could rapidly create a recurring revenue, non ad-supported revenue stream that would be differentiated in the technology platform world.

Plus, we think capital allocation could improve and this is where Elliott could offer considerable help. The company has built a large cash stash that bought time in pursuing a turnaround while still unprofitable on the income statement; however, today, with cash flowing and the stock cheap based on what the company has been emphatic are shorter-term revenue product issues, a repurchase would be smart. 

One of the problems investors have with Jack as a manager is that he is very atypical leader who doesn’t fit a mold. There are personality traits and interests that seem more like parodies of tech types in HBO’s Silicon Valley. While people are quick to point out some of Jack’s quirks, he has two demonstrable strengths that shine through clearly at both Square and Twitter:

  1. Jack is one of the legendary product visionaries of our time, having founded three different billion dollar revenue products: Twitter, Square for merchants; and, Cash App.
  2. Jack is a leader: he hires top notch talent for key roles and empowers people to fulfill their mission in a decentralized management structure that incentivizes independent thought, nimble action and the capacity to take risks that might fail. Meanwhile when failures do happen, Jack takes responsibility himself without pointing fingers. Some of the outstanding hires we have been impressed with include Leslie Berland as CMO, Sriram Krishnan and his replacement Kayvon Beykpour as Head of Product, Bruce Falck as GM of Revenue Product, and Sarah Friar and Amrita Ahuja as CFOs at Square.

We think this description of Jack from Yahoo Finance’s deep feature is incredibly apt: “He’s a good listener. Good observer. Very patient. His emotional IQ is very high even though, because of his demeanor, people aren’t sure whether he’s really present. Jack is a man of few, but powerful, words.”[4] These are exactly the kind of traits we would want in the leader of the world’s most important information network.

We look forward to working constructively with IR and fellow shareholders in helping Twitter achieve its fullest potential.

Sincerely,

Elliot Turner

Managing Partner, CIO

RGA Investment Advisors LLC

 

 

 

[1] http://www.rgaia.com/twitter-presentation/

[2] https://www.forbes.com/sites/kathleenchaykowski/2017/02/16/jack-dorsey-twitter-lacked-focus-and-discipline-for-growth/#1fe29c606d83

[3] https://www.voguebusiness.com/companies/influencer-paywall-what-it-means-for-fashion-brands

[4] https://finance.yahoo.com/news/jack-dorsey-twitter-square-profile-140037540.html

Q4’2019 Investment Commentary – 2019 in Review

2019 saw the S&P register a 30% total return. In isolation, this looks like a banner year, and it sure was; however, when we take a step back and look at the market’s two-year stack the reality is far more normal. Thus is the nature of markets: moves happen in lumps and one must zoom out to find some semblance of an orderly trend. Instead of thinking about the 30% return, we can look at the annualized return since the start of Q4 in 2018. From that lens, the S&P has returned an annualized 10.82% since the first day of Q4 2018. This level of return is consistent with the long-term price trend of the index. All that truly changed along the way was sentiment.

Markets across the world looked awful heading into 2019, despite a brief reprieve that commenced promptly on Christmas Eve 2018. At one point, the S&P was within one fifth of one percent of a “Bear Market.” Alas, those who live on proclamations such as “this is the longest bull market in history” can still make the claim because of a mere twenty basis points.[1] This is the second time in the Bull Market that started in March of 2009 where the S&P came within one percent of hitting “Bear Market” territory (the first having been 2011’s -19.4% peak to trough move). Just imagine how different today’s narratives would be had things moved slightly further in the wrong direction one random afternoon.

Labels, as such, are great for selling headlines but have little value for us investors. Does the longevity of the Bull Market mean anything in and of itself? Had we registered a 20% correction in 2018 instead of a 19.8% correction would prognosticators bemoan the “maturity” of this Bull Market? Another common refrain is about how expensive stocks look today. We concluded our end of 2018 introductory section with the following point that is worth repeating today:

In the end, 2018 marks one of the biggest one-year declines in the forward P/E in the past few decades fueled by a combination of strong realized earnings growth and a decline in the stock market. Some of the earnings growth was the sugar rush from tax cuts, though a healthy amount was realized via higher revenue growth. While one might call the early 2018 levels “the upper end of fair value,” today is on the lower end of the fair value range. Yes, we have been below these levels, but they were in far different environments. This makes now a compelling time for long-term investors to put money to work.[2]

While last year ended at the low-end of the valuation range, 2019 saw the pendulum swing back to the high side when looking just at the market’s P/E (what we have lovingly called “Mr. Market’s mood indicator” in the past). Even looking at P/Es can be a little misleading however, given the following visual which is especially helpful in contextualizing where things stand:

[3]

Yes, when we look at traditional valuation metrics (like P/E), stocks do appear expensive on an absolute basis. However, pay attention to the bottom two lines in the above table for the one relative (in contrast to absolute) valuation metric: stocks are on the historically cheap end of the spectrum relative to the 10-year Treasury yield. Importantly, stocks are exactly in the middle of the long-term range with respect to “free cash flow yield.” The contrast between P/E ratios checking in at the 88th percentile and free cash flow yield at the 53rd percentile is one of the most interesting realities of markets today. This contrast speaks far more to the nature of today’s leading businesses and the composition of earnings than it does what the market itself is doing. Over the past decade, companies like Circuit Cities, Countrywide Financial, Lehman Brothers, RadioShack and KB Home have been replaced in the S&P by the likes of MasterCard, Intuitive Surgical, Salesforce, Booking and Blackrock. Is it any wonder that while earnings might appear lower on a per share basis overall that cash flows are much better? The S&P is built to evolve with the times. As older industries struggle, shrink and inevitably perish they get replaced by the younger upstarts, with better growth dynamics and different business models. These compositional changes tend to happen gradually; however, the financial crisis accelerated the pace of change. Today we are witnessing the consequences.

New Business Models, New Opportunities

The last time we called out a group of companies who shared similar traits was in our January 2016 commentary entitled “Robust Networks for the Long Term.”[4] We see something similar developing today. On the one hand, the market has been enthusiastic about new business models, rewarding them with rich valuations, while on the other hand, a certain subset of companies with distinct properties seem neglected. Two kinds of companies stand out for stellar performance last year:

  1. Companies with no earnings and rapid growth.
  2. Companies with low growth, high free cash flow and high repurchase yield alongside perceived “safety.”

In the middle is a third type of company that got left in the dust. In some respects, the Dow Jones Internet Composite Index holds many companies evincing these traits. In 2019, the composite as represented by the First Trust Dow Jones Internet Index (FDN) returned 19%, well less than the market’s 30% returns. This index includes 40 holdings listed below:

[5]

Some of these companies have unique problems, while others are strong. By and large, the traits that bind these companies together beyond the “internet” being core to their business model are as follows:

  • Descent though not other-worldly growth rates (think high single digits up to 20%)
  • High and growing operating margins (>15%)
  • High free cash flow yield (the consolidated index boasts a 4.5% free cash flow yield, greater than the S&P at 4.1%)[6]
  • Over-capitalized balance sheets

Taken all together, you have an index with faster growth than the market and lower valuations, operating in the new economy, yet with somewhat extreme underperformance. Clearly this space looks like fertile hunting grounds for investors with a growth at a reasonable price (GARP) bias. Several companies in the FDN ETF have been in our portfolios for years, though we added a few more of these kinds of companies in the last quarter (most are in the actual holdings list above, the exception we are adding boasts all of the same traits but cannot be included due to its low float). Here are the companies in alphabetical order:

  • Alphabet (GOOGL)
  • ANGI Homeservices (ANGI)
  • Dropbox (DBX)
  • eBay (EBAY)
  • Grubhub (GRUB)
  • PayPal (PYPL)
  • Twitter (TWTR)

For the remainder of this letter we will dive into four of these positions, two of which because they are new to our portfolio and two because they suffered especially poor returns in the fourth quarter, deserving some attention and reflection.

ANGI: The House Isn’t The Only Thing Getting Fixed

Barry Diller and IAC have an incredible history of nurturing and growing companies who are digitizing the offline world including stalwarts like Ticketmaster, Match.com, and Expedia.[7] In 2004, IAC acquired ServiceMagic before rebranding the company to HomeAdvisors in 2012. In May 2017, HomeAdvisor acquired Angie’s List and the company (“ANGI”) was listed publicly with IAC retaining ownership of over 80% of the combined company. ANGI provides digital marketplaces for home services. It connects service providers (“SP”s) with homeowners in need of service requests (“SR”s).

Each marketplace match performed by ANGI throughout the years has provided a datapoint for a price on a specific job in a specific geography. ANGI currently has the largest database for job pricing in the United States. Although ANGI was not initially sure what the benefits of this database would be, the company is now deploying this information to offer transparency and in some cases, a fixed, fair price for projects in 133 specific verticals in certain zip codes, leveraging a strong data moat into a unique offering for homeowners. ANGI’s CEO William Ridenour explains:

So one of the opportunities I see, and this is a huge area of concern for homeowners and consumers, be — the fear of not getting a fair price. … And the difficult part is nobody knows what a fair price is. … So we think that there’s an opportunity to actually, as a brand and as a service, become this reference point for home services pricing, with the idea that before you buy, check to make sure you’re getting a fair price, an easy, fast, digital way to see what you can get that service for.[8]

This strategy is a key building block for ANGI’s efforts to increase mobile app usage, create a fixed price booking platform, and ultimately increase the number of service requests per customer. As the product improves, customer loyalty improves, adding to ANGI’s already lush cash flow generating capabilities. ANGI is currently investing significant cash flow into customer acquisition and earning slightly above a 10% free cash flow margin despite these considerable investments. If ANGI can use improved loyalty to migrate customers onto the mobile app and away from the rising toll Google charges for traffic, the company could generate considerable leverage on the over 50% of revenue it invests in sales in marketing (40% of that S&M expense goes directly to customer acquisition).

In addition to customer acquisition, sales and marketing investments are funding the growth of the SP network. As ANGI evolves from lead generation, to a managed marketplace, to a fixed price platform, the importance of growing SP supply only increases. ANGI currently has the largest supply of SPs in the market which creates a challenging barrier for competitors to overcome. A fixed price platform with price transparency should catalyze SP engagement since it would lower barriers for SPs to land jobs in a cost-effective, time-saving way.

Platforms provide network effects as they grow, and network effects would grow margins meaningfully.  Even if margins only expand by 200 basis points per year and sales growth is less than half of what management expects over the next five years, ANGI should be valued at $12.60 a share based on a DCF, 60% above the price at which we made ANGI a position in our portfolio independent of our holding in IAC. ANGI is at least a couple years away from an adoption inflection in the fixed price platform given the early stages of implementation. As such, the exciting benefits of the fixed price platform were not baked into the base case and left as an asymmetric source of upside. In our base case DCF for ANGI, we use a 16% CAGR on the top line for 6 years (well below the company’s 20-25% target range) and a terminal EBITDA margin of 26% (decently below the company’s 35% long-term target). These assumptions result in a value for ANGI of $16.00 per share, over twice the price we initiated the position at.

Dropbox-Storing Files and Saving Time

We have long admired Dropbox for how it facilitated the operations side of our business at RGAIA. As many of you have experienced, we can securely share files, with HIPAA/HITECH compliant encryption,  password protection and links that expire, without ever attaching sensitive documents to an actual email. Many people were first exposed to Dropbox through the free, limited space offering that spread virally amongst certain peer groups. Through virality alone, Dropbox has built up a universe of 600 million users, 360 million of whom are “potentially monetizable” in either their personal or business capacities. The virality of the product affords Dropbox a major advantage in customer acquisition.

Dropbox is a classic example of a company that stayed private for too long only to come public when growth was slowing and questions about competition intensifying. Some contend that the cloud storage space has been commoditized by Google, Microsoft, Apple and Amazon offering competing services to Dropbox, bundled into broader suites and as such, “free” to the customer. Although there is some merit, especially in the retail photo-sharing and saving market, these concerns miss how valuable Dropbox’ suite of services with greater power and flexibility have become in the workflow of small and mid-size businesses. We have often expressed an affinity for pure-plays against large, well-capitalized competitors due to the contrast of having a product be one’s essence versus one’s unit. This further helps Dropbox vis-à-vis the technology giants as the company’s engineering-centric culture further iterates and improves its product suite while competitors rely on free being “good enough” for the customers who use it. In the storage market, there is room for both.

There is a misperception due to the viral origins of the product that most users are individuals, when in fact 80% of Dropbox users deploy the product primarily for work, with the remainder personal. On the surface, competing with free looks like a losing battle; however, in reality,Dropbox’ suite ends up priced as a tiny cost in a typical business’ operating budget and its better UI/UX as a product saves time in quantifiable ways. Its robust tools for control are crucial to businesses in regulated industries and its fluidity in sharing is a true differentiator from mere “storage” in collaborative industries like architecture, sales, engineering and inventory management. In the third quarter, Dropbox reported that the average user paid $123.15. While this number is clearly more expensive than free, it can be contextualized as follows: according to the BLS, the average worker in the US earns $28.32 per hour of work, while the average information worker earns $42.34 an hour.[9] If the advantages of Dropbox over the competition save the average worker 4.3 hours in an entire year or the average information worker 2.9 hours in a year, Dropbox pays for itself. With a better product suite, the bar is not too high for Dropbox to deliver a demonstrable benefit over the large scale, unfocused challengers.

The greatest evidence that Dropbox is meeting the needs of its customers stems from both its ability to raise prices as a growth lever alongside declining churn in aggregate. Dropbox recently raised the price of its Plus plan by 20% and while the company suggested it might slow net new customer additions for the next several quarters, there has only been a modest uptick in churn.[10] Customers already onboard clearly recognize the value. To make the price increase more palatable, they executed the price hike intelligently, along with doubling storage capacity and adding functionality like restoring folders and/or files to past dates. Dropbox benefits from multiple growth levers, including the aforementioned pricing power, along with opportunities to lower churn, improved conversion of free to paid and more products like Paper and New Dropbox.

With net revenue retention in the mid-90s and customer retention in the mid-to-upper 80s (probably higher but think mid-90s less mid single digits ARPU lift), at today’s $6.6 billion enterprise  value, assuming a 7 year average customer lifespan, you are buying the value of the existing customer base with any growth essentially free on top. If that lifespan drops to five years, there would be 15% downside; however, given that the company will have grown its user base in the low teens in 2019 and users will grow base case in the high single digits in 2020, we see a margin of safety in the churn assumption. Dropbox is a Rule of 40 SaaS company[11], with a commitment to the market of expanding margins as growth moderates. If growth reaccelerates, they will be able to maintain margin. When adjusting free cash flow for duplicative headquarter expenses that will end in 2020, the trailing free cash flow yield here is over 5.4%. Rarely does one find companies growing so much faster than the market with a higher free cash flow yield. Founder Drew Huston showed what he thinks of the stock this fall, buying $10 million worth on the open market.With an over-capitalized balance sheet and some clear frustration with the stock’s performance, perhaps the company considers commencing a largescale repurchase program in the coming year.

Grubhub-Eat or be Eaten, The Story of an Upset Stomach

We revisited our thesis on Grubhub in our Q1 2019 commentary and events have not played out as hoped. We want to take this as an opportunity to share some lessons learned and our reassessment of the thesis from here. We simplified our thesis in Grubhub with an intense focus on “economic parity” which we explained as follows: “ Grubhub could reach what they call “economic parity” between marketplace and delivery orders as measured by EBITDA per order, leaving the platform agnostic, the diner indifferent and the restaurant empowered to choose the model that best fit its own needs.” Unfortunately while Grubhub did achieve a number nearing economic parity in Q3 2019, the level of parity was well below where the marketplace had been trending largely a consequence of growth slowing well below management’s and our expectation. Such is the nature of businesses with serious operating leverage. In the future, we will focus our simplification efforts on situations where there is a distinct qualitative tie-in to the customer relationship. This means we will either isolate on a revenue driver (as we did with engagement on PayPal) or a margin item with a direct customer nexus.[12]

Alongside the disappointing results, management issued a unique shareholder letter analyzing the history of the nascent online delivery industry and the competitive landscape today, blaming increasingly “promiscuous” behavior from diners due to promotional activity at competitors for the problems. In response, management made the case to shareholders for pursuing a “scorched Earth” strategy whereby Grubhub would spend (invest?) its own cash flows just at the moment when competitors like UberEats and Doordash were attempting to delivery on promises to its current and prospective investors for a path to profitability. It is difficult to determine whether the Grubhub move is offensive or defensive in nature. It is offensive insofar as the company is attempting aggressively to win diners; however, it is defensive for how it aims to keep competitors in a grinding battle defending their core markets instead of spending more aggressively to fight Grub on its own turf. Essentially the battleground in this delivery war has been primarily second and third tier cities—the new frontiers of growth—while marketshares in the Northeast have remained largely stable for Grubhub.

[13]

Upon hitting “send” on this letter, whether they knew it or not, management commenced a tectonic shift in the food delivery landscape. In Europe and around the world, a wave of consolidation is taking place in the industry, while the US has thus far been mostly immune (Doordash taking over Caviar aside). With the sharp reset in Grubhub’s stock price, the economic accretion available to those with larger market caps in the industry looks increasingly attractive. Taking a glance at the city-by-city breakdown shows the clearest opportunity in Grubhub’s stock today: With 67% of New York City marketshare (with an over-representation to Manhattan itself), whoever acquires Grubhub between Uber and Doordash will own 80% of the single most valuable delivery marketplace in the country. 80% is a magic number first noted by Italian economist Vilfredo Pareto in what is now known as the “Pareto Principle.” If one player achieves 80% share in NYC they will likely generate over 100% of the EBITDA in that one key geography. At the October 30th closing price of $34/share, Grubhub was trading for a discount to the standalone NYC value. NYC alone generates upwards of $250m in EBITDA which gets reinvested within the company to other growth initiatives. What choice do those with broad aspirations in the sector have but to give an acquisition a look?

The list of potential acquirers is deeper than just the two main US competitors. Prosus, a Naspers carve-out with a focus on the food delivery space has large, global ambitions.[14] Strategic acquirers range from big tech companies to super market companies. Most logically we think someone already in the industry, who is bleeding cash but wants to grow, will find the ridiculously high cash flow margins of the core marketplace business a crucial piece in achieving their own aspirations for profitable, cash flowing growth. While the recent path in this stock has been turbulent, we still remain sanguine on a constructive outcome.

Twitter: Will this bird finally set sail?

In many respects, Q3 2019 should have been cause for a chest-thumping victory lap at TWTR.  Account growth, as measured by year-over-year monetizable daily active usage (mDAUs) slowed to the single digits in the second-half of 2018. In Q3 2019 this number registered 17% year-over-year growth, the fastest rate of mDAU growth in at least three years. With pure inertia it will end the year closer to 20%. Notably, this acceleration happened without any major events or catalysts to spark engagement, on top of a tough comp with the World Cup having occurred in the same quarter, last year. Historically, the stock has moved based on the trend in mDAUs; however, this past quarter’s report came with a new problem. Twitter was inappropriately using data for personalization on accounts who had opted out of data collection and Twitter shared data with mobile application promotion (MAP) advertisers it should not have shared.[15] These problems collectively stem from a lack of investment in revenue product while the company was laser-focused on enhancing the user experience.

MAP in particular is a big revenue product in Japan, which is Twitter’s second largest market after the US. ARPU in Japan was thus down meaningfully, dampening the impact of the mDAU acceleration. Our analysis shows that while the US ARPU will actually be up somewhere around 5% in 2019, International will be down 3.4% and Japan in particular will be down over 12%. In a loose sense, it might be fair to suggest these problems are isolated and they open up intriguing possibilities. Improving the demand response product is a major opportunity that will now get the attention it deserves:

But what can we do around direct response and bringing more advertisers to the service? So our MAP work should lead to more direct response-type opportunities over time. And in terms of bringing more advertisers to the service, we have a nice business where we help smaller advertisers in reaching their customers on Twitter, but that’s not an area that we have prioritized improvements around in the recent past. It’s a place where we know that there’s millions of small businesses throughout the service, where we could help them more in reaching their customers on Twitter. But we’ve got to do the engineering work and make the case to them better than we are today. And right now we’ve chosen to prioritize other things first.[16]

Twitter has a fair reason for putting off the redevelopment of direct response revenue products. The platform is well-established for brand building and product launches; however, that might have been at risk had the company not achieved measurable progress on safety and user growth first. If they put demand response ahead of user experience as a priority, they might have lost this crucial support (and budget) in the advertising community and considerable revenue, which would have rendered any progress futile. Now that the company has a growing user-base story once again, we think it is only a matter of time for revenue to follow.

From a valuation perspective, the Twitter only needs modest ARPU growth in order to support today’s prices. We like backing into the market’s implied expectations and using 2.7% ARPU up-lift per year, for eight years (well below the trend of the last three years) Twitter’s user growth would need to track the yellow line in the following chart in order to justify today’s market cap:

Importantly, the yellow line today is in the process of accelerating and it is rare that these things so swiftly reverse. This is especially so with 2020 being an Olympic and a US election year.

Meanwhile, the opportunity on ARPU remains relatively untapped. We think one of the single biggest opportunities for Twitter is launching paid feeds whereby instead of merely “following” another user, someone could “subscribe” to a feed and Twitter could take their cut for building the infrastructure to make it all work.  There are companies who do this over Twitter’s rails, like Premo Social, for an all-in take rate of about 13%.[17] This would be an intriguing revenue opportunity considering most Internet revenue at the giant Internet companies comes from advertising. A subscription-based take rate would be far less volatile, far more consistent and open the door to all kinds of serendipity for the platform.

The hurdle for success on the existing business here is set very low. Should the acceleration in mDAUs persist, the stock would be worth upwards of $60 without any ARPU recovery. If ARPU recovers its swoon and returns to a 5% growth trend, this is upwards of a $70 stock. New paths to monetization are pure optionality. Taken as a whole, Twitter is one of the most compelling risk/reward opportunities we have seen.

Where it all goes from here:

It is impossible to know what the market will do from year-to-year and what kinds of stocks the market will take a liking to. What is knowable is that over the long run, stocks are worth the discount of their future cash flows. These companies we discussed today all share many common traits that lend themselves to good future returns including: 1) low starting valuation; 2) high margins and 3) good growth tailwinds. While these companies in many respects share a lot of similarities, importantly, the key drivers of their revenues are all unique. ANGI connects homeowners and service professionals, Dropbox is a service for small and mid-sized businesses, Grubhub connects diners and restaurants and Twitter is the modern associated press and interest network for the masses. In other words, none of these companies will be reliant on the same macro forces to drive their profitability, while all are in advantaged areas ready to move key offline processes to the digital world.

These companies also share another important trait with respect to their institutional imperative. Companies with no profits and rapid growth are incentivized to pull the growth lever and gear their organizations accordingly. In effect, one can say the objective of such companies is to grow. These companies we are highlighting do exhibit growth; however, their institutional imperative is far more balanced: they are incentivized to deliver both growth and profitability. Companies that understand the tradeoff between growth and profitability gear their organizations towards achieving profitable growth. Growth then becomes about scaling proven unit economics instead of goosing the top line at all costs. It is important for management teams to effectively communicate how they think about these tradeoffs to their shareholder base.

One reason Grubhub has been so volatile is how poorly the company has managed communication with a shareholder base focused on margin, in a competitive landscape dominated by companies whose owners are pushing for growth at all costs. Grubhub’s institutional mandate put the company at odds with the demands of its industry; however, the company’s profitability in core markets provides the financial lifeline necessary to know life will persist even when the regime shifts. Market regimes will inevitably shift the extent to which they reward growth and that will be painful for companies who have not yet created pathways to profitability with talent and staff who understand the precise balance between the underlying levers that drive the tradeoff.

Growth-at-all-cost companies can prove their ability to grow, though they cannot explain, nor can investors determine whether they are merely growing, or scaling proven unit economics. When companies exhibit both growth and profitability, there is implicit evidence the unit economics do work and that scale can deliver more profit long-term. Further, profitable growth companies have the added financial flexibility and runway necessary to experiment with ways to improve their offerings and accelerate their growth in out-years while profitless growth companies will spend their time figuring out how to turn $1 of revenue into some degree of margin.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Partner, President
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Partner, Chief Investment Officer
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

 

 

[1] https://www.cnbc.com/2019/11/14/the-markets-10-year-run-became-the-best-bull-market-ever-this-month.html

[2] http://www.rgaia.com/2018-year-end-investment-commentary-easy-come-easy-go/

[3] Eye on the Market Outlook 2020, JP Morgan Private Bank.

[4] http://www.rgaia.com/robust-networks-for-the-long-term/

[5] Bloomberg

[6] Free cash flow yield as of 12/31/19 https://www.ftportfolios.com/retail/etf/etfsummary.aspx?Ticker=FDN

[7] https://moiglobal.com/elliot-turner-201806/ is a link to a presentation on IAC we gave in 2018

[8] ANGI HomeServices Inc at Credit Suisse Technology, Media & Telecom Conference

[9] https://www.bls.gov/news.release/empsit.t19.htm

[10] https://www.theverge.com/2019/5/31/18647053/dropbox-storage-increase-price-plus-watermarking-smart-sync-rewind

[11] Rule of 40 in SaaS is defined as Sales Growth + EBITDA margin exceeds 40%.

[12] http://www.rgaia.com/wp-content/uploads/2019/01/PYPL-and-ROKU-Best-Ideas-2019.pdf, Slide 12.

[13] https://secondmeasure.com/datapoints/food-delivery-services-grubhub-uber-eats-doordash-postmates/

[14] https://finance.yahoo.com/news/prosus-still-chasing-food-deals-133837837.html

[15] https://adexchanger.com/data-exchanges/limits-on-targeting-hurts-revenue-just-look-at-twitters-unfortunate-q3-earnings/

[16] Ned Segal, Twitter Q3 Earnings Call, 10/24/19, Sentieo.

[17] https://premosocial.com/

 

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