Capital Flywheels

The World’s Most Valuable E-Commerce Company

Is possibly going to be Alibaba very soon.

Amazon vs BABA

For a long while following it’s IPO in 2014, investors were highly skeptical of Alibaba. Many still are, but many more are starting to recognize Alibaba’s incredible dominance in China. More importantly, as mentioned briefly in my post Tencent vs Alibaba on the Quest to Go Global, the company stands a fairly good chance of going global.

Despite the rising enthusiasm for Alibaba, the company appears to be underrated. A few examples:

As of FY16, Alibaba reported gross merchandise volume (GMV) of $547 billion across its e-commerce platforms. Amazon does not report GMV but estimates peg it around $300 billion.
Alibaba had annual active buyers of 466 million as of 2Q17. Amazon does not report annual customer count, but Statista pegs it at ~300 million.
Alibaba owns approx. 1/3 of Ant Financial, which is the world’s largest fintech co. Amazon has surprisingly limited interest in fintech.

Amazon is rightly known as an aggressive competitor, but Jeff Bezos once squared off with Jack Ma in China and lost (Amazon was also relatively late to China). Both are now vying for control of India. But their strategies could not be more different: Amazon is essentially carrying out a very similar playbook to the one in the US (superior distribution/logistics + Prime), while Alibaba has gone the fintech route and leveraging that to enter e-commerce.

Will be interesting to see how India plays out since Amazon is determined to not let India slip out of its hands and is currently near pole position.

Predicting the Potential of “New Electricity” by Looking at the Lessons of “Old Electricity”

Andrew Ng (former Chief Scientist at Baidu, Co-founder of Coursera) is fond of referring to AI as the “new electricity”. Similar to how electrification ended up transforming every single industry during the 20th Century, AI is broadly expected to have similar (if not greater) impact in the coming years.

This post by Oscar Li does a great job encapsulating Andrew Ng’s thoughts as shared during a recent lecture at Stanford.

The social and business ramifications are easy to extrapolate / imagine: Anything that you can do now, you can do better with more AI and data. And as the technology that underpins AI continues to improve and the datasets continue to grow, AI will allow us (or machines) to do whole new things not possible before.

If you’re like me, it’s actually quite overwhelming to ponder the full implications of AI. But if AI is on track to transform the world like how electricity did, we should be able to learn some lessons and create some useful predictions by looking at what happened a century ago.

Lessons from Electrification:

Everyone Electrified and then Electricity was no Longer a Differentiating Factor: Today, companies that use AI and data have an advantage over those that don’t. A similar dynamic existed a century ago. Retailers that were electrified had an advantage over those that didn’t. Factories that were electrified had an advantage over those that didn’t. Eventually all businesses either adopted electrification or were out-competed. However, once electrification was fully borne out, it was no longer an advantage. A similar dynamic also played out with air conditioning in the middle of the 20th century where early adopters had an advantage, but once every retailer adopted air conditioning, it became a necessity rather than an advantage.
Electricity Changed How Business was Done But Had Less of an Impact on the “Jobs to be Done”: Electrification allowed businesses to extend their hours of operations, drastically increasing efficiency and productivity. Electrification also brought about new machinery and tools that similarly improved efficiency. In other words, electricity made businesses (and people) better at their craft but had less of an impact in terms of the goals that businesses pursued. Retailers remained retailers. Manufacturers remained manufacturers. Service providers remained service providers. This is perhaps the most interesting takeaway (or contrast) with current assumptions around AI – namely that AI will necessarily lead to “new” products / services.
The New Business Model Created by Electrification was the Electric Utility: Although electrification had large ramifications on how existing industries operated, the only key new business model to emerge appears to be the electric utility to provide the fuel for the disruptive technology (I’m not quite sure if this statement is entirely accurate – if any readers have supporting evidence for / against, please do share). Similarly, how many new business models should we anticipate in the coming AI explosion? It’s clear that AI will be important for existing industries, but how many new types of businesses should we expect? Perhaps a “data utility”, but what else?
Other than Utilities, No One Made Money on Electricity: Once every business adopted electricity, it was no longer a differentiating factor by and of itself. As a result, electrification become purely a cost of doing business. Only utilities made money off of electricity. Can this be extrapolated to AI and data? Will it purely become a cost of doing business?
Electricity Led to a “Cambrian Explosion” in Hardware: Although electrification appeared to merely change how businesses were run, it did lead to many new hardware products such as light bulbs, phonographs, radios, televisions, etc. Turned out that the best way to monetize electricity other than operating a utility was to produce hardware. This was the genesis of General Electric. Perhaps that is also what we should expect of AI.

These are just a handful of lessons. There are probably more that can be added to this list.

Taking these into account, it’s not outrageous to ponder whether AI can truly be monetized if not offered as B2B service (e.g. the utility model) or bundled with hardware (e.g. Amazon Echo, Siri / Google Assistant / Cortana in devices). Are there alternate monetization pathways if neither of these are feasible?

One thing that is an interesting contrast between AI/data and electricity is that AI algorithms and datasets are not commodities like electricity. Every utility’s product is the same. But AI algorithms and datasets are not interchangeable. What are the implications of having non-interchangeable “fuel” for one of the most disruptive technologies of the 21st Century?

Tencent vs Alibaba on the Quest to Go Global

Finally catching up on some reading: Bloomberg published an excellent profile on Tencent and the co’s strategist, Martin Lau. I highly recommend the article as it not only goes through the history of the company, but reveals the type of thinking and mentality that has helped Tencent become one of the most successful companies in the world.

For the uninitiated, Tencent is one of the “BAT” trinity (Baidu, Alibaba, Tencent) that dominate the Chinese tech space. The Chinese are increasingly living their lives in a “digital-first” manner, and as a result, BAT’s influence extends across nearly all aspects of Chinese life in a way that Google, Facebook, Amazon, Apple can only wish (and try to replicate with limited success thus far). All three players operate across nearly all verticals including social, video/entertainment, e-commerce, search, browsers, app stores, delivery, cloud services, payments, finance, and many more. They have gone beyond being just software/service companies to essentially digital lifestyle companies.

Despite the BAT moniker, investors view the strengths of each company quite differently.

Generally, Baidu (the company with search as its core strength) is viewed as the weakest. Unlike Google’s dominance in the US, Baidu has struggled to find its place in China’s highly digitized mobile world were users largely spend their time in Tencent or Alibaba’s walled gardens. Whereas Google has been able to run its search crawlers through the open internet and through the Android platform (majority global share), Baidu does not have the luxury of a dominant mobile platform nor access to the increasingly large amounts of data that is generated outside of the browser.

Of the remaining two, Alibaba and Tencent are generally neck-and-neck. Alibaba absolutely dominates in e-commerce and payments/finance while Tencent owns the incredibly sticky WeChat messaging super-app with a fast growing payments solution. Nonetheless, investors overwhelmingly consider Tencent to be a much stronger business with a 1yr forward P/E of 45x to Alibaba’s 34x despite similar growth rates according to consensus estimates. The difference in perception largely comes down to the fact that investors consider WeChat to be mostly un-disruptable while Alibaba is currently contending with a sizable #2 player in JD.

However, I believe that perception is misplaced especially when we consider Tencent’s and Alibaba’s prospects for going global.

The Bloomberg article mentioned above highlights the challenges that Tencent faces in trying to export its WeChat model abroad:

Then there’s the matter of Facebook Inc. and WhatsApp, which have a huge market advantage pretty much everywhere outside China. Going overseas, Lau says, “is essentially the challenge of every Chinese company. We tried to make WeChat international. The reality was that there were other products in the market already.”

Tencent faces a much more formidable competitor in Facebook as they try to expand abroad, while the global e-commerce landscape is much more benign for Alibaba. E-commerce is much more fragmented on a global scale, and Amazon is nowhere near as dominant on a global scale as Facebook is for social networking.

The valuation gap between the two companies only make sense in a China-specific context. In a global context, why should that gap exist?

Disclosure: I have no direct beneficial interest in Tencent (700 HK) or Alibaba (BABA) as of publishing date and have no intent to initiate a position within the next 48 hours.

Temptations to Go Beyond Our Circle of Competence

Summer’s full swing has kept me away from this blog, but luckily it gave me some time to think more deeply about a number of ideas and topics.

One of those is: What tempts us to go beyond our circle of competence?

Buffett constantly warns investors against going outside their circle of competence since doing so would mean treading into industries/areas where one would not have an edge. Yet, despite this constant exhortation and strong evidence that sticking to one’s own domain of expertise is a very good strategy, very few seem to follow that sage advice (including myself on a number of occasions in the past – I certainly hope I won’t ever experience another JCP).

Although I am speaking from an investing context, this advice is clearly useful as a general life strategy. I often chuckle when the average Joe wants to teach their doctor about how to deal with certain ailments…

So I gave this question a good think while on a walk.

And then I realized that it’s not so much that we, humans, are terrible at remembering good advice. It’s that the cards are stacked against us.

The investing market has become far more crowded in recent years, and there are far too many bright people chasing similar ideas. In order to truly make a lot money, two things need to happen: 1) You are right about something that nearly everyone thinks is wrong (contrarian), or 2) You are right about something before anyone has even heard about it. And unfortunately, both of these things naturally push us outside of our circle of competence.

Let’s consider the first case where we find ourselves amongst a small minority view. If the opposition is equally smart (and good looking) and working purely within their circle of competence, it is highly unlikely that we, as a minority, would have the right view and also be within our circle of competence. It is highly unlikely in such a situation that both longs and shorts are within their own circle of competence but then come to different conclusions from the facts at hand. These are battleground stocks (like Ackman short Herbalife vs Icahn long Herbalife) and best avoided…clearly one of them is outside their circle of competence. Where the investor base is generally “smart”, the consensus probably holds the right view, and as a result the opportunity for alpha is low.

Let’s consider the second case where we find a brilliant new opportunity (a fine gem!) before anyone else has heard about it. These situations usually only come about from two pools of stocks: 1) Small caps, and 2) New companies. Assuming we put in the effort to sift through the long tail of small caps and new companies, we should be able to generate alpha. But here we also find that the world constantly conspires against us to push us outside of our circle of competence! These companies are often in new industries or with untested business models. Though we may deem ourselves to be within our circle of competence, the potential for misjudgment is higher.

In some prior time, investing was a much simpler endeavor, and sticking within one’s circle of competence was likely a much easier task to accomplish. Generating alpha is always easier when “investors” do not understand the basic tenets of fundamental investing. Now the market is crowded, and it seems to me that sophisticated investors are increasingly pushed outside their circle of competence in order to achieve alpha.

What a tough cookie.

You Know What’s Better than Owning an Airline?

An airport.

Airports are natural monopolies. Who wouldn’t like owning a natural monopoly?

And unlike other natural monopolies such as local utilities, airports tend to be higher growth assets (air travel is less penetrated than electricity).

At a high level, airports receive revenues from 2 sources: 1) fees on passenger tickets, and 2) commercial revenues generated in airports (e.g. rents from terminal vendors, parking fees, baggage fees, etc).

Airport business models are generally superior to airline business models in nearly every single way:

Usually exempt from competition at the local / micro level – Many cities only have one airport. Only in extremely high-trafficked areas will there be multiple airports serving the same catchment area, but that’s a rich problem to have.
Less cyclical than airlines – Airports generally receive a large proportion of revenues as fees from passenger tickets. During recessions or downturns, airlines are incentivized to cut prices to keep planes full. That behavior supports passenger flow, which acts as a countercyclical buffer for airports.
Beneficiary of irrational airline competition – Since airports are more levered to passenger flow than ticket prices, irrational competition between airlines (e.g. low ticket prices) could lead to higher passenger flow, while airline income statements bear the cost.
Lower sensitivity to commodity prices – No need to worry about direct impact of oil (although there is some indirect impact if oil prices change enough to affect ticket prices and air travel demand).

There are no publicly traded airports in the US, but many well-trafficked airports around the world are privately operated and publicly listed. And a cursory glance at 10-year stock price performance illustrates the lower volatility and range of outcomes for airports vs airlines.

Mexican American Airports (ASUR MM – Cancun, GAPB MM – Guadalajara, OMAB MM – Monterrey) vs Mexican Airlines (Aeromex, Volaris) and Pan-LatAm/Brazilian Airlines (Gol, Copa)

The Mexican airports have seen stock price increase anywhere between 4x to 9x over the last 10 years. The Mexican airlines have only been public for less than 2/3 of the timeframe but have not even doubled. I have also generously left out the Mexicana bankruptcy in 2010. Gol has declined by 93% over the last 10 years. Copa has done decency well, returning 4.7x.

Mexican Airports

Mexican Airlines

European Airports (KBHL DC – Copenhagen, FHZN SW – Swiss, FLU AV – Vienna, FRA GY – Frankfurt) vs European Airlines (IAG LN – British Air/Iberia/Aer Lingus, RYA ID – Ryanair, EZJ LN – Easyjet, NAS NO – Norwegian Air, AB1 GY – Air Berlin)

European airlines have done decently well (excluding Air Berlin, which has lost 96% of value in 10 years), mainly because of the low-cost carriers Ryanair and Easyjet. As a result, airlines have kept up decently well with airports but with higher volatility, nonetheless.

European Airports

European Airlines

Chinese Airports (694 HK – Beijing, 600009 C1- Shanghai, 600004 CH- Guangzhou, 357 HK – Hainan) vs Chinese Airlines (1055 HK – China Southern, 670 HK – China Eastern, 2610 TT – China Air, 600221 CH – Hainan Air, 753 HK – Air China)

Out of the various geographies, China appears to be the most volatile, even for the airports. Airports have done fairly average, returning 56% to 2.9x over the last 10 years. However, similar to the other geographies, airport performance is better clustered than airline performance. Airlines have returned anywhere from -65% to 4.8x.

Asian Airports

Asian Airlines

Seems to me that airports are generally one of those assets that you can buy and tuck away for a very long time.

Disclosure: I have no direct beneficial interest in any airline or airport mentioned as of publishing date and have no intent to initiate a position within the next 48 hours.

Pandora – Fast Fashion or Fad Fashion?

What would you pay for a well-regarded, branded business that is expected to grow revenues and net income around 10% CAGR for the next 3-5 years with industry leading margins, high returns on capital, and low capital intensity?

And better yet, given that this business has low capital intensity, the company generates and distributes high free cash flows back to shareholders in the form of dividends and share buybacks, bringing total shareholder returns to 15%+ per year?

That’s Pandora (the jeweler) in a nutshell.

And unusually, Pandora trades at just 12.5x trailing P/E (~10.5x 1yr forward P/E) and 10x trailing EV/EBITDA (~8.5x 1yr forward) based on analyst estimates.

Were the multiple to revert closer to branded peers or the index as a whole, that would potentially add another 40-50% return. Realizing that over a 3-5 year period would add an additional 10-13% return per year, bringing total returns to 25%-30% CAGR.

Of course the natural question to ask is why the market doesn’t see or believe the story? It all comes down to durability of the core product.

A Brief History of Pandora

Pandora is a Danish jeweler that was established in the 1980s. Although it’s been around for quite a long time, the company’s modern formula for success did not come about until the early 2000s when Pandora launched the charm and bracelet product.

Pandora Charms.png

The bracelet forms the core of the product, but the charms is where the magic lies. Through the selection of charms, Pandora customers (almost exclusively female) can personalize their bracelets and switch it up depending on the occasion. Today, Pandora carries a catalogue of more than 700 different charms, covering nearly every occasion and personal taste imaginable.

Through this product, Pandora embarked on a fantastic journey of growth with revenues expanding >12x between 2008 and 2016.

Pandora Revenue Growth.png

Pandora Today

Today, charms makes up ~60% of revenues with another ~20% coming from bracelets. The remaining 20% is composed of rings, earrings, and necklaces – categories that were mostly launched after 2013 in order to expand Pandora’s portfolio.

Pandora sells through 3 formats – concept stores, shop-in-shops, and multi-branded. Concept stores are standalone Pandora stores where the customer experience is designed and tightly-controlled by the company. Over the past few years, Pandora has been shifting the mix from predominantly shop-in-shop and multi-branded towards concept stores.

And layered on top of the channels, Pandora either runs the stores themselves or acts as a franchisor. Currently, 38% of revenues are generated through Pandora owned concept stores while the remainder is generated by franchisees or 3rd party distributors. In owned stores, Pandora captures the full retail price, while in franchise/3rd party stores, Pandora sells into those channels at a wholesale price. The difference is 2.4x (i.e. $100 worth of wholesale goods would fetch $240 if sold within owned stores).

Charmed or Cursed?

So far, the charms business has performed exceptionally well. Not only has it attracted a large customer base, it is also distinctly Pandora, which is an unusual feat of differentiation in the jewelry business. Jewelry tends to be a fairly commoditized industry (the inputs are commodities and final products are usually not distinguishable across brands) so product differentiation is usually non-existent except perhaps in ultra-high-end jewelry.

But that is exactly the paradox here – Pandora is not an ultra-high-end jeweler (Pandora’s price points are $25-$200), and the company sells a product that is quite non-traditional for a jeweler.

The prevailing thinking is that Pandora charms are a fad. One day customers will get over it, and sales will plummet.

This fear has percolated for a decade, but over the past 12 months, the fear seems to have materialized. Reported like-for-like sales slowed across all regions with the most recent numbers in North America turning negative (this was partially compounded by confusing metric calculations, but I’ll refrain from discussing the nuances to avoid complexity). As a result, the stock has declined approx. 1/3 over the last 12 months.

In essence, the market appears to assume that Pandora is cursed, and one day investors will wake up to find that the charms business has been nothing more than a passing illusion.

What Makes a Fad?

I challenge that view. Certainly there will come a day in which the charms business will be fully mature, but the performance of the charms business does not carry the usual characteristics of a fad.

For one, Pandora has been selling charms since 2000. If charms were a fad, the customer base would have likely moved on many years ago, yet the charms business still exists 17 years later. If this were a fad, it would certainly be the longest living fad.

Pandora recently conducted a survey of former customers and discovered that many customers remain interested in the brand and would consider buying Pandora products even after 6+ years.

Pandora Customer Consideration.png

In addition, fads usually tend to develop within certain groups (e.g. teens) or geographies. Yet, neither of these are observable within the Pandora customer base. Pandora charms and bracelets are worn across the age spectrum, and Pandora’s products are finding success across the world from the US to Latin America to the UK to continental Europe to Australia and to Asia. The global success of the product suggests broad appeal, and such broad appeal does not suggest a fad.

A Fast Fashion Business Model

Rather than getting hung-up on whether the product is a fad or not, I think it’s more instructive to think about the business model and how the company operates.

At its core, Pandora is a fast fashion jeweler. Unlike traditional jewelers that have inventory cycles longer than a year and glacial lead times, Pandora’s inventory cycle is less than a year and lead time is only ~100 days. The company is targeting lead times of just several weeks by the end of this decade. Like Zara, the fast fashion retailer, Pandora can respond relatively quickly to customer preferences and adjust the product mix as the data prescribes. No one worries that Zara can’t sell fashion because when they do have a fashion miss on their hands, they can respond and fix the issue within weeks. Pandora is positioned similarly in the jewelry world.

Pandora sells fashion and newness, not “forever”. Diamonds are forever. Pandora doesn’t do diamonds. What Pandora does do is drop 7 collections a year. Every season and holiday brings a new collection, a new reason for customers to pop in and see what else they can add to their collection, in effect creating a recurring customer/revenue streams. Given the low prices, charms are priced to be impulse purchases.

In addition, Pandora is a branded affordable jeweler. Investors and pundits seem to have a tendency to compare Pandora to other branded jewelers, which tend to be higher end. Pandora is no Tiffany. Pandora’s true competitors are mom & pop jewelers. Pandora offers customers a good brand, attractive products at an affordable price, and fashion – everything that mom & pops do not have the scale to offer.

If we consider the business model, it seems more than likely that if charms truly were declining, Pandora has the right business model to quickly adjust and adapt to whatever is next.

What If I’m Wrong

Pandora is already priced as if the business will cease to exist in 10 years. That’s a fairly large margin of safety given that analysts expect the business to continue to grow at 10% CAGR for the next few years, but a couple of other things offer additional comfort:

Jewelry as a category is growing ~5% per year. If Pandora’s above-average growth simply normalized to industry growth, you would still have an okay business for the share price available today.
Pandora’s newer categories are growing >50% per year. In just about 3 years, Pandora has launched and grown non-charms/bracelet categories that now represent 20% of total revenues. Within a few years, these categories could represent 40-50% of total revenues, significantly reducing the dependence and fear of charms.
If worst comes to worst, Pandora’s continued conversion of franchise stores to owned stores would keep revenues unchanged even if the entire charms business goes away since owned stores generated 2.4x more revenues on an apples-to-apples basis compared to the wholesale channel.

So the risk/reward looks pretty good to me.

Disclosure: I have no direct beneficial interest in PNDORA DC as of publishing date but I may initiate a position within the next 48 hours.

Value Creation in the Investment Management Business

Do investment managers add any value?

This question is clearly of interest to clients of asset managers, but it is also an increasingly important question for industry professionals as well. It’s hard for industry professionals to do good work if they do not believe in the work they do, and for clients, it is dangerous to be invested alongside managers that are distracted.

Part of the challenge of answering that question is that the general dialogue usually conflates two separate questions into one:

Do asset managers add any value when they do not outperform the benchmark?
Does the industry add any value when it moves money around trading listed equities/bonds and not directly funding new ventures (e.g. venture capital or IPOs)?

These are very different questions that could lead to very different answers.

Performance as the Primary Value-Add

The argument is seemingly quite simple – most managers don’t beat the index. So asset managers, on average, don’t create value.

The long-term statistics are quite depressing. Depending on the study and timeframe, the proportion of active managers that beat their benchmark can be as high as 1/3 (and that’s on the high end) to as low as 15%. Whatever the actual number, it’s not good…especially when you throw in the exorbitant fees that the public is paying for that underperformance.

However, I don’t think the argument is that simple.

I don’t think it’s that simple because this argument assumes that the alternative for the average investor is to buy and hold the benchmark through thick and thin when there is strong, consistent evidence that the average investor buys high (following strong market performance) and sells low (after painful breaks).

Although indexing is indeed a very sound strategy for most people, the average investor generally does not hang on through thick and thin.

And this is precisely an area where asset managers will increasingly need to focus on in order to make up for the collective shortfall on the performance side: How to impart confidence in clients so that clients will invest through the cycle, or better yet, invest when markets are down.

After all, if an asset manager is able to do just that, clients would likely achieve a better outcome investing through the cycle even if performance is marginally subpar compared with the alternative of indexing but buying high and selling low. This becomes even more apparent when considering the number of studies that show that many clients underperform when invested with managers that outperform because clients invest high and sell low.

Managers that are able to engender confidence and encourage countercyclical investments, create value that is not captured in pure performance comparisons.

It’s also important to consider that an investment manager’s value-add is more than just returns. How that return is generated is also an important consideration: How much risk was required to generate that return? And, how volatile are those returns? Historically, hedge funds also added value by mitigating volatility (hence hedging). Hedge funds have strayed from that orientation, but the argument remains true today.

Value of Trading in the Secondary Markets

The second question is a trickier one: if the secondary markets purely involve exchanging stock/bonds between different investors where one investor’s gain is another’s loss, is there any value creation at all?

It’s tempting to say no, but that ignores the interdependence of the primary markets with the secondary markets. Without strong liquid trading of stocks and bonds in the secondary market, the primary market would also be much weaker. And we know this because when the secondary markets are poor, companies tend to hold off on IPOs leading to a drying-up of the IPO market. Without a strong IPO market, venture funding would likely also be impacted.

At the extreme, you also have many tech companies that pay a significant portion of employee compensation in the form of stock options. For example, Facebook recognized $3.2bn of share-based compensation expense in 2016. Secondary market trading is needed to create the value associated with those shares for employees. And for a (albeit controversial) company like Tesla, which is largely unprofitable at the moment, the ability to divert compensation costs into stock options/grants (>$300mm in 2016 vs net loss of >$200mm) gives the company additional room to continue to operate.

————–

Lately, it’s become quite unfashionable to believe that asset managers create any value (and for good reasons). However, it’s not an untenable situation. Remediating the problem simply requires being more thoughtful about what clients need and how the asset management industry operates within the broader financial sphere.