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

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

[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.


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:


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:


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.


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

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



[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/


Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Q3’2019 Investment Commentary – Kambi

2018 was a watershed year for turning this formerly illegal activity into a regulated, legal activity. Many regular people cheered and entrepreneurs greeted the news with enthusiasm. Meanwhile, the stock market hardly noticed. From the first two sentences, you may have thought we were writing a prelude to a marijuana company pitch, but you need not worry, we have yet to find an investment even tangentially related to marijuana that is not inflated with hot air. Instead, we will use this space to present to you our investment in sports betting.

On May 14, 2018 the Supreme Court of the United States ruled 6-3 in favor of striking down The Professional and Amateur Sports Provision Act of 1992 (PASPA). PASPA effectively made sports betting illegal in any state who had not already commenced a sports betting system (the four grandfathered in states were Nevada, Oregon, Delaware and Montana, though only Nevada actually had a single-game betting regime in place).[1] [2] The case was commenced in 2011 following a New Jersey referendum in favor of legalizing sports betting in Atlantic City. Consequently, once SCOTUS overturned PASPA, New Jersey was the first new state ready to take a legal bet in a decades. On August 1, 2018, in New Jersey, DraftKings became the first company in the United States to take a legal sports bet through a mobile app ever.[3] That historic bet was powered by a company named Kambi Group PLC, the subject of this writeup.

Rarely can one find companies like Kambi that are well-positioned in an industry undergoing dramatic change, while also reasonably valued in the market. There are a few reasons this opportunity exists as it does. First, Kambi’s ownership base is predominantly European and the European sports betting market is far more mature on the regulatory and technology fronts. Familiarity with the US market and the regulatory regime is complicated and challenging for some Europeans to fully grasp. Second, US investors intrigued by sports betting hardly have Kambi on their radar. In our informal survey of other investors on the space, we have yet to encounter anyone who has heard of the name before, even those who have invested in companies premised on their exposure to the sports betting opportunity. Good evidence of this is a Bloomberg article boasting how “Draftkings’ Legal Betting Shows How Big Gambling Can Be.”[4] There is not a single mention of Kambi, though there is much excitement about the scale of the opportunity. In the hundreds of articles we have scoured from mainstream sources like Bloomberg and the Wall Street Journal, there is hardly a mention of Kambi anywhere. We are quite fond of this setup.

In gold rush industries, the saying goes: “invest in the picks-and-shovels, not the gold miners” and we think the sports betting industry is no different. Kambi is the “picks-and-shovels” in the form of a SaaS provider of the tools the “gold miners” (aka the sports books) need in order to conduct their business. We have always been fond of the SaaS business model for its recurring revenue nature and high customer-level margin profile; however, given the market shares this infatuation multiples have become incredibly stretched at US-listed SaaS companies. Worse yet, many of these high valuation SaaS companies have yet to prove their business models can be profitable over the long-run. Kambi is different. They are both profitable and valued at a fraction of the sales multiple of the more glamorous SaaS names.

Kambi has a $430 million market cap and a $402 million enterprise value. The company is headquartered in Malta, and listed in Sweden on the NASDAQ OMX under the symbol KAMBI, with a pink sheet ADR in the US under the symbol KMBIF. Kambi boasts many of the qualities we often espouse in our commentaries: the people operating the business own meaningful equity, have a history of innovating in product and business model in their sector, are applying technology to old industries, benefit from strong secular tailwinds, boasts high margins and even higher incremental margins, and multiples that are downright reasonable. In fact, while Kambi’s stock has compounded at around 32% since its June 2014 IPO, its EV to Forward Sales (EV/S) multiple has contracted from about 4.5x to 3.25x. In other words, the returns in Kambi’s stock since inception have come from increasing the value of the business itself.

Kambi’s origins:

Kambi was founded in 2010 as part of a larger company formerly known as Unibet (today Kindred Gaming). Kambi CEO Kristian Nylen and his cofounders at Unibet saw an opportunity to take the prowess they had developed in setting lines and managing risk for the Unibet sports book and packaging it as a full service, business-to-business backend for both established and aspiring sports book operators. Founding essentially meant bringing in a customer who was willing to pay for the services other than Unibet and giving 80 employees a seat in the new division. By 2014, Kambi had established meaningful relationships with growing sports book operators, demonstrating robust top line growth and a scalable cost structure. The concept was thus proven and in 2014, Unibet decided that Kambi would need independence in order to achieve its highest ambitions. Independence from Unibet would be instrumental in Kambi’s go-to-market strategy of trying to win business with operators who may be competitors of Unibet in some or all jurisdictions. It would also afford Kambi its own institutional imperative and opportunity to forge its own unique identity separate and apart from a parent, while aligning incentive structures for employees. As such, on May 20, 2014, shares of Kambi were spun off to Unibet shareholders and Kambi became an independent public company.

Kambi’s business model is smart and aligned with their front-end partners. Partners who use Kambi have a better menu of possible wagers, can offer more lines in more situations, and are ultimately more profitable. The company charges a take rate in the low to mid-teens percent of net gaming revenue in exchange for providing their services. Net gaming revenue is the revenue an operator earns after deducting all regional and federal taxes and promotional activity offered by the operator from gross gaming revenue (GGR). Kambi’s revenue can be calculated as follows

 Kambi Revenue = (GGR – promotions) * (1-tax) * (take rate)

The Industry Landscape:

Stated simply, the industry is highly complex. The complexity itself is multi-faceted. This is an industry with black, gray and legal markets. In places where sports betting is legal, investors and operators must contend with a highly fragmented regulatory regime, where each domicile has different rules and taxes. Plus, there are multiple layers of companies operating in the industry who in some respects look like competitors, while in other respects they may be partners. Establishing an addressable market for the industry, let alone a given company focusing in a niche is thus a complex endeavor itself.

Essentially there are three ways sports books make lines (the following three are paraphrased from The Logic of Sports Betting by Ed Miller and Matthew Davidow)[5]:

  1. Algorithms that rely on troves of data to estimate probabilities.
  2. Scraping lines from publicly available betting sites on the Internet.
  3. The market making price discovery function.

None of these are mutually exclusive and the best bookies rely to some degree of all three. For bookies where the algorithms drive the lines, human traders add an overlay and reassess changes in model inputs that a computer simply cannot see on its own.

A recent example illustrates why this is so important:


When Andrew Luck announced his sudden retirement on August 24, 2019, the Borgata sports book, (run by GVC) held its lines related to the Colts for extended periods of time. Any time a quarterback will miss time, especially one with the skill of Andrew Luck, betting lines related to the team should change. This mistake at the Borgata afforded the opportunity for some sharp bettors to place action on stale lines, reflecting imperfect information. The bettors gain in this case is the book’s loss.

The landscape in the United States offers a nice microcosm for the challenges the entire industry faces. While the repeal of PASPA opened the door for legalized betting on the state level, the Interstate Wire Act of 1961 (The WIRE Act) effectively makes interstate sports betting efforts illegal.[7] As a result, even if sports betting were legalized in each and every state individually, there would be challenges in operating a national sports betting business.

Here is a good map that as of the time of this writing, shows where each state stands:


Even if every state does eventually legalize sports betting, each state has taken its own approach to creating an industry structure. Effectively there are three distinct market structures states can choose from:

  1. Open competition. Allowing any and all worthy operators with a license the opportunity to compete.
  2. Monopolistic/oligopolistic licensing structure. So far this typically evolves in states with an existing, but limited brick-and-mortar betting industry, where operators are given the right to launch their own sports books.
  3. The lottery structure whereby the state owns and operates the book itself.

Each state has approached the distinction between brick-and-mortar and mobile licensing differently. Some have only legalized brick-and-mortar, some have fully legalized mobile, while others have legalized mobile with the requirement that either funding or withdrawal be done at a brick-and-mortar location. As for the parties that actually take bets, there are two basic business models: those who are fully integrated and make their own menu and betting lines, and those who rely on an outsourced provider for the menu and lines. No two operators in either bucket are exactly alike.

The front-end, in general (whether it be for integrated operators or pure front-ends) is a low margin, highly competitive business, while the back-end is structurally higher margin with considerable operating leverage and meaningful points of differentiation between offerings. While front-ends primarily invest in customer acquisition, back-ends invest in research & development in order to build out their capabilities and enhance their offerings.

Scale is incredibly important in making good lines; however, the balkanized regulatory regime makes scale a complex challenge. With greater scale, a book can take less “proprietary trading” risk and end up with better matched markets. A scale operator sees more flow and has insight into whether their lines are priced appropriately. An important value in seeing this kind of scaled flow is how the operator can build customer files and know who is a “sharp” bettor. If all the “sharps” are coming in on one side, it becomes a strong tell that a line is mispriced. Pulling this all together, scaled operators have less variance in their daily, weekly and monthly profitability. Further, scaled operators can offer a bigger menu because the costs to build out each pillar of the betting business are largely fixed. The quest for scale is even more important insofar as in-game betting is concerned (discussed more below), where lines must be priced every second, requiring distinct technology for both the estimation of probabilities and the acquisition, incorporation and delivery of the information.

One of the big distinctions industry people talk about in sports betting is the “European vs Vegas model.” The Europeans tends to focus on user experience and the entertainment angle to sports betting, whereas Vegas is far more interested in the skill and quantification thereof.  Kambi put this rather succinctly: “So from the end-users’ perspective, we believe that we are in the entertainment business. We help our customers to provide a service to our end users — or not a service but an experience to our end users. And if the end users do not find that experience compelling, they will easily move to another sports book and put their bets there.”[9] Vegas is more purist and idealistic in the “American” way, thinking the “best odds” (aka lowest vig) are what win customers at a book. These differences in perspective have consequence, because in the early stages of regulation in the US market, the European companies have had a considerable advantage getting to market. European companies are already profitable, with scalable technology infrastructures. In contrast, American ones (represented colloquially as “Vegas”) were never built for scale and never had the opportunity to open up for in-play betting.

Kambi’s solution:

Kambi offers its partners two essential services that are related to one another—1) they build the menu and set the lines, and 2) they manage the risk. Here is Kambi’s explanation for how the process works:

What you do when you deliver this end-user product called sports betting? You can look at it this way, somewhere in the world 300,000 events per year is played in all various types of sports. They may have some relevance to some end users to bet on. We buy data from all these events in realtime. And this date then streams into our system and our organization. So there we work with a mix of specialist traders and algorithms. So we use that data to — for any really type of occurrence of what can happen here to predict the outcome. So I think we heard before, we — today, we do in a month 480 million predictions like that, which is what we call odds spin. That’s about 100 predictions per second.

And we actually don’t think that we get this right every time. It is impossible to, at that scale with a quite small margin, get that probability right every time. And that leads us onto the third part here, which is really a core part of what we do, and that’s the risk management. So in the lifecycle of an odd as we publish it on the site, a lot of new information comes. You have bets being placed, you have market movements, you may have injury news, you may have a really big bet or you may have really a high accumulated risk for one operator. And our risk management is about really optimizing at all times the price given this new information that we get.

At the heart, really, of risk management for us comes what we call player profiling. So this is about for every end user really that does something with our product, we build a profile of future profitability of that player. In around 98% of the cases here, we don’t really act on the information from end users from a risk management perspective. But around 2% of the players, they actually come with new information to us that we use in the trading. So adapt the price.

Further, Kambi gives their partners great latitude in how they want to use the platform for their own differentiation:

“How Kambi differs from its competitors is that it offers this freedom, this flexibility, to innovate, to create and to build a sportsbook as desired. Kambi takes all the heavy lifting through the provision of sophisticated technology, a powerful sportsbook core and an experienced trading and risk team to deliver exciting sports betting experiences, while the operators, if they so wish, can work with us to co-create how those experiences are packaged and presented, as well as what levels of vig are applied per sports and per market.”[10]

Kambi’s edge stems from their ability to offer large scale, leading partners, across geographies:

  • Easy integration using Kambi’s APIs
  • A scalable software platform with little down time
  • Integrity
  • Quick access to markets following regulatory change.
  • A broad menu of diverse betting options, priced appropriately
  • A fair operator margin

Key partners (in no particular order) include Kindred, 888 Sports, BetPlay, Draftkings, Rush Street, Penn Gamin and more adding up to about 25 total relationships.

Back-end is the SaaS end:

“I think the biggest change that has happened for us here — the last 4 years is when we really moved over from delivering a service including a front-end client. We then started also delivering a service where you don’t need to take our client, you can work directly on our APIs. You have our full product either end to end with a mobile and web client or you can work directly on our APIs and create this yourself.”[11] – Erik Logdberg, Deputy CEO & Chief Business Development Officer

In the call following the announcement of Flutter Entertainment’s merger with The Stars Group (TSG), there was an insightful exchange on the lack of synergy between a front-end and back-end in sports betting:

Edward Young, Morgan Stanley, Research Division – Equity Analyst

 I’ll ask 2 genuine questions. The first one is could you just elaborate a little bit what you meant on the conservative API approach to tech integration? And does that affect your capacity to generate additional synergies above that GBP 140 million target? And the second one is, are there any gray markets that TSG operates in that you or the Flutter Board would consider exiting?

 Jeremy Peter Jackson, Flutter Entertainment PLC – CEO & Director

 Okay. Thanks, Ed. Look, in terms of the first question about a conservative API approach, if I look at how we manage the Paddy Power Betfair integration work, we effectively had to turn the Betfair technology stack into something that could operate on a certain multi-brand, multi-jurisdictional basis. And we then migrated all of Paddy Power onto its back, and it’s a big, complex thing to do.

 Since then, we’ve actually been able to separate our front-end and back-end platforms such that our front-end platforms communicated our back-end platforms by APIs. And that will allow us under this transaction — this proposed transaction to effectively allow teams with their own front-end platforms to maintain those product road maps, but then just to fit into a back-end betting platform and our global risk and trading capability, which we think will allow us to maintain momentum into the business, maintain individual identities associated with the brands but still deliver some considerable cost savings.

Jonathan Stanley Hill, Flutter Entertainment PLC – CFO & Executive Director [4]

 The only thing I’d add there is it also — we feel is a much better customer proposition for enabling the front — the local teams and the brand teams to maintain their own identity and deliver really what the customers are after. [emphasis added][12]

Following the completion of the Flutter and TSG merger, the combined entity will be the largest sports betting company in the world. The foremost synergies in the deal come from “API based technology integration” though that effectively means that TSG will no longer run its own platform and all incremental investment to improve the product will be foregone and narrowed. The entirety of the synergies add up to 7.3% of TSG’s revenue run-rate (and even less so on the 3 year forward revenue guide, in the year in which synergies are actually meant to be achieved) and 3.7% of the combined company’s revenues. Simply put, the synergies are a fraction of the rationale behind the deal, with cross-selling the customer file serving as the primary motivation.[13]

The fact that the back-end’s relationship with the front-end, even at the largest sports book in the world, is so “complex” is the ultimate validation of Kambi’s raison d’etre and strategy. In effect, within Flutter, you have two separate companies with little vertical synergy, relationship or cross pollination between the teams. Front-ends have fundamentally distinct skill sets from back-ends. Front-ends have customer files and marketing prowess, whereas the back-ends are the technology. The Flutter team makes it abundantly clear that the front-end and back-end are essentially two entirely different businesses. Meanwhile in the industry there is only one other back-end who can adequately service both retail and mobile needs (SBTech) and a few others who do well at retail but suffer mightily online (William Hill/IGT, Don Best, NYX). If you want the best multi-jurisdiction sports book, Kambi is essentially the only option for a high quality operator.

A look at the common-sized income statement of Kambi (a pure back-end) versus Kindred (a pure front-end) paints a clear picture of the distinct differences in the two business models:

Note the higher EBIT and EBITDA margins at Kambi, despite boasting well over double the top line growth rate, in an investment phase. The two highlighted lines are the big points where Kambi must spend more than Kindred, but importantly, these are the two lines with the most leverage on the income statement. As Kambi grows, the highlighted expenses will shrink, while Kindred will remain in steady state in aggregate. The clear difference between the front and back-end here is how the back-end invests in its human and technological capital (human capital is captured in “Administrative Expenses” where just less than half of the line is covered by personnel and personnel related expenses), while the front-end invests in marketing. This is the skill divide between the two: back-ends are competent in technology, while front-ends are competent in customer acquisition. Flutter’s emphasis on “cross-selling” with 18 references littered throughout their merger call hammers home this distinction in competency.

The beauty of the SaaS model from Kambi’s perspective is how it translates to very high incremental margins. There is very little incremental cost to onboard a new partner. Instead of charging customers a fixed fee per month, Kambi charges a take-rate on NGR of approximately 15%. We do think there will be some modest atrophy to somewhere around 13% over time as some larger customers achieve their scale ambitions, while remaining on Kambi in order to protect the front-end’s own profitability. Meanwhile, Kambi can continue to invest in product development and share the benefits of that investment with their partners. Kambi has 700 employees today, which includes 250 traders and 200 developers. The trading team is the non-SaaS piece; however, that is already at its mature size. Meanwhile, the company is recruiting more developers in order to continue enhancing the technology side. A key area within technology is risk management, where you need a higher degree of control to make sure no one has better information and better stakes. The infrastructure to aggregate, analyze and apply data is also a key area of investment. As of today, Kambi makes 450 million odds changes per month. In order to accomplish this feat, you need exceptional technology and people behind it. The investment is considerable and few, if any front-ends have the scale in order to do it on their own.

Partner with Integrity, Build Industry Knowledge:

“And the reason why is because we have that one solution and what it includes in it is about challenging mindsets, it’s about educating. And what we focus on is that second point there. Don’t turn up for meeting with the CEO or a Chairman or Board member or anyone if you haven’t got something insightful for them to take away from it. They may not buy from Kambi then, they might not buy in the next 3 years, but if they come to see Kambi, they’re coming to some get information and insight because they know Kambi really understands what they are doing. And that’s the difference. That opens doors. That’s what makes us stand out. We’re not there to just try and sell from — straight from the beginning. They will understand through our insights, “You know what Kambi knows something that we have don’t.” So even if they’ve got full trading solutions themselves internally, you go, “Hey, I really understand that Kambi could help us here, maybe we should consider things, maybe we should take more meetings, maybe we should meet the CEO of Kambi, let’s have more conversations.”[14]—Max Meltzer, Chief Commercial Officer.

“First of all, our unwavering commitment to integrity and corporate probity. Kambi is a [NASDAQ] listed company and therefore holds itself up to the highest of standards. For example, since our inception we have been careful to avoid markets where gambling is prohibited. This was a conscious and long-term decision as, not only is it the right thing to do, but we realized it was likely to be looked favorably on by regulators when moving into new territories in the future – particularly in the U.S. which has always been a key part of our long-term business strategy.”[15] –Max Meltzer, Chief Commercial Officer.

Kambi is discriminant about who they are willing to partner with and will only partner in regulated markets. This is important for both regulators and prospective partners, as their primary competitor in the pure-play back-end is not nearly as discriminant. SBTech is the company’s foremost competitor and was recently rumored to be in late stage talks to be acquired by Draftkings.  Nylen has pointed out that he “think[s] it’s positive rather than negative that we have a good competitor nowadays, and I think the market is definitely large enough for both (SBTech) of us. But so far I am very pleased that we have been able to win our top targets.” Competition offers Kambi the opportunity for differentiation and one of the key pillars has been on integrity. While some of this can change, it is notable how Kambi received an actual license as a “Sports Information Services Limited…For A Gaming Related Casino Services Industry License” whereas SBTech settled for a temporary “Qualification Waiver.”



Pennsylvania, the other large, early legalizer of sports betting on the state level gave SBTech conditional approval and cited concerns with the company’s partnership relationships that enable betting in Iran.[18] While SBTech is insistent they do not facilitate operators in Iran, their response perhaps implicitly acknowledged they know some of their operators function in what the betting world calls “gray markets”: “To be very clear, SBTech does not operate in any black markets.”[19]

Scale + Time = Compounding Advantages

The two outside lines illustrate the upside and downside tracking error representing a 95% confidence interval. The selected confidence interval indicates that on average, for 19 months out of 20, the actual return should be between the two tracking error lines.

Over time the tracking error band has become narrower, indicating that the monthly margins have become more stable. The increased stability is primarily due to a relative increase of live betting, which is less volatile than pre-match betting, and a stabilizing effect resulting from Kambi’s risk management tools becoming increasingly sophisticated in identifying and managing different customer segments.

While Kambi has not revisited this specific chart, they have shown what the daily, weekly, monthly, quarterly and annual distribution of operator margins looks like:


This is the nature of a business relying on assessment of probabilities. You can set the right probability for an outcome to happen, yet still lose. Without skill, the longer time-frames would also be random; however, with skill the longer timeframe would smooth the outcomes. That is clearly the case here. While the day-to-day can be volatile, the range of outcomes narrows as the timeframe is extended. We have spoken to industry experts, including employees at Draftkings involved in onboarding Kambi and at Kambi involved in managing the Draftkings relationship. One fundamental truth we have seen acknowledged on both sides is that Draftkings would be less profitable at their sports book and would take a period of three years before they can get their models up to Kambi’s skill and stability today. Meanwhile Kambi will continue improving, such that Draftkings would be trying to catch a moving target.

This risk management side is especially compelling. Kambi is phenomenally good at using anonymized information in order to hunt down people who are sharp betters and have figured out ways to whittle down the book’s edge. Sharp bettors find this especially frustrating and have come to facetiously call the company “Kan’tBet” for how little action they are willing to take from the experts; however, this is exactly why front-ends use Kambi. Notably, Kambi will take action from these people, but in small amounts, because learning their intents help in the process of refining their own line making.

Vegas as often been more willing to take this kind of action and the sharp bettors claim this is the fundamental flaw in the European model. Kambi brings their distinctly European model to the front-end operators they work with, even in the US. On their capital markets day, they pointed out how:

Ever since I started in 2005, we have looked at this chain being about one thing. And that’s not about margin, that’s not about accuracy and probability predictions. In the end, it is about user experience, it is about delivering entertainment. So our quant analyst, for instance, they’re not tasked with the sort of theoretical challenge of only predicting probability, they’re tasked with a challenge of delivering a fantastic experience. —Erik Logdberg, Deputy CEO & Chief Business Development Officer

Handicapping the probabilities is obviously an important endeavor, but so too is managing the user experience. Kambi does not exist to serve as a counterparty for sharp bettors. If a book consistently provides opportunity to those with an edge, the book will lose money. There are hedge funds and advanced quant strategies launching in an attempt to take advantage of inefficiencies in betting and the beauty of it from Kambi’s perspective is how the adverse selection bias of skill in risk management will ensure that those books who are not good at identifying sharp bettors will ultimately perish before the harvests of the industry landgrab are reaped.

Kambi is not resting on its laurels as a European Model innovator. Instead, the company is opening its first US office in Philadelphia, a strategic location given both Pennsylvania and New Jersey are the large, early-adopter states.[21] In keeping with management’s culture of shareholder value, Philadelphia was strategically selected for its lower costs than New York City or other technology hubs, its passionate sports fanbase and its many high quality universities offering a good opportunity set on the hiring front. The company is “ hoping to take people who have a passion for sports — maybe they’re in another business like finance or whatever — and convert that into what we need from an operational perspective — trading, risk management, sales, partner success.”[22] To date, Kambi’s progress in US markets has come without an on-the-ground premise here. The US office opened in Q2 and is in the process of staffing up. This will only help as more states legalize and regulate betting.

Adding it all up to shareholder value:

Kambi boasts large insider ownership and is operated by its founders, with a shareholder friendly management team and aligned interests. They both say and do the right things:

“Moving on to our shareholders. On top of what I’ve talked before, which is naturally also important for our shareholders, is to have a return on their investments. And one of the absolutely most important task for us, as the management team, is to have a very stringent and sophisticated approach to our capital and resource allocation with the ambition of securing a high return on investments for our shareholders.”[23] –Cecilia Wachtmeister EVP of Business & Group Functions

The company has a mandate to think long-term in capturing the large opportunity, while remaining anchored in establishing measurable, deliverable goals:

“and we have further evolved it during the last year, a very established strategy process where we set our long-term strategy on the 3 years horizon. We break that down to company performance target on a yearly basis, which in turn gets broken down into quarterly key objectives. And that gets actually broken down to departmental and team level within the company. And in that way, we’re really having the connection between what we want to achieve as a company and what is expected from each and every one of the employees. It’s a very, very solid and thought-through process. And we, as the management, we monitor this on a monthly basis how the progress is and where we are.”[24] –Cecilia Wachtmeister, EVP of Business & Group Functions

This will help innovate Kambi develop and tailor products that are more sanguine for the US sporting environment and create a local salesforce in the pursuit of partnerships.

Sizing up the TAM:

In Kambi’s 2018 annual report they offered the following estimate for global sports betting GGR in 2018 and five-year forward forecast:


Historically, Kambi has operated primarily in Europe, which is about a €20b plus GGR market. 2018 was the first year where online betting exceeded retail in Europe and this trend of growth coming from online will only continue to accelerate:


The repeal of PASPA makes the US perhaps the most compelling market and largest opportunity the industry has ever encountered. Shortly after the SCOTUS ruling, Morgan Stanley pegged their base case 2025 revenue opportunity (in this case, revenue is a proxy for GGR) by 2025 at $5 billion:


(Please note, while the above chart is in US Dollars, much of the below conversation on TAM is covered in euros given that is the reporting currency for Kambi. Pay attention to the currency, for we change from euros to dollars depending on the source). The entire regulated market globally generated €5.4b in GGR in 2018 and is expected to grow to €11.5b by 2023 (a 16% CAGR). In order to translate that into a revenue opportunity for Kambi we need to know both the average tax rate across all their regimes and the company’s take rate; however, neither is precisely knowable. We will visit the assumptions later, but for now let us work with a 20% all-in tax rate (arguably on the high side) and a 13% take rate in order to translate GGR into Kambi’s revenue TAM.

Today at €5.4b, Kambi’s revenue TAM is approximately €562m, while in 2023 that number jumps up to €1.196b. Inevitably TAM will be highly sensitive to the cadence of regions legalizing sports betting. And thus far there are pieces of evidence that show regulated market GGR could exceed expectations. We think there is a degree of conservatism embedded in these numbers and that is a good thing insofar as planning corporate strategy and analyzing risk/reward in investments goes. For example, the American Gaming Association believes the illegal sports betting market size in the US to be “at least $150 billion annually.”[28] It is incredibly challenging to size up an illegal market.

When we think about addressable market, the upside of converting a black market to a regulated market is intriguing. This is true for several important reasons, mainly built around the idea that establishing trust in a regulated market is far easier than in an illegal bookie scheme. Some people simply won’t engage in an illegal activity even if the general idea is appealing. Some people may just hold back on the actual volume they would like to play. Most importantly though is the innovation and creativity that legalizing these markets unleashes for the industry. In Europe, it is said that over 70% of all sports betting occurs “in-game” versus less than 5% of US-based action occurring in-game pre-PASPA repeal.[29] In-game creates novel experiences and relies heavily on technology ranging from challenges in data and speed to building sharp algorithms to price probabilities in real-time and managing risk, while adding a human overlay in order to adjust to rapidly changing circumstances. For example, were a starting QB to leave the game with injury, the odds of the next play being a completed pass would be drastically different than immediately before the injury. It’s simply impossible for an illegal bookie to even contemplate offering in-game betting, meanwhile in many respects, this is Kambi’s specialty. In-game betting is basically entirely novel to American sports bettors, yet in some respects, our favorite sports are perfectly suited for this opportunity.

As a result of these unknowns, the range of potential TAMs is incredibly wide. Most US analysts expect somewhere between a $7.5-12b TAM in the US, base-case, while the American Gaming Association pegs the US market size at $150b total wagers (or the equivalent of $75b in GGR).[30] We do our work based on the low end of these estimates, while viewing any upside as incremental to our expectations.


Our valuation process starts with working backward to solve for the embedded assumptions in Kambi’s stock price. At todays price of around $14.50 USD, the market is pricing top line growth to slow down to a 9% 5 year CAGR and a 10x terminal EBITDA multiple all discounted at a 12% WACC. We think these results are highly achievable, even with the loss of Draftkings as a customer. Before the US market even legalized sports betting, Kambi was growing its top line at a 13.8% rate. That growth was lumpy and was slowing in the later periods; however, its core markets in Europe as of today are still growing at ~8% GGR. Meanwhile its partners are taking share with a combination of organic and inorganic growth, supporting base rate growth assumptions of around 12%. By our estimates, the US business has contributed nearly half of 2019’s 22%+ growth rate. Draftkings has accounted for a little less than half of the US contribution.

One thing to consider in valuation is the asset value and replacement value. Kambi is a truly unique asset and management and ownership recognizes this. As such, they have a convertible note held at Kindred which is effectively a poison pill to prevent a hostile takeover attempt. Draftkings perhaps would prefer to acquire Kambi than SBTech, but no way management is selling. Meanwhile, the rumored Draftkings acquisition of SBTech quoted the prospective price tag as between $300-500 million, essentially bracketing Kambi’s market cap today.[31] SBTech is not public, so their financials are not disclosed though it is well established that they are smaller than Kambi and revenue estimates peg the run-rate at approximately $24 million USD (less than 1/3rd that of Kambi’s).[32] One other point of reference for replacement value is the price Scientific Games paid for NYX and Don Best in order to accelerate their own attempt to get into the sports betting industry. Scientific Games spent $632 million for NYX and around $40 million for Don Best, meanwhile they have no key partnerships to show for it, are suffering from employee exodus and an offering that is sub-par at best.[33]

To value Kambi directly, we rely predominantly on DCF. While Kambi does not disclose the GGR or NGR metrics for their operators, we can back into a rough approximation of the historical numbers and forecast them going forward. The key assumptions that we need to make in doing so are on the tax rate, the level of promotional activity and Kambi’s tax rate. Tax rates are the most challenging assumption here because we do not know the geographical distribution of GGR and tax regimes vary widely. Even within the US there is a high degree of variance. For example, Delaware and Rhode Island are lottos with the state getting a direct revenue share equivalent to a 50% tax rate, while New Jersey has an 8.5% tax at land-based sports books, 13% for casino-operated online sports books and 14.25% for racetrack operated online sports books.[34] Pennsylvania, another early adopter, has a 36% tax rate.[35] The UK recently raised their betting tax rate (which includes sports books) from 15% to 21%.[36] We cite these numbers here as illustrative examples. For the backwards numbers we apply a 15% tax rate to build up to our GGR estimate and for 2019 on, we use a 20% tax rate. Our purpose with this analysis is not to precisely nail down the GGR that Kambi’s partners generate, but rather to estimate roughly how much total GGR Kambi needs to capture over the coming five year period in order to rationalize our financial estimates for the company.

As for take rate, we know from triangulating around industry sources and company conversations that today they are in the mid-teens and take rates have come down modestly in the past few years. With some smaller operators, early on, take rates have been as high as the low 20s. Kambi has cited SBTech’s emergence on the competitive front as putting pressure on take rates, though the market is now approaching a degree of stability. Some of the US operators were more insistent on joint venture relationships which have an even higher implicit cost than a take rate, for even lower quality. In a lot of respects, we think of Kambi’s value much like programmatic DSPs for advertising and we would note that the highest quality operator in that sector (The Trade Desk) earns a 20% take rate. Long-term, we expect some modest degradation, though think working with an approximate 15% rate today makes sense. We take that down to 14% in 2021 and 13% thereafter under the assumption that some of the larger operators with long-term deals and little volume as of yet (like Penn Gaming) have come on with more favorable rates than the existing book of business. Here is where we think GGR has come from and where it will go:

The most important takeaway from this chart should be how much incremental GGR Kambi’s partners need to receive in order to underwrite out-year earnings expectations. In order for Kambi to compound top line at a rate just above 20% for the next five years, their partners need an incremental €1.7b, or $1.9b of GGR. That $1.9b of GGR can come from the US and Kambi’s operators. With the more mature, European online business expected to grow at ~8% annualized (5% tailwind in global GGR w/ excess capture in transition from black/gray markets to regulated) , that means Kambi partners need to capture about $1.2 billion of the US opportunity over the next five years. Given most industry estimates peg the opportunity between $7.5-12 billion in GGR over that time, that means Kambi partners need to capture anywhere from 10-16% of the US opportunity. As of today, Kambi’s market share is well above these levels. Here is how Kambi’s suite of partners stacks up in revenue share in the more mature New Jersey and Pennsylvania markets:


While we hardly expect these market shares to remain constant over time, we think with its crop of partnerships Kambi has cemented its place as a key provider in the US sports betting industry. Importantly, we see upside not just for the base case market shares, but also for the potential size of the US market. Rather than incorporating that into our estimates, we will leave any upside for optionality on top of our base expectations. Plus in effect, this “US” number we are using here is the rest of the world outside of Europe. Kambi sees great potential in Latin America and APAC though given we are less familiar with those markets and the sporting industry in general is far less mature there, we are not willing to incorporate that into our expectations.

In the investment phase of US market launches, Kambi had formerly guided to 4-6% quarter over quarter growth in operating expenses. That has been taken down this year to 3-5% growth given “in some states, it’s actually going to be slightly lighter-touch application and therefore, by implication, a slightly lower cost for us.”[39] By and large, the operating cost structure is fixed once Kambi launches in a state. As of today, the company need not hire more traders (as discussed above), with incremental investments flowing predominantly into state-by-state launches and technology. The launch costs will roll off and incremental technology investments will continue, though with benefits of scale affording more overall technology investment at a lower percent of revenues. Incremental EBITDA margins are in the mid-40 percents. We expect a low 30 percent EBITDA margin in 2019 that gradually walks up to a low 40% margin in out-years. This adds up to about 200 bps of EBITDA margin leverage per year.


For our purposes here, beyond EBITDA, we assume fairly modest leverage on technology expense (which is not incorporated into EBITDA) to the tune of 100 bps over the next five years. Pulling it all together, this is how we think about the value in Kambi:

We see a path to a 275 krona stock in Kambi, based on today’s value, which would represent 95% upside to recent closing prices. It is important to emphasize that while the model is close to a straight-line CAGR, the reality for Kambi will be very different. Embedded in here are assumptions on future states legalizing and then regulating betting, including California. Consequently, there will be considerable lumpiness to the actual path. Additionally, sports betting itself is cyclical, with notable spikes around major events like the World Cup and varying degrees of interest in events like the Super Bowl depending on the teams involved. The key takeaway is what the company will likely look like in 2024 once more states have had the opportunity to legalize and regulate sports betting and the United States becomes the most important global market for sports betting. In order to achieve the run-rate we would apply our 15x EBIT multiple (equivalent to 10x EBITDA), Kambi would need to capture the $1.9b of incremental GGR, $1.2b of which comes from the US.

If the US market does not develop as contemplated, the stock today trades at reasonable values. Growth will still register low double-digit levels, on near all-time low multiples at 3.25x EV/2020 S (see chart below) and EBITDA margins registering in the mid-30s. Multiple expansion is unnecessary for a good return, for the company’s top line and cash flow generation would support where the stock is trading today:

The adverse scenario in the US market would still result in a stock that is undervalued on DCF, cruising along as a rule of 40s SaaS operator with long-term margin leverage. The core sports betting market globally continues to grow at about 5%, with the dual uplifts of regulatory acceptance and digitization enabling a better, more engaging experience.

Risk factors:

  1. Competition. This can come either from new entrants in B2B or more large suppliers buying or building their own backend. SBTech in particular competes with a broader suite of services including marketing services and digital casino games, while Kambi operates as a pure sports operator.[41] IGT in the US packages in their sports offering with slot machines. Neither boasts the quality of Kambi; however, both use other levers to try and capture their share of the sports business.
  2. Regulation. This can manifest in several ways. States can be slower to legalize sports betting than expected. States (and countries) can also be more aggressive on the tax front. The impact of taxes hits twice. Taxes factor directly into the calculation of odds, so higher tax rates make odds less favorable, which translates to lower betting volumes, plus operators must give up more of that volume.
  3. Integrity fees. Leagues are strategizing on how they can monetize betting and while no outright integrity fees have been demanded from US leagues there are intimations that leagues will use data in order to grab their cut.[42] Kambi passes these costs on to front-end operators; however, this could negatively impact aggregate GGR.
  4. Customer concentration. Kindred Group is an especially large partner globally while Draftkings is a large US partner. Kindred risk is mitigated by virtue of the corporate history, a shared concentrated owner in Anders Ström and a long-term partnership agreement.

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

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

[1] https://www.law.cornell.edu/uscode/text/28/3704

[2] https://www.legalsportsreport.com/18718/nj-sports-betting-case-2/

[3] https://www.reuters.com/article/us-usa-betting-draftkings-new-jersey/draftkings-launches-mobile-sports-betting-in-new-jersey-idUSKBN1KM60H

[4] https://www.bloomberg.com/news/articles/2019-08-23/draftkings-soaring-legal-betting-shows-how-big-gambling-can-be

[5] We strongly recommend reading The Logic of Sports Betting by Miller and Davidow for anyone looking of a detailed overview for how sports betting itself works, what kind of bets are possible and how sports books make their lines.

[6] https://twitter.com/darrenrovell/status/1165583562025951232

[7] https://www.law.cornell.edu/uscode/text/18/1084

[8] https://www.wsj.com/articles/mobile-sports-betting-is-the-moneymaker-as-more-states-legalize-11567445689

[9] Kambi Capital Markets Day, Sentieo.

[10] https://www.pennbets.com/kambi-interview-max-meltzer-sports-betting/

[11] Kambi Group PLC Capital Markets Day, May 20, 2019. Sentieo.

[12] Edited Transcript of Flutter Entertainment PLC M&A conference call presentation, October 2, 2019, Sentieo.

[13] https://www.flutter.com/sites/paddy-power-betfair/files/documents/Investor-Presentation.pdf

[14] Kambi Group PLC Capital Markets Day, May 20, 2019. Sentieo.

[15] https://www.pennbets.com/kambi-interview-max-meltzer-sports-betting/

[16] https://www.nj.gov/oag/ge/docs/Petitions/2018/06152018.pdf, page 8.

[17] https://www.nj.gov/oag/ge/docs/Petitions/2018/04302018.pdf, page 4.

[18] https://floridianpress.com/2019/04/online-gaming-company-could-have-business-ties-to-iran/

[19] https://www.vegasslotsonline.com/news/2019/06/19/oregon-pay-27m-controversial-sports-betting-operator-sbtech/

[20] Kambi Capital Markets Day – May 20, 2019

[21] https://www.inquirer.com/business/sports-betting-bookmaker-kambi-sets-up-shop-philadelphia-sugarhouse-parx-20190708.html

[22] Ibid.

[23] Kambi Capital Markets Day, May 20, 2019. Sentieo.

[24] Kambi Capital Markets Day, May 20, 2019. Sentieo.

[25] https://www.kambi.com/sites/default/files/Documents/Annual-Report-2017/Kambi%20Group%20plc%20Annual%20Report%202018.pdf page, 19.

[26] https://www.kambi.com/sites/default/files/Documents/Annual-Report-2017/Kambi%20Group%20plc%20Annual%20Report%202018.pdf page 19

[27] “US Sports Betting: Who Could be the Winners?” Morgan Stanley Research. June 26, 2018. Page 6.

[28] https://www.americangaming.org/new/97-of-expected-10-billion-wagered-on-march-madness-to-be-bet-illegally/

[29] https://www.si.com/mlb/2018/10/11/ryan-howard-sports-betting-game-app-investments

[30] https://www.americangaming.org/new/97-of-expected-10-billion-wagered-on-march-madness-to-be-bet-illegally/

[31] https://ayo.news/2019/07/01/draftkings-about-to-fully-acquire-sbtech-for-up-to-500m/

[32] https://www.zoominfo.com/c/sbtech/348729494

[33] https://www.reuters.com/article/us-nyx-gaming-group-m-a-scientific-games/scientific-games-to-buy-nyx-gaming-in-c775-million-deal-idUSKCN1BV1Q9

[34] https://www.thelines.com/betting/revenue/

[35] Ibid.

[36] https://www.onlinepokerreport.com/32913/uk-gambling-tax-increase/

[37] https://www.playpennsylvania.com/sports-betting/revenue/

[38] https://www.playnj.com/sports-betting/revenue/

[39] Kambi Q2 2019 Earnings Call, Sentieo.

[40] Sentieo for historical financial data and RGA Investment Advisors for estimates.

[41] https://sbcnews.co.uk/partners/sbtech/2018/02/01/richard-carter-sbtech-solving-mansions-vertical-challenge/

[42] https://www.bloomberg.com/news/articles/2019-08-12/nfl-takes-first-major-gambling-step-with-sportradar-data-deal


Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Q2’2019 Investment Commentary

The second quarter was a little choppier than the first quarter, with an upward bias in the end. Markets largely spent time digesting the magnitude of the moves from the fourth quarter of 2018 and first quarter of 2019.  Amidst the choppiness there was indeed one notable happening of market consequence:

The chart above shows the spread between the S&P’s equity risk premium as measured by the S&P’s current earnings yield (in other words, E/P, the inverse of the market’s P/E ratio) minus the 10-year Treasury Yield. Although “the market” as measured by the S&P traded pretty sideways during the quarter, during the brief June selloff, the market’s equity risk premium hit its second highest level in the past three years and reached levels seen mainly in the wake of the Great Recession. As the third quarter is now underway, this rise in the equity risk premium has only gotten more extreme, measuring near the highest levels in the past five years.

With the market trading sideways, it is clear that one variable alone drove the majority of the rise in the equity risk premium: The 10 Year Treasury Yield. The 10 Year Treasury yield started the quarter at around 2.4% and reached a low of 1.95% in June.  As Charlie Munger once observed: “Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics.” Since all of us investors exist and operate in the real world, we constantly must weigh various investment options. When the equity risk premium is high, the opportunity cost of bonds relative to stocks is high and thus investors in aggregate are incentivized to put money to work in equities. This will be especially notable come quarterly rebalance when the huge pool of assets in 60/40 strategies kick in the self-calibrating trade of selling bonds to buy equities and restore equilibrium. Approximately 7% of bond exposure in such strategies must be sold in order to buy 4% more stocks.

It is important to emphasize that our investment decisions are made on a bottoms-up basis. In other words, we do not look at the market on the whole and say “are stocks in aggregate cheap? If so, let’s invest.” Our process is on a security-by-security basis, whereby we deeply analyze a business’ management, industry, moat and valuation in order to come up with an investment thesis. That said, we always like being conscious of our environment. When the equity risk premium is high, we are far more sanguine on the broader opportunity set than when it is low.

A thought from Elliot:

With baseball season in full swing now seems like an opportune time to visit one of my favorite setups in the market. In fantasy baseball there is this category of player called “the post-hype sleeper” that I find appealing. A post hype sleeper is defined as a “player with minor league pedigree who [has] failed in limited major league time.”[1] When the player is called up, fantasy baseball players draft him with enthusiasm, paying for value that is expected to be realized instantly. Instead, as often happens, there is a developmental curve and many players take a little extra time to mature into big league readiness. In a rut (whether an instant slump or a “sophomore slump”) the player’s value in the eyes of the fantasy baseball community erodes.

While some players ultimately never live up to their pedigree, there are others who make meaningful improvements in their true skill level and build a foundation for enduring success in the Major Leagues. Fantasy baseball players can draft these truly skilled players for far less in the wake up the slump than beforehand and are thus called sleepers for how the new Major Leaguer holds the potential to surprise expectations to the upside. There is an analogous setup we look for in equity markets that takes shape in an individual asset, as follows:

  1. A big following and a lot of momentum based on what could be in the future.
  2. Internal metrics of the company’s performance all continue to move in a positive direction.
  3. Despite the company’s intrinsic value rising, the pace of advance is slower than what investors were looking for, or some kind of headwind emerges.
  4. Momentum evaporates and leads to a sharp, rapid plunge in the company’s share price.
  5. The momentum overshoots to the downside, while business performance continues moving forward.
  6. The stock is not cheap enough to be a deep value investment, and it too recently burnt momentum/growth investors to regain their interest.
  7. The stock price has leveled off into a range of apathy for an extended period of time.

A good friend loves explaining how “the market has a problem with accelerating revenue” because people simply do not know how to value such companies. This is why Mr. Market tends to overshoot to the upside when things are giddy. The post-hype sleeper is a corollary of this idea, because accelerating revenue does not level off at a plateau, but rather drops off and must find a new range or equilibrium. The process is sloppy and just as the market overshoots to the upside, so too does it overshoot to the downside.

Post-hype sleepers come in many forms in the stock market, but busted IPOs are perhaps the most fertile hunting grounds to seek out such opportunities. IPOs tend to be sold to the market amidst a drumbeat of positive momentum and news that results in a high multiple on the stock. The problem with a high multiple is how challenging it becomes for the company to meet expectations. When an inevitable disappointment hits the market, the stock drops considerably and the multiple contracts accordingly.

Just like in fantasy baseball, it is important to figure out which of these busted stocks has the potential to forge a sustainable future of value creation. To that point, we look to operate in situations that are nuanced in contrast to those that are binary. In other words, we are not looking for situations where the company will either be wildly successful or flame out, but instead we want situations where the question the market is grappling with is “to what extent will this company succeed?” This is a key distinction and part of what we rely on as our “margin of safety” alongside our qualitative analysis of the business, the industry and the management team.

Number three in our list above is thus crucial and what could be called the essence of the entire setup. If intrinsic value is not increasing, we will not give the company our time of day—such a company would be a turnaround, not a post-hype sleeper. The ideal company in this setup also tends to be an asset in its own right, whereby at least a portion of the value can be attributable to strategic value in an industry or vertical. From the perspective of analyzing the distribution of possible returns, strategic asset value provides both a put option and call option to the holder. If the nuanced question about growth rate is not answered quickly and the stock price drops, strategic buyers might step in quickly. Should the market experience a drawdown with little change to the company’s specific fortune, opportunistic buyers would enthusiastically swoop in. Therein lies the put. On the call side, strategic buyers are often willing to pay a significant premium to the outright earnings power of the asset. This can pull forward returns and enhance IRRs in the process. We do not bank on M&A and often prefer the opportunity to hold such companies for the long run; however, we appreciate the role that the M&A option plays in assessing the range of possible outcomes.

Often the pivotal question in such companies is surrounding the mid-term growth outlook, as a company’s 20+% revenue growth rate heading into IPO slows to the high single digits or low teens. We can apply our suite of valuation tools and triangulate what we think is a fair price for the company, analyze the likelihood of a growth re-acceleration and think about what a worst case would look like amidst a longer-term stagnation in the growth outlook. If a growth re-acceleration does not arrive, we should have a decent IRR; however, if it does we might end up owning something very special. To date, all our five best returns have emerged from this exact stock market setup.

Elliot recently had the privilege to present at the MOI Global Wide Moat Investing Summit. This year’s presentation was on Grubhub and introduced with the post-hype sleeper setup. You can watch the presentation here (https://moiglobal.com/elliot-turner-201906/) and see the slides at this link (https://moiglobal.com/wp-content/uploads/moat19-elliot-turner.pdf). As of this writing, we own nine positions that we regarded as post-hype sleepers at the time of our entry. Several on this list are no longer sleepers with the market appropriately recognizing the value, while for the rest the verdict remains out.

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

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

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

[1] https://www.espn.com/fantasy/baseball/story/_/id/26054216/fantasy-baseball-post-hype-sleepers-2019

Q1’2019 Investment Commentary

We’d like to take a moment, ahead of our investment commentary, to share some exciting happenings within our investment practice. Our firm has come a long way since its inception a decade ago with our deliberate effort to improve on every aspect of our business, from our technological infrastructure to our research capabilities and investment process.

Our commitment to continuous improvement runs deep in our DNA and we consistently strive to be the best investment managers possible, while knowing that tomorrow we will be better than we are today. Over the past five years we have invested heavily in our research capabilities by accessing financial data terminals, joining industry round tables and adding to our already robust roster of investment research publications. One of our financial data platforms put together a case-study on our firm which provides a window into how we leverage technology to create efficient workflows to analyze large amounts of company data. Sentieo’s write-up on us can be viewed here.

In 2015 we chose to become a GIPS verified firm. This enormous undertaking stress-tested every aspect of our business, from our compliance requirements to investment policies and procedures. Adherence to these standards, which are widely regarded as the gold standard in fair representation and full disclosure of a firm’s investment performance, afford us the ability to operate a truly world-class asset management firm. You can review our firm-wide verification letter and annual disclosure presentation results here.

This year, after considerable searching, we are excited to announce the first expansion our team with the addition of Ari Lazar. Ari comes to us from Lincoln International in Chicago where he worked as an Analyst in the firm’s Valuation and Opinions Group. In his previous role, Ari provided valuation coverage for the investment bank’s clients across a variety of industries and in doing so, developed a robust set of industry knowledge and equity analysis skills. Ari is a CFA Level II candidate with deep rooted intellectual curiosity and a passion for investing — his new role with us is what he has dreamed of doing since learning about the stock market as a child. He will be right at home here at RGA. Ari has already contributed considerably to our research endeavors since his March 1st start date. Ari works primarily out of our Stamford, CT office. He can be reached at 516-600-0200 or at ari@rgaia.com

As we look back in awe at the progress we’ve made over the past ten years, we couldn’t be more excited to embark on this next leg of growth. Our first hire is crucially important to us as it sets a precedent and perpetuates a culture of integrity, inquisitiveness, and collaboration. We couldn’t be more pleased with our new addition and we are confident that you will agree.

What a difference a quarter makes:

It is hard to put into words the contrast in action between the fourth quarter of 2018 and the first quarter of 2019. As 2018 drew to a close, markets were searching for a bottom to three months of selling pressure that drew parallels to some of the worst episodes of market history, including the 1987 crash. While we concluded our macro overview in our year-end commentary with a “what if we go into a recession in 2019” section, as of today, two key catalysts have lessened the perception of that risk. First, and most important, the Federal Reserve Bank shifted its rate path from hiking to an extended pause, and second, earnings reports and guidance for the full year 2019 were fair with modest weakness in the first half outlook offset by strong expectations for the second half of the year.

When the Fed hiked interest rates in December of 2018, many were left wondering whether they were intentionally trying to invert the yield curve and tip the economy into a recession to ease some of the tension in labor markets and prevent the economy from overheating. This was a fair question since the typical recession in the post-Depression US Economy was the result of Fed tightening in the face of rising inflation. Between the end of December and the Fed’s meeting in late January, it became clear that the Fed did not explicitly want to bring on such a recession. Fed members immediately commenced their public relations efforts to ease these concerns when the market reacted harshly to the December hike decision and these concerns were put to rest with the Fed’s (in)action in January to keep rates unchanged while removing their language about more rate hikes being necessary and adopting a more flexible stance on the balance sheet wind-down.

During the first quarter, as stocks rose and earnings reports came in largely in line with expectations, the analyst consensus for first quarter earnings kept dropping lower. Per FactSet, “the first quarter marked the largest percentage decline in the bottom-up EPS estimate over the first two months of a quarter since Q1 2016 (-8.4%).”[1]

Source: FactSet[2]

This trend left many frustrated. In hindsight, what becomes obvious is that heading into the quarter, markets “discounted” the impact lower earnings would have on stocks in aggregate and priced that in. Outsized moves in markets (whether it be individual securities, indices, currencies, etc) never result from one catalyst alone. There is however one behavioral constant: the path of incremental information becomes disconnected from the state of expectations. This is the Mr. Market in Benjamin Graham’s famous parable. When the direction of the news is increasingly good, Mr. Market’s enthusiasm grows. Conversely, when the flow of information gets worse, Mr. Market’s enthusiasm turns into despair. Typically, Mr. Market is most euphoric at peaks and most depressed at bottoms, where the incremental information can only surprise insofar as it’s “less bad” than before.

A Thought from Elliot

Of the many powerful lessons learned from reading “The Snowball: Warren Buffett and the Business of Life” by Alice Schroeder in 2016, one subtle takeaway continues to emerge in my semi-regular musings. Warren Buffett’s grandfather owned and operated Buffett & Son, a grocery store where a young Charlie Munger had worked as a clerk. Schroeder wrote about it within the following context:

Buffett & Son was a direct descendant of the oldest grocery store in Omaha and Ernest’s demanding ways were all in pursuit of an ideal vision of service to his customers. He felt certain the discount national chain stores that were encroaching on the neighborhoods were a fad that would disappear because they could never provide a comparable level of service. Sometime during this period, he wrote confidently to one of his relatives: “The day of the chain store is over.”[3]

Today’s supermarkets all build around a layout which was introduced around this time, where you enter the store in the produce section, travel through the packaged goods aisles and finish collecting items in the dairy and egg shelves. In the pre-WWII America, a grocery store was completely different. As a fascinating blog post about “Grocery Shopping in the 1920s” explains, instead of walking through the aisles and selecting produce for oneself, “In the early 1920s, the customer approached the counter, made a request, and the clerk selected the merchandise for the shopper. Much of the merchandise was kept behind the counter.”[4]

In fact, the customer rarely, if ever handled any product until they were in the comfort of their own home.


Ever since the rise of the Internet, people have mused about the eventuality for Internet-driven delivery, but interestingly the grocery delivery model is an old idea that worked incredibly well within a certain model. The key technology facilitator for delivery in groceries was the telephone. When competition emerged from the early incarnation of the modern supermarket, the town grocer, as Ernest Buffett lays bare, relied on their relationship and customer service as key points of differentiation. As we now know today, lower prices ultimately won out over personal touch and convenience.

Although the town grocer lost out to the scaled supermarket, embedded in the old model is an interesting concept worth exploring. The grocery, as a customer-service centric model conferred a high degree of trust on the grocer himself (back then they were mostly men). The customer service principle included the job of curator. It was the grocer’s responsibility to select the products that checked off the everyday needs of his customer. When a customer called in an order the ask would be for “bread, cheese, soda, a can of beans and toilet paper” in reference to the generic.

The transition to a grocery shopping experience that empowered customers to walk the aisles and select their own products would not have been as simple without the concurrent emergence of brands like Coca-Cola, Kellogg’s and Kraft in the supermarket. The rise of the supermarket aisle saw bottled Coca-Cola overtake fountain sales fueled by the six-bottle carton, the introduction of ready-to-eat cereals from Kellogg and the launch of a powdered beverage named Kool-Aid from Kraft. Given Mr. Buffett’s proximity and familiarity with the fall of the local grocer and rise of the mass supermarket, we perhaps have an explanation for his infatuation in branded CPG like Coca-Cola and Kraft, two names which populate Mr. Buffett’s portfolio today. Brands were the most important shortcut in helping customers navigate the aisles of the supermarket. In other words, there would have been no empowerment absent the power of brand. To that end, brands subsidized the very existence of the supermarket and the resulting relationship was thus symbiotic.

Many have observed that often what’s old becomes new again, and new old. While the Internet has yet to unleash scaled grocery delivery, we can muse about the effects that the online world already hath wrought on brands and one of the biggest consequences is the reemergence of a layer of curation which dilutes the value of brand. There are many great writings on the impact the Internet has had on brands, but we find the history in thinking about this story interesting for analyzing who will win and lose today. To that end, there is one kind of company we are increasingly enamored by for how it fills a vital role in today’s ecommerce landscape: the app that owns the customer. An abundance of really high-quality companies are emerging to help consumers navigate a fragmented ecosystem, full of friction with little differentiation.

A few verticals where we have specific investments include payments (PayPal), content (Roku, and Disney going DTC), home services (IAC, specifically the HomeAdvisor vertical) and food delivery (Grubhub) which we will cover for the remainder of this letter. Each of these referenced companies owns the customer in some way, where customer’s decision-making process starts effectively in-app and leads to a kind of transaction. It is interesting to contemplate the economic reality of a food delivery order placed by searching “Pizza hut delivery” with explicit intent versus an experience that starts with a hungry diner opening up the Grubhub app, given some of the limited screen real estate anyone has on their phone, and browsing through a list of restaurants organized by a combination of proximity, paid targeting (the restaurant giving up a higher take rate) and a diner’s historical preferences. Explicit intent brings little value to the restaurant with no likelihood of incrementality, while owning the customer in app and sending them to a restaurant premised on curated taste is uniquely valuable. Keep this in mind as a point of context while we discuss our investment in Grubhub.

Mr. Market Delivers Time and Again

One of the best positions in our firm’s history, which inadvertently has neither been written up nor presented, though has been discussed in depth with many of you is Grubhub. While our portfolio had a great start to 2019, Grubhub also happens to have been our worst stock in the first quarter. From the first day we bought shares in the company, it has been one of our most controversial positions. We bought our first shares in January of 2016 and from there the returns look stellar; however, over the past six months, shares have shed over 50% of their value.

Grubhub and its SeamlessWeb division (hereinafter we will simply refer to Grubhub) are collectively the patriarchs of the Online Delivery Provider business model. The two brands started as pure online marketplaces, built to connect diners with restaurants for a fee (the take rate). Diners place their orders online at Grubhub, after which restaurants receive a fax detailing the order, manually enter their acknowledgment of receipt of said order, then deliver the food to the diner’s door. As a pure marketplace, Grubhub was just a middleman, collecting its generous take rate in exchange for connecting restaurants to incremental sources of demand and simplifying the process for consumers.

Own the customer, build your TAM:

In building its business, Grubhub removed two crucial pain-points in the food delivery process for consumers. First, consumers often didn’t know all the delivery options in their area and what each had to offer. Grubhub gave a platform through which restaurants could share this information and strategically purchased Menupages in order to improve their own access and awareness to this crucial piece of the puzzle in an effort to drive its salesforce in the right direction. Second, calling in an order was prone to error and in high-volume restaurants, subject to repeated busy signals. For a diner to painlessly click in their order online and know reliably that it will arrive without error was a big change. Grubhub’s success on these two fronts conferred important power on the company as a source of demand generation for restaurants. The site became a hub through which hungry diners commenced their search for food delivery and consequently, while most expected Grubhub’s take rate to compress over time, it actually rose as the company added in the capability for restaurants to offer more take rate in exchange for a higher listing in a diner’s search.

So successful was Grubhub in removing key delivery frictions that in the process, the diner appetite for delivery grew alongside the company itself. When Grubhub started, its opportunity was converting phone orders to online and the total addressable market was clearly defined in that sense; however, as Grubhub proved tremendously successful, the opportunity grew to include shifting a bigger portion of restaurant consumption generally to the online ordering world.

This is all amidst the backdrop of a huge shift from “food at home” to “food away from home,” best demonstrated by this chart shared with us by a sharp analyst:

Source: BLS CPI data, Bloomberg

Making a S***** Business Yummy:

When we first commenced this position, Grubhub shares were weighed down by the emergence of the turnkey delivery business and well-capitalized competitors with no imminent profit mandate like Uber and Amazon entering the delivery business. Pure marketplaces are phenomenal businesses, with high profits and little capital necessary to support the business. With well-capitalized competitors offering to do delivery for restaurants in exchange for a higher take rate, Grubhub was hit with a tough dilemma: do you stick with the marketplace and subsist on your lush economics or do you build your own turnkey operation and expand the platform’s offering?

Grubhub, led by CEO/founder Matt Maloney and CFO Adam DeWitt chose the harder, but more ambitious path of launching their own delivery business. At the time, Maloney called delivery a “s***** business” and lamented that “I’m running my delivery-based business with the explicit goal to break even. That’s not fun for me, and normally I’d say that’s the dumbest business you could ever be in. Why run a break-even business? That’s a pain in the butt.”[6] Grubhub was all-in on this plan in 2015 with the acquisition of three regional delivery services (RDS), commencing its own investment plan and the hire of Stan Chia from Amazon to run operations and logistics for delivery. While Maloney did indeed call delivery a “s***** business” what he meant is that on delivery itself, there would not be much room to generate a margin, even with Grubhub’s scale advantage over both venture-backed and well-capitalized competitors.

It just might be that delivery when added to a marketplace is a better business. Delivery is effectively a three-sided marketplace, which connects diners (first side) to restaurants (second side) via an independent contractor driver (third side). Maloney’s vision was that if delivery could run at break-even, then Grubhub could continue to earn its marketplace margin on the “demand generation” piece. The take rate for a restaurant on the pure marketplace side is around 15%, while the take rate for one who uses Grubhub’s fleet of driver’s is 30% plus a$2 delivery free. Think of this 30% as two separate pieces—15% for the demand generation piece, 15% for delivery. It thus became Grubhub’s imperative to squeeze the cost structure of its delivery service into 15% of the average order. In doing so, 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.

The introduction of EBITDA per order parity was important in setting expectations, because as delivery increases as a percent of gross food sales (GFS), revenue grows faster than before (due to the 2x take rate), while margin is suppressed. EBITDA per order thus gave us analysts a way to track the company’s progress on monetizing orders, in contrast to modeling out revenue and margin assumptions that would now be dis-anchored from past trends. The economics break down as follows:

We note that Grubhub’s delivery take rate of over 30% is far superior to UberEats’ comparable take rate of under 20%, due to UberEats over reliance on McDonald’s as a source of demand at extremely low take rates. Per Uber’s S-1: “the large chain relationship we charge a lower service fee to certain of our largest chain restaurant partners on our Uber Eats offering to grow the number of Uber Eats consumers, which may at times result in a negative take rate with respect to those transactions after considering amounts collected from consumers and paid to Drivers.

In Grubhub’s Q4 2017 earnings report in February 2018, management declared its achievement of “economic parity” between marketplace and delivery alongside its most important strategic partnership to date: Yum! Brands, owner of KFC, Pizza Hut and Taco Bell invested $200m in exchange for a ~3% equity stake with the two set to rollout a nationwide partnership with Grubhub providing delivery services to Yum’s subsidiaries and its franchisees. The relationship with Yum was about more than just bringing Yum on platform. With proven economic parity in their existing model, Grubhub was able to use their lessons learned along the way, leveraged with the Yum platform in order to expand their delivery business from what had been exclusively first tier cities to second and third tier cities. As Maloney explained, “by leveraging our chain partnerships, where they[Yum] have a lot of footprint and a lot of excitement where they can see your [sic] more growth, we can kind of create those anchor tenants and then we fill out the mom-and-pops as we continue to expand our market coverage in these nascent markets.”[7]

For any new delivery market launch, Grubhub had to foot certain overhead expenses (like driver subsidies) in order to ensure enough scale is in place for where delivery volume would go, even before the demand is evident in the market. Yum’s national footprint of brands helps bring the demand necessary in order to justify the cost of starting in these less dense markets. This leaves open a key question: if Grubhub has been a “demand generation” platform historically, what would the economics with Yum look like? CFO Adam Dewitt explained as follows:

“It’s impossible to think about just the economics of the Yum! deal without thinking about the value of the advertising that we’re getting, the value of the cobranding that’s not explicit, that’s more implicit, the new diners that we’re getting, the value of the — the value of just having the brands on the platform and driving new diners. And so you need to take all that into consideration, and we still think that — we still feel really good that over time, even in the kind of short to medium term, you’re not going to see a detrimental impact to EBITA per order related to the Yum! deal or other deals.”[8]

Yum, with its big brands and marketing prowess accomplish the following for Grubhub:

  1. Help with customer acquisition by introducing new diners to the platform
  2. Support brand marketing for Grubhub alongside the Yum brand names with paid marketing on TV and a branded presence in each of the restaurants.
  3. Bring enough demand in order to justify the cost of operating a delivery network in cities that don’t have the same scale and density of New York and Chicago.

Yum effectively introduced a third key pillar of the Grubhub business model beyond marketplace and delivery—a white labeled, outsourced delivery and technology partner. Whereas Grubhub gets compensated for “demand generation” in marketplace or delivery, with a large chain partner Grubhub gets a take rate but also builds the website, the app and handles delivery in addition to the benefits of scale and awareness that come with a large chain’s marketing prowess. As Dewitt explains, “in aggregate, that we get to an EBITDA per order that is not significantly accretive or dilutive, and instead, just adds a lot of growth.”[9] If Grubhub could support Yum “at cost” with its take rate (a secret between the two parties), then the company’s insistence that the deal would be “EBITDA per order neutral impact” would require the scale benefits provided by chains to drive down its “operations and support” costs per order and the halo of the Yum brand portfolio to lower customer acquisition costs and boost lifetime values for Grubhub diners.[10]

Despite the vague economics, investors were initially enthusiastic. Enthusiasm gave way to doubt in the fourth quarter of 2018 when the rollout of the new delivery markets was slower than hoped and with a series of large funding transactions for Doordash on the heels of its reemergence from near demise. With a huge influx of cash, a growth mandate blessed by Softbank with profitability an afterthought and a series of aggressive tactics, like selling non-partner restaurant food, skimming tips from drivers and positioning smartly in Google’s new “delivery” console Doordash was able to quickly take share.[11] [12] This raised concern about Grubhub’s first mover and scale advantages and the captivity of customers to any of the delivery platforms. By some accounts, Doordash overtook Grubhub in aggregate US market share during the month of March in 2019.[13] While this may be the case, there are four important reasons why aggregate market share is misleading:

  1. The market is growing rapidly and even in seemingly losing share, Grubhub is growing alongside the delivery market itself.
  2. A lot of the growth is coming from Tier 2 and 3 cities, where Doordash launched first, meanwhile core existing markets remain far more stable than aggregate market share data would have one think.
  3. Doordash services “non-partner” restaurants whereby the company earns no take rate and marks up menu prices at the diner’s expense in order to cover the cost of the delivery. Many of these restaurants don’t know they are listed on Doordash nor do some of them want to be.
  4. An unknown but meaningful portion of Doordash’s “market share” comes from non-restaurant deliveries, most notably their Walmart This is a good “last mile logistics” business, but is not comparable to GFS at Grubhub.

Competition puts opportunity on our plate once again:

We must confess that the rise of Doordash caught us by surprise; however, we think the fears surrounding Grubhub are as much about the swinging of Mr. Market’s pendulum from euphoria to despair as they are about Doordash or Grubhub itself. The market took the Yum partnership and subsequent acquisition of LevelUp (which we could spill much ink on, but will spare you for now) to such an optimistic extreme that the stock became setup to fail. The launch in tier two and three cities happened alongside Doordash’s ascent and analysts were challenged to figure out whether the EBITDA per order decline across the business was the result of operating nascent markets sub-scale or the influence of competition driving down core economics. In the Q4 2018 earnings call, management shaped expectations as follows:

“We expect adjusted EBITDA and EBITDA per order to increase throughout the year as we gain efficiencies in the newer delivery markets, start to get increasing leverage from the recent marketing and technology investments and achieve general operating leverage as we continue to grow.

As a result, we expect to exit the year generating EBITDA per order much closer to our third quarter 2018 rate of $1.57 than our fourth quarter ’18 rate of $0.98. If you take our 2019 order volume and apply the third quarter of 2018 level of EBITDA per order, it implies that the business would generate $40 million to $50 million in EBITDA above our full year guidance for 2019. So when considering 2020 and beyond, we believe the base EBITDA from where we’ll continue to grow should be closer to that figure than our full year 2019 guidance.”

With sentiment now squarely reset, the risk reward in the stock is as good as it has been since November 2016. There have been several key catalysts since then that have enhanced the company’s advantaged position and some setbacks. They key variables to follow on this thesis are the rate of net new diner additions and operations and support as a percent of delivery revenues. Net new diner adds continue at a robust rate and while competition is forcing customer acquisition costs upwards, the lifetime value to customer acquisition costs remain robust for the company. Further, Yum’s co-branded marketing efforts with Grubhub only kicked in during the first quarter. Consequently, we have so far only seen the impact of the costs associated with supporting the Yum partnership (sub-scale utilization in nascent markets) without seeing any of the benefits. We think management’s perspective here is smart. Maloney summarized it as follows:

“If we wanted to grow at a slower pace, if we wanted to grow similar to what we are doing in the first quarter or the second quarter last year, we could add $20 million to $30 million EBITDA right now, but this is the right choice for the business long term, right. We have — as I mentioned in the call, we’ve accelerated our DAG growth every quarter for the last 5 quarters with a couple hundred basis points consecutively for the third quarter and fourth quarter.”[14]

With this stock trading at 4.40x consensus 2019 sales estimates, the market is implying that growth will slow and future margins will be well below the “economic parity” margins the company generated just one year ago. In fact, this is the lowest price to estimated sales in the company’s history since going public. The Q4 2015 P/S dip below 5x coincided with skepticism surrounding the initial launch of the delivery business.

As Maloney and team executed on achieving profitability goals, the multiple expanded. We see many parallels to late 2015 when looking at the following chart:

Source: Bloomberg

We find market cap to forward GFS an especially insightful and important valuation metric:

Source: Sentieo, RGAIA

EBITDA to gross food sales has hovered around 4.5% historically and as such, a consistent market capto forward GFS is an expression that the economic value Grubhub extracts per dollar of GFS will remain consistent over the long-term. At today’s market cap of around $6b and expected GFS of around $6.4 billion in 2019, the stock is trading below a 1:1 ratio. At around a one ratio, an investor could reasonably expect to earn a return commensurate with the growth of GFS over a holding period, assuming economics stay consistent. In our fairly conservative estimate for GFS, which notably excludes any economic benefit from LevelUp, we expect a 15% compound annual growth rate (CAGR) over the next three years and around 14% over the next five years, with exit growth beyond that period expected to maintain growth rates into the double digits. We think there is the reasonable opportunity for EBITDA/GFS to improve over this time period, which would be accretive to returns, though we are not underwriting the position under the presumption this happens. The biggest opportunities in improving EBITDA/GFS stem from leveraging the Sales & Marketing. Technology the Operations and Support expense lines over time.

In many respects, we view this situation as analogous to buying Booking Holdings (Priceline Corp) when it was at a similar revenue run-rate in 2006, only better (for added color, consensus expects 36% top line growth for Grubhub this year, vs 17% growth for Booking in 2006). Grubhub is similar to Booking back then, in how there are questions about competition from well capitalized players and industry incumbents and general frustration with the high fees the platform was able to generate their respective merchant bases. The similarities are deeper in how Grubhub and Booking each earn the majority of their economics off of an incredibly fragmented customer base (in Booking it’s the largely independently owned European boutique hotels, while with Grubhub it’s the independent restaurant landscape). Grubhub is superior is how the company owns the customer with its presence at the top of funnel where search and discovery commence, while operating in an area where the frequency of interaction with the company is far more regular. Booking unfortunately must reacquire customers each time someone plans travel, which for many customers happens only once or twice a year. Booking merely offers both parties the removal of friction, Grubhub offers demand generation as an added layer and thus should earn superior economics in the very long run. Notably, Booking was able to grow its top line at a near 24% CAGR since 2006—a span of twelve years. If Grubhub’s high growth time period could meet Bookings, even if at a much lower rate, the returns to long-term holders would be incredibly attractive. In our DCF, we think the mid-$80s per share is justified today. Each year we increase our forecast period beyond year five adds upwards of $30 in expected value. This goes to demonstrate just how important the company’s ability to extend its high growth period before reaching terminal value will be in driving long-term returns.

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

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


[1] https://insight.factset.com/largest-cuts-to-sp-500-eps-estimates-since-q1-2016

[2] https://insight.factset.com/largest-cuts-to-sp-500-eps-estimates-since-q1-2016

[3] Schroeder, A. (2008, 2009). The Snowball: Warren Buffett and the Business of Life. New York, NY: Bantam Books. Page 69.

[4] https://rememberedsummers.wordpress.com/tag/grocery-shopping-1920s/

[5] https://rememberedsummers.wordpress.com/tag/grocery-shopping-1920s/

[6] https://www.forbes.com/sites/briansolomon/2016/04/20/why-grubhub-is-building-what-its-ceo-calls-a-s-business/#5fd011691124

[7] Grubhub Q1 2018 Earnings Call Transcript.

[8] Grubhub Q2 2018 Earnings Call Transcript.

[9] Grubhub Q1 2018 Earnings Call Transcript.

[10] Grubhub Q1 2018 Earnings Call Transcript.

[11] https://www.chicagotribune.com/business/ct-biz-doordash-restaurant-food-delivery-lawsuit-20180109-story.html

[12] http://www.cincyrideshare.com/great-doordash-tips-heist-1/

[13] https://foodondemandnews.com/0328/doordash-passes-grub-in-delivery-market-share/

[14] Grubhub Q4 2018 Earnings Conference Call


Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

2018 Year-end Investment Commentary: Easy come, easy go

As the saying goes, markets go up on an escalator, down on an elevator. January 2018s smooth escalator ride higher was more than outweighed by December’s swift elevator ride lower. In hindsight, the culmination of the January ascension in February’s storm of volatility was a precursor of what was to come. The Old Wall Street rules dictate that a 20% rise from lows in markets is a “Bull Market” while a 20% fall from highs marks a “Bear Market.” By that token, we had been in a relentless “Bull Market” since March of 2009, what many call the “longest on record.” As the saying goes, “all good things must come to an end.” The final nail to the post-Financial Crisis Bull came on Christmas Eve, 2018 when the S&P hit an intraday low that was 20% off highs.

During the fourth quarter we saw historically bad stock market performance stack up on several timeframes. This was amongst the dozen worst quarters ever for markets, with December ranking as the worst December. Included in this mess was a four day stretch of the S&P registering consecutive 1.5% down days, which according to Bespoke Investment Group only happened twice outside of the Great Depression.[1] Looking at lists that stack up the “badness” of this period is a history in true economic chaos featuring the Great Depression, the 1987 crash, the Iraqi invasion of Kuwait, the popping of the Dot Com bubble and the Great Financial Crisis. 1987 is very similar in terms of the prevailing economic conditions with a benign US economic outlook amidst turbulent geopolitical tensions and valuations on the high side of their longer-term ranges. The look of things and the extent of the washout though looks most similar to 2002:

Essentially 2002 was a three-month waterfall. The big difference is how in 2002 the fears at the time were far more severe than we are seeing today. Here’s one such warning during 2002’s bear market

In 1998 it was somebody else’s problem, with their blood splashing on our trousers,” he said. “This time we’re ankle deep in our own blood.” Unlike 1998, the current crisis is rooted in the United States. It’s our stock market bubble that popped. The United States was attacked, and our CEOs cooked the books. In 1998, U.S. investors were staring out at the world and wondering where it would end. Now the world’s investors are staring at the United States and wondering the same thing.

Griffin can imagine, he said, a Japanese-style pullback from risk in the United States, in which investors give up, banks refuse to lend and the economy languishes. He can imagine other countries, accustomed to the United States’ role as the world’s economic locomotive, not taking up the standard. He can imagine a crisis of capitalism of a 1930s order. Griffin thinks the people talking about deflation are probably wrong, but he doesn’t think they’re crazy.[2]

As we all now know, 2002 was merely the warning shot and the deflationary shock came before the decade ended.

A contrast with our expectations:

Our preview for 2018 featured a few appropriate points, but more wrong ones. The appropriate ones remain applicable and we will start there (we will spare you any Bitcoin here this year). First, it was clear that the returns from 2017 were the “pulling forward” of future returns. The year was simply too good to be repeatable. In 2013, when we issued a similar warning, we emphasized that the pulling forward of returns can resolve either with sideways action or downside. Despite this call as 2018 began, we were hardly saddened to see the year on track for a back-to-back repeat of strength through September. This was before Mr. Market suddenly hammered home the idea that a pulling forward of returns can also be corrected with swift downside, in addition to extended sideways stretches.

We were especially wrong on three big things: the slope of the yield curve, the outlook for financials and the reemergence of dispersion. It turns out all three of these expectations were correlated with one another. If you were to look at the yield curve from the day the S&P made its all-time high, the expectation of more slope was mixed: inside of three years there was a steepening but the long end had flattened.

The 10-year is the level to which a considerable amount of corporate and household lending activity is tied. In the week after markets peaked, the 10-year made new highs. When equities bounced again in November, there was yet another new high in the 10-year yield, over 3.25%. This was the highest 10-year yield since 2011! At the time, banks were exhibiting considerable relative strength to the rest of the market, despite a weak year-to-date showing. As the selloff in equities escalated, the main cause was attributed to rising bond yields. We got headlines like “Here’s why stock-market investors suddenly freaked out over rising bond yields this week” which raised the prospect that Fed rate hikes Fed might push us into recession sooner than feared.[3] Interestingly, through it all, credit spreads remained firm. Later in the quarter, credit yields gave way to market pressures; however, despite the worst peak to trough market move in a decade, credit spreads remained within normal bounds and well below the scarier tumult of the winter of 2016.

The context here is helpful. While credit has hardly performed well lately, markets went from incredibly narrow spreads to modestly wide ones. We are well within the “comfortable” zone. It would however be supportive to see the direction of change stop worsening and start improving. Markets grasp onto directional change and sentiment tends to extrapolate momentum.

Housing—“The Scene of the Crime”

The rate narrative and its tie to financials is important for housing–one of the key sectors driving our economic cycle. Housing was the economic “scene of the crime” last decade and while the fundamental backdrop is drastically different today, investors tends to anchor to the past risk in hunting for future risk. While the market down move started this quarter with the spike in rates, the pressure accelerated with the late October release of poor September home sales data.[4]

Several prevailing narratives emerged with respect to housing affordability:

  • Rising rates made mortgage interest a bigger burden for prospective purchasers.
  • Years of upward momentum in Case-Shiller, especially in areas with job growth kept younger would-be purchasers sidelined
  • Tightness in labor markets pushed up the key input cost for homebuilders (40-45% of input cost) leaving the builders in a position of either needing to sacrifice margin or pass on costs

The affordability problem amidst a backdrop of accelerating wage growth is a challenging cross-current for analyzing this key economic sector. For example, the low end of the housing market had been neglected by builders since the crisis; however, just this year, low-end jobs wage gains reached their highest level since the crisis. One of the most fundamental problems is a mismatch in new construction between what worked over the last decade and where the strongest demand resides today. A selection of quotes from recent homebuilder earnings calls highlight this phenomenon:

  • “We are experiencing healthy market conditions across most of our markets with solid demand, especially at affordable price points. And the supply of new homes remains limited. In this environment, we’re reducing sales incentives or raising prices in communities where we’re achieving our targeted sales pace, while striving to ensure that our product offerings remain affordable.” Q3 2018 D.R. Horton 7/26/2018
  • “So there’s not a lot of inventory out there at the affordable price bands, and much of the headlines, I think, are tied to higher price points that are seeing some slowdown. And we’re trying to stay ahead of that at the price points that are slower, are well above us today and where we’re operating. But if it comes down, we have to be prepared for that, and it’s in part why we’re rotating to lower priced communities, positioning smaller models in higher priced areas even to keep affordable and keep some insulation there. But we think market conditions are very good and continue to see a growth opportunity as we head into ’19.” Q3 2018 KB Homes 9/25/2018.
  • “Well, sort of on a general basis and there are some exceptions at the higher price points, it’s gotten a little bit softer than the lower price points have been. And that’s not unusual in a market that there’s a lot of publicity as to what’s going on in mortgage rates and price depreciation. Because the more affluent buyers time their purchase based on where they think the world is going. And so we think, as we said consistently, that this is just a market adjustment to a more normalized market from what was, really, a red-hot market in some of these markets.”Q3 2018 Lennar Corp 10/3/2018.

While some of the signs are troubling for the housing market, we think the shift from high-end to affordable is a mix-shift problem that will resolve without too much residual damage. Further, recent market activity has gone a long way towards correcting two of the big prongs impairing affordability: first, mortgage rates have come down considerably since peaking in early October, along with the 10-year yield; and, second, although housing markets correct more in terms of volume than price  the rise in price will be held in check by rising inventories, sluggish volumes and a down stock market. [5]

The call that remains outstanding is one that has become a mantra of sorts for us since the commencement of RGA Investment Advisors in the wake of the financial crisis and is perhaps the most important. Last year we said:

It is hard to sit in our seat today and say exactly which areas of the market would best withstand the next bear, for there are yet to be obvious areas of overinvestment like the technology sector in 2000 and the financials in 2007 that will lead the way down; however, we have confidence that the nature of the next recession (and let’s not forget, a recession is an inevitability eventually) will be different than the last. To reiterate: “the 2007-09 bear market was an actual liquidity crisis where deflation was the risk that imperiled the economy, whereas the next recession will be a normal Fed induced recession when inflation gets too high and the Fed thus raises rates to cool things off.

China and tight labor are the kindling for broader fears

One of the fears today is that market action can be self-perpetuating and self-fulfilling. In 2018, we saw no real signs that point to an imminent recession in the U.S. but markets have now gone a long way to price one in. The global situation is messy and the idea that “Trade wars are good, and easy to win” is truly being put to the test. [6] We are insistent that they are neither good, nor easy to win. That said, there is merit to pushing a harder line with China on global trade; however, we think a resolution in a reasonable timeframe is imperative.

A conversation we had with the CFO of a manufacturing company was truly insightful on this point. The CFO told us that the biggest challenge is not knowing how to pursue strategy. Companies spent over a decade building their supply chains to run through China–this was not done overnight. For some of the largest multi-nationals, it makes sense to accelerate planned supply chain diversification to areas like Vietnam; however, this CFO warns that Vietnam’s labor pool is not skilled enough for hard durables and the port volume is not deep enough to handle the swell in demand. Further the strategic bind is intensified because if there is a timely resolution to the trade war, a diverse supply chain will end up as a cost that dampens future returns. C-suite strategists are left flat-footed between action and inaction with severe costs on both sides of hindsight proves either side wrong. This leaves many in “wait and see” mode because it’s easier to undo inaction than action. In the near-term, the combination of a strengthening dollar and some tactical maneuvers like batching orders and changing the “importer of record” have helped cushion the impact, affording the luxury of time. This state of affairs cannot last for too much longer.

This CFO conversation featured a second insightful angle on the state of the US economy. While he expressed caution about the China situation, he emphasized that an even bigger challenge was the US labor pool. The CFO’s company manufactures at low wage rates, though with a degree of skill required for some harder tasks. The CFO emphasized how the ability to retain employees was killing efficiency necessitating a change in their compensation structure to enhance retention. The company went to higher base rate and incentive compensation tied to efficiency and productivity. This was echoed a late December survey claiming “82% of U.S. CFOs expect a recession to have started by 2020.”[7] Per the survey, “The biggest concern U.S. CFOs had was the tightening labor market, which makes hiring and, therefore, continuing operations and expansion more difficult.”

Tight Labor and the Fed

Federal Reserve Bank Chairman Jerome Powell has come under fire from various corners of the political and market sphere for raising rates in December despite weakening equity markets. We think his decision was largely motivated by concerns about the labor environment.  2018 saw the swiftest rise in average hourly earnings since the financial crisis and with full employment, the Fed is expressing caution that inflation can stay within its targeted range. This gets back to our point that the next recession will be caused by the Fed, and some seem to already believe this is the Fed’s intent right now (something we believe is an overly hawkish take on the Fed’s intents). We do think it was a mistake to raise rates in December and that the risk from holding on just one more month was far more modest than acting too swiftly, though at the same time we do not think the economy is so fragile as to tip over from one 25 bps move.

It is very hard to call a good employment environment a “headwind” to the economy. After all, the economy relies on consumers, with gainful employment, investing and spending the proceeds of their labor. Rising wages should thus lead to both better consumption and better investment. This should be one of the factors most supportive of preventing a deeper slide in the house market. Importantly, this could help alleviate one of the big mysteries of the wake of the Financial Crisis–why has productivity growth been so poor?

The answer might be as simple as the amount of slack in the labor market that persisted for far too long. Why would an employer invest in productivity when they could simply hire a helping hand for decently less than the inflation adjusted wage a decade prior? Investments in productivity take an economic calculus of opportunity cost. Can I buy technology that will enhance my productivity over the next five years for less than it would cost to train and employee a worker over this time? Today with unemployment in the high 3%s is very different than five years ago at this time sitting just beneath 7%. Below we will tie this force with one of our new investments during the quarter.

What if we go into a recession in 2019?

If we do head into a recession now (and it’s hardly a foregone conclusion), the economy will do so on much stronger footing than in 2008. The employment backdrop is one of the more important differences today. The composition of the workforce both in terms of age (millennial cohort is hitting peak employment rates and ages today) and sector are very constructive. Bank capital ratios are in their healthiest state in decades, household balance sheets are as strong as they have been in decades and the key industries that led to the 2008 recession massive job losses are on much firmer footing. Over any long-term timeframe, recessions are a guarantee. The key is understanding where the real economic and market damage will come from within in. In other words, it’s important to have confidence in a portfolio that there will not be true long-term impairments in value vs interim markdowns in stock prices that will eventually revert to trend once the dust settles.

Market structure matters a lot for how stocks handle shocks–whether they be intrinsic or extrinsic shocks. We spoke about the industry reclassification undertaken by S&P shaking up the “technology” label as a sector. The major shuffle, which was described as “the biggest impact on the sector landscape in GICS history” went into effect on September 21, 2018. Markets peaked on September 20, 2018. We do think that begs the question whether there are structural or fundamental causes to the subsequent market action. While one can never know for certain, the crowding of certain pockets of the active investment community (ourselves included) in the technology sector was vulnerable to the crosscurrents that the rebalancing flows created. Add to this pocket of vulnerability a sluggish housing number and ongoing China questions and you have the makings of a bear market with or without a recession.

This also helps resolve the question: “if the biggest risks are labor tension and the trade war with China, why are some technology stocks with minimal exposure to trade wars and labor an immaterial portion of margin the biggest losers over the last three months?”

Forward P/E’s today are the lowest they have been since 2013, the year in which we had some “normalization” post crisis:

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.

See through the lumps at Cognex’ bright future:

Cognex is one of the most compelling companies we have come across in some time. The company boasts gross margins in the mid-70%s and ROICs upwards of 100%. Yes, that is not a typo on the ROICs. Consequently, Cognex has built a healthy balance sheet featuring a cash stash upwards of 10% of the market cap today. The problem for the company is that demand cycles are incredibly lumpy, and growth is inconsistent from year-to-year. While Cognex targets a 20% compound annual growth rate in revenue, which they have come close to over the past five years, the longer-term realized growth is closer to 15%. This longer-term period includes the crisis.

Cognex is in the business of “machine vision.” They build the sensors and the supporting software for manufacturing, supply chain and logistics companies to process and analyze a high velocity of product and data moving through a field of vision. The industry is somewhat fragmented, with the two largest players (Cognex and Keyence) combining for about 40% of share in the core machine vision segment. The core TAM for Cognex will represent about $4.3 billion in 2019, expected to grow at an 8% compound annual growth rate into the foreseeable future. Vision itself is a mission-critical add-on to other core automation initiatives and is a modest percentage of the cost for a company to automate in their respective field. While there are some functions of vision that are commoditized, the high function areas are both research and relationship intensive. Cognex and Keyence spend meaningfully more than the rest of the industry in R&D (a target around 15% of sales at Cognex, one of the most R&D intensive companies) and they have dedicated sales forces of highly trained engineers who work in close conjunction with their customers to develop uniquely tailored solutions.

Cognex CEO Robert Willett explains this nicely in the company’s Q3’18 earnings conference call:

“I mean, machine vision is very difficult to do, and the competitive advantage of advanced products from us and a few of our competitors is very substantial. So in general, this is not a market driven by price. It’s a market still driven by technology. Of course, we could drop price to try to win share, but that’s never been something that we’ve wanted to do. It’s not what we’re about as a company nor I believe it’s really what about — our major competitors are about.”

Note that while the units sold are measured much like a hardware company would, what Cognex (and Keyence) really sell is the software designed to process what the hardware reads. Customers get an ROI within two to three years of purchase, creating an incredible pricing advantage for these two unique companies.

Willett, as CEO, has the background and incentive structure we admire. He built his own business–Willett International LTD–that he sold to Danaher for $125 million in 2003. Danaher merged Willett’s business into their Videojet subsidiary and made him the head of the business unit. You may have heard of Danaher recently, when its former CEO Larry Culp was picked to help GE out of its mess.[8]  Danaher is known for both outstanding operations built around the “Danaher Business System,” (DBS) a form of the Japanese “kaizen” and a deep capital allocation playbook deployed with prudence. DBS and kaizen feature continuous improvement and efficiency. Despite proceeds that would make anyone comfortable financially, Willett’s drive led to him joining Cognex in 2008 as an executive VP, rising to COO in 2010 and ultimately CEO in 2011 when the company’s founder Robert Shillman stepped back.

Cognex growth has been fueled by a robust secular tailwind driving automation’s increased adoption within and across various industries. The company has been further aided by taking a growing share of the revenue pie. One notably large customer is Apple at over 20% of revenue. This has left Cognex vulnerable to Apple’s iPhone upgrade cycle, further fueling the lumps. Apple is unquestionably a great customer and the willingness of Apple to pay Cognex an exceptionally high margin despite a reputation for pressuring key suppliers is demonstrative of both Cognex quality and importance. Importantly however, we see the future of revenue streams diversifying to Cognex’ benefit.  Two emerging areas of growth are logistics and 3d vision. Logistics is interesting for how low the overall penetration has been. Arguably this has been a direct result of the high unemployment rate over the past decade. With labor tightening alongside the rapid escalation in ecommerce and commensurate rebuild of supply chains to accommodate new market realities, the outlook is as bright as ever for logistics. [9]

Today, about 10% of Cognex’ revenues come from logistics, a market which vision has 10% TAM penetration. We see Cognex’ share of revenues from logistics nearly doubling over the next five years. Similarly, 3d vision will continue its own rapid growth.

We envision Cognex’ revenue base evolving along the following lines:

Notably, the future growth drivers have far less lumpy demand channels than the existing ones. Meanwhile, the existing channels will continue to grow albeit at their consistently inconsistent pace. Diversifying the revenue stream in this way will give analysts more confidence in forecasting out-years and investors more confidence in ascribing an appropriate multiple to the company’s earnings stream.

With over 100% ROICs, capital allocation is an important driver of future value and the hardest to model. The company boasts over $830m in cash, though does not screen that way since around $300m of that resides in “long-term investments.” Given Willett’s background at Danaher, it’s no surprise that capital allocation has been a strong suit. Despite the huge cash balance, Cognex’ share repurchases have been incredibly lumpy with the company demonstrably “buying low.” To that end, repurchases have been reaccelerating in the past year after having paused on the share price’s rapid ascent.

In our base case, we see a clear path to double digit annualized returns with a minimum three-year target holding period, assuming no return is generated on excess cash flow either via strategically timed repurchases or acquisition. We expect the primary driver of growth to be a presumed 12% CAGR in top line, with modest EBIT and EBITDA margin leverage. Note this 12% CAGR falls well short of the company’s 20% target and below the 15% realized growth rate. In our bull case, growth in the high teens for the next four years, settling into the mid-teens thereafter, alongside 200 bps margin leverage supports prices today into the $70s, with the same prevailing assumption on reinvestment of cash flow. In our bear case, a mid single digit CAGR and flat margins give us confidence that a worst-case outcome would yield a mid $30 stock over our targeted 3-5 year timeframe. This bear case also assumes a WACC of 10% vs 9% for the base and bull cases.

Full Stream Ahead with Roku:

In our January 2016 commentary, we detailed our attraction to networks and platforms in the digital age. We were insistent on the appealing valuations and growth prospects for a certain crop of elite company. Today we see a similar opportunity taking shape and we have found our favorite risk/reward setup in a “robust network for the long-term” since then: Roku, Inc. (NASDAQ: ROKU). Many of you heard of Roku and have a streaming device of some kind in your household–likely also a Roku. Our younger readers are likely not just to have a Roku, but to consume a high percentage of video content on one of their devices. Per Anthony Wood, CEO of Roku, “10% of the 18 to 34 year olds watch their television on a Roku,” meaning Roku itself is the exclusive platform through which this key demographic watches TV.

You can get a sense of the future by seeing how this breaks out timewise:

(Nielsen Q2 2018 audience report)

Roku IPO’d in 2017 and the stock has been highly volatile ever since. At the time of IPO, approximately 56% of revenues were driven by low margin hardware sales (“Player” sales) and the remainder from “Platform” sales. In the first quarter of 2018, Platform exceeded Player sales for the first time in the company’s history. This was the inflection point upon which it became clear the company’s future value will be driven by Platform sales. The company strategically views Player sales to drive placement of the Platform. Once a streaming device (whether a stick or increasingly a TV itself) is placed in a household, the company then seeks to monetize an account with a combination of successful subscription and Video-on-Demand (VOD) purchase royalties (1/3rd of Platform revenues) and, more importantly advertisements (2/3rds of platform revenues and growing quicker than the combined segment). Ads take several forms, including home screen placements for audience building, but most important is advertising VOD (AVOD).

Once a household has an “Active Account” on Roku, the Platform side benefits from several levers enhancing monetization over time. First, with a surging abundance of streamable content, hours streamed continues to grow. Second, Roku can “fill” more of the available inventory on the platform. Third, Roku can drive better CPMs (cost per mil/thousand impressions) augmenting advertising inventory with its growing trove of user data. Roku boasts 95% completion rates on commercials, which contrasts favorably with linear TV.


The enhancement to the user experience offered by lower ad loads makes the ads themselves more valuable. Scott Rosenberg, the one who runs the advertising platform at Roku, described it as follows in their Q3 2018 call:

“We’ve been very effective at showing them the ROI math, that the last dollar that they put in the linear TV is reaching a smaller and smaller base, and that if they move that dollar to Roku, it’s going to deliver much more reach and ROI. I’m just — I mean, backing up more broadly and thinking about our advantages as an ad platform, the reason advertisers come to us in the first place is we’re an ad-scale platform with the largest, most engaged user base. It’s a unique audience that can only be reached on Roku. We’ve got that direct consumer relationship and all of the data that flows from it. And ultimately, it’s ads that work.” Roku is building its own “walled garden” with this virtuous cycle.”

In 2018, just shy of $70 billion will be spent on advertising over linear TV. When measured as “linear TV,” advertising is no longer growing.[11] Advertising on digital platforms will grow nearly 19% in 2018. Advertising on the Roku platform will nearly double. Roku was early to realize there was demand for free content, supported by ads in the streaming world, while the rest of the world was focused on subscriptions. As a result, some estimate Roku controls as much as “87% of ad requests” on connected TV today.[12] This kind of scale has advantages for viewers and advertisers alike.

We think inevitably most TV will be consumed through one of the digital platforms and as of today, two clear leaders are emerging: Roku and Amazon. Each boasts unique advantage and each benefits from considerably more share in the relevant metrics than the peers on the outside looking in (like well capitalized Google and Apple). One of Roku’s most important advantages in this competition stem from the platform’s openness. On Roku, you can watch Amazon’s Prime TV, YouTube, access the Google store and channels with add-ons ranging from ESPN to NBC, whereas on Amazon there have been extended periods of time where YouTube is inaccessible. Roku’s combination of interface, quality and low price are garnering favor with customers and reviewers alike. For TV manufacturers competing amidst this monumental shift in the content distribution landscape the answer is rather simple. Wood summed up the advantage of Roku software for a manufacturer as follows:

“So for example, so what’s better about Roku software? Well, a big one is that phones are expensive, like they cost a lot of money, they’re super computers. TVs are cheap, the main board on a TV is $25 and TVs are brutally cost competitive, no one makes money in the TV business. So our software runs on low-cost TVs, it costs less to build a TV with Roku software. When you’re trying to get 50 cents off your bill of materials so you can win a Black Friday special at Walmart, the amount of money you save by cutting your RAM in half and your CPU in half by running Roku software — which actually has great performance and more content — is huge. It’s the difference between getting distribution and not getting distribution in Walmart.”[13]

Roku is led by Anthony Wood and its origin story sounds more Hollywood than Silicon Valley. Wood himself owns 25.9 million shares, or 24.2% of the company. Wood’s ownership is via the Class “B” voting shares, of which he controls 42.3% of the vote. As such, investors in Roku are effectively business partners with Wood, granting him an extremely high degree of control. While the separation of voting control is not ideal, we like how much Wood’s own fortunes are tied to Roku’s stock and view this as an important alignment of interests.

Wood’s background is interesting and worthy of such co-investment. He founded a DVR company that was an early competitor to TIVO, called Replay TV and learned much about the box placement and content challenges along the way. The successor company to Replay TV is now owned by DirectTV. The proceeds from this early foray helped Wood bootstrap Roku early on and has led to a determination to conservatively finance the company while investing in growth. Roku’s history is tied to Netflix and streaming itself. In fact, it’s first name was “The Netflix Player by Roku.” The idea within Netflix was to create a platform for easier distribution of streamed content, but Netflix instead decided to pursue licensing arrangements with various hardware-based distributors ranging from gaming consoles to TV makers. Wood speaks with grand ambition when he talks about making Roku the operating system for the future of TV:

So the big picture is if you think about when new competing platforms have emerged, the software platform has always changed. So if you go back, we were talking about PCs back in the early days, well before PCs, there were mini computers like that PDP 11. Those had their own operating systems. Those operating systems didn’t make the transition to PCs. Instead of operating systems designed for PCs, Windows became the dominating operating system on PCs and then when phones became a computing platform, Windows didn’t make that transition. No one’s running Windows these days on their phone, they’re running Android or iOS. [14]

Since Roku places an actual piece of hardware in a house, increasingly in the form of a TV, the churn associated with the platform is inherently lower. Per Roku’s analysis, one out of four smart TVs sold in the US are powered by Roku’s OS. Evidence of this is provided by TCL’s rise from a non-factor in the TV industry (24th in market share) to number three overall share, driven almost entirely by the Roku relationship.[15] The Washington Post recently called a Roku-powered TCL TV “the best deal on a premium TV I’ve ever seen” when comparing it to a high-end Samsung [16]

It is important to consider both the actual and the strategic value of Roku. Disney, which has every reason to downplay the value of Hulu as it seeks to acquire the 40% it does not own recently valued Hulu and it’s near 30 million users at $9.26 billion[17]. In contrast to Roku, which is modestly cash generative in today’s high growth mode, Hulu continues to burn cash. Further contrasting the two is how Roku places hardware whereas Hulu sells subscriptions. Digital subscribers tend to churn with regularity.

As of today, Roku boasts nearly 24 million households. In its Q3 2018 report, Roku reported trailing twelve-month annual revenue per user (APRU) of $17.34, up just shy of 48% yoy. CPMs on the platform are said to be upwards of $30, rivaling some of the best networks on linear TV. Roku tastefully inserts ads at approximately 1/4th the industry average ad load (4 minutes of advertising per hour on Roku vs 16 minutes on linear) and have banned pre-roll ads before movies or shows in an effort to “premiumize” the experience watching content monetized with ads. The effort to make advertising more personal and to consume less time per hour makes the platform and its supporting ads appear less intrusive to consumers. This makes viewing content on Roku increasingly appealing driving further growth in hours viewed per account, thus making the entire platform increasingly attractive for advertisers to be on.

The Roku Channel (TRC) itself is becoming a key driver of value. TRC was first launched in October 2017 and is already one of the top 5 most watched apps on Roku. Originally, TRC was solely available on Roku itself, but now the company has a distribution agreement with Samsung covering their smart TVs (perhaps a precursor of a bigger agreement), has enabled web-based login and a forthcoming mobile app. These changes have untethered TRC from the Roku hardware and unleashed TRC as a streaming asset with universal availability. The increased engagement with TRC has driven ad revenue growth which has empowered Roku’s ability to acquire more desirable content. There are also signs Roku will use TRC as a home screen and a modern aggregator/bundler of content. Roku started the New Year by announcing the availability of subscription content within TRC that will be payable all via one simple, monthly bill.[18] Our guess is that this subscribable content is monetized like the standard royalty Roku takes on subs over its platform. There have also been suggestions The Roku Channel might eventually become fertile grounds for Netflix to release past seasons of some of their own shows as advertising supported content, to both further monetize that content and tempt new subscribers to join.

At the end of 2019 we expect unit economics to look like the following:


These assumptions are also unfair to the Player business, which does generate margin. The company views this “margin” as a form of “negative customer acquisition cost” and for the purposes of our analysis, we use this as an offset to selling & marketing expense per new active user. Wood explained the margin rationale as follows: “And if we felt like…it’d be better for us to go to 0 gross margin or even negative on players, we would certainly consider that. But right now, at some point, there’s diminishing returns. I mean, the cheaper you make the players, the more likely that someone buys it and doesn’t use it.”[19] Laying out the money up front for a Roku device is effectively a commitment that it will be used. This is the same rationale behind a Costco or even Amazon Prime membership.

If Roku can get to 40 million Active Accounts (32% penetration of the 126.22 million US households, leaving aside the international opportunity for now) and an ARPU of $25 by 2020, the company can hit $1 billion in platform sales (approximately 66% growth for Active Accounts and 50% growth for APRU over expected 2018 final results, both implying a fairly large slowdown from present trends). This $1 billion expectation is slightly ahead of the consensus expectation, which has been rising consistently as the year progressed (Roku is one of those rare cases where a stock will finish the year down 40% all the while forward revenue expectations rose). If we assume no value or margin for the Player business, we can use today’s roughly $3 billion market cap and think about what the 3x P/S means. P/S = net margin * payout ratio * (1+g) / (r-g). In solving for net margin, assuming a 10% WACC and either 4% or 5% growth, you get an implied net margin at maturity of 17.3% or 14.3% respectively.

We think 3x what is an achievable 2020 platform sales targets a unique wager. If beyond that timeframe Roku achieves one of the following, returns on an equity investment today will be comfortable in the double digits annualized:

  • Greater than 40m households long-term
  • Greater than a $25 ARPU
  • Greater than a 20% net margin
  • Growth above terminal rate in 2020 and beyond

It’s possible for Roku to exceed each of these hurdles, with ARPU being the most likely and an answer on net margin farthest in the future as the company invests to drive growth beyond the forecast period. To put the 3x P/2020 Platform sales in context, many great high growth digital platforms trade with P/S upwards of 8 (see NFLX, SHOP, CRM, SQ, ETSY, and TTD to name a few). We expect the primary driver of returns to be Roku’s delivery of exceptional growth; however, we also see a path to multiple expansion as the market comes to appreciate the company’s uniquely advantaged business model, scale and free cash flow generation ability on a recurring style of revenue base.

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 Director
O: (516) 665-1940
M: (917) 536-3066

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174


[1] https://twitter.com/bespokeinvest/status/1077261781586849792

[2] https://money.cnn.com/2002/07/19/news/crash2002/:

[3] https://www.marketwatch.com/story/stock-market-investors-are-right-to-be-frightened-by-rising-bond-yields-economist-2018-10-12

[4] https://www.cnbc.com/2018/10/24/new-home-sales-september.html

[5] Leamer, Edward. The Housing Cycle IS The Business Cycle https://www.nber.org/papers/w13428.pdf

[6] https://www.cnbc.com/2018/03/02/trump-trade-wars-are-good-and-easy-to-win.html

[7] http://fortune.com/2018/12/12/cfos-recession-2020/

[8] https://www.cnbc.com/2018/10/05/new-ge-ceo-larry-culp-inks-stock-heavy-contract-worth-up-to-300-million-if-shares-soar.html

[9] https://cgnx.gcs-web.com/static-files/8ca19d6f-3ea7-44b3-bf08-6bc7d9616cd8

[10] https://www.iab.com/wp-content/uploads/2018/06/extreme-reach-video-benchmarks-2018q1.0079873a72f3.pdf

[11] https://www.forbes.com/sites/danafeldman/2018/03/28/u-s-tv-ad-spend-drops-as-digital-ad-spend-climbs-to-107b-in-2018/#28bef1077aa6

[12] https://www.broadcastingcable.com/news/demand-for-connected-tv-ads-jumped-in-last-year

[13] https://www.recode.net/2018/9/13/17852908/roku-anthony-wood-apple-google-amazon-tv-competition-peter-kafka-media-podcast

[14] https://www.recode.net/2018/9/13/17852908/roku-anthony-wood-apple-google-amazon-tv-competition-peter-kafka-media-podcast

[15] https://www.recode.net/2018/9/13/17852908/roku-anthony-wood-apple-google-amazon-tv-competition-peter-kafka-media-podcast and https://www.cordcuttersnews.com/tcl-still-plans-to-sell-roku-tvs-after-restructuring/

[16] https://www.washingtonpost.com/news/the-switch/wp/2018/06/08/this-tv-youve-never-heard-of-is-the-best-tv-deal-weve-ever-seen/?utm_term=.f47b86bfe5ba

[17] https://deadline.com/2018/11/disney-values-hulu-at-9-3-billion-1202506231/

[18] https://www.businesswire.com/news/home/20190102005277/en/Roku-Adds-Premium-Subscriptions-Roku-Channel

[19] Roku Inc at Citi Global Technology Conference 9/6/2018

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