Shopify case study – No earnings, negligible cash flows but one hell of a moat

A few days ago, I read an excellent Fortune article on Shopify, the Canada-headquartered company that allows business owners to easily and quickly set up their digital e-commerce presence. It got me thinking about plenty of things on business and and investing.

 

My experience with choosing e-commerce platforms

I’ve known about Shopify for years, since at least late 2013. Back then, I was planning to set up a simple e-commerce store and was choosing between a number of platforms. These ranged from free ones like WordPress to paid platforms like Wix and of course, Shopify.

I actually quite liked Shopify as it seems fuss-free and powerful enough. What turned me off was the pricing. Well, at US$29 a month for the basic plan, it was not exactly unaffordable. But when I first started out, every cent counts. Besides, the margins of the products I was intendinf to sell were relatively lower and I guess it was just the penny pinching mindset that was part of the package as a value investor.

I ended up on the WordPress platform which is more robust than Wix or Shopify but requires a certain level of technical and programming expertise (of which I had very little of). Although I had to install it myself, the most crucial factor of deciding on WordPress was that it is largely free! Over the years, whenever I need technical expertise to upgrade or if the site breaks, I had to seek external help by turning to gig platforms like Fiver. For minor issues, Googling DIY solutions had been most useful. While the overall explicit costs from using WordPress were definitely lower, if I had known beforehand that I could have avoided all the headaches, struggle to learn how to use it, time spent to resolve issues, security fears, inability to utilise new functions due to obsolete underlying system, lost revenue when the site is down, minor errors faced by customers, I would probably have opted for Shopify instead.

Fast forward about 4 years later today in July 2017, Shopify is now a public company listed on the NASDAQ, with a stock price that’s climbed from US$17 to about US$89 since it’s listing in 2015.

Financials wise, Shopify remains unprofitable even though revenue has continued growing like a weed. In fact, it seems to be that the higher the revenue generated, the greater its losses. Cash flows from operations were barely breakeven and would have been negative without adding back stock-based compensation. The dismal quality of its financials stopped me from exploring further and from considering investing in Shopify. But the stock price keeps marching upwards. What is it that the market knows that I don’t? Could it just be a bunch of loonies pushing prices up? Turns out, the closer I read the article, the more I realised there could indeed be substance behind the skyrocketing stock price.

 

A tech startup’s snake oil – “We can be profitable if we want to”

It has been argued that Shopify can be profitable if it wants to. It just has to cut marketing costs. I viewed it with great scepticism. After all, all tech firms are saying exactly the same thing. There’s alot of Kool-aid being passed around and I thought this was one of it.

Well, it turned out there is truth in cutting down marketing expenses to gain profitability but it only applies to very specific business models. It only applies to businesses with strong recurring revenue, of which a complete reduction in marketing expenses would not lead to its existing customer base bailing out. Shopify’s business model is a prime example of this phenomenon. In my opinion, the function of its marketing costs is really to grow and acquire new customers rather than retaining existing customers.

The moment a customer signs up with Shopify, sets up shop and gets some revenue streaming in, you can be quite assured he will stay with Shopify for some time as long as his operations remain profitable. After learning how to use it and having invested effort into optimising his storefront and utilising value-adding third party plugins from riding on Shopify’s platform, he gets locked in to the system.

Contrast this with a fashion retail brand like Abercrombie & Fitch (“A&F”). Once a consumer purchases an item from A&F, that’s the end of the transaction. To induce the same consumer to spend at the store, he has to be convinced that down the road he will be perceived to be cool when people see him wearing a new piece of A&F apparel. That’s where marketing and advertising expenses come in for A&F – to not only attract new consumers but also retain existing ones.

**High switching costs**
The point on Shopify’s third party plugins is what makes the customer lock-in extra powerful. Over the years, Shopify has built an ecosystem of app creators not unlike Apple’s app store. Shopify is no longer just a web host and template provider. It is an ecosystem which app vendors can build onto Shopify’s underlying platform and integrate their functions with customers’ stores. As an example, Mailchimp, a highly popular marketing email automation tool layers onto Shopify’s platform, allowing store owners to automatically send emails to re-activate customers who have not made a purchase for 60 days by encouraging them to make a purchase, perhaps through discount codes. Customers pay a small fee to Mailchimp, but the returns can potentially be way more exponential. The more extra tools (plugins) customers use, the more app vendors Shopify sign up and the more innovative they are, the more locked in Shopify’s customers become. And of course, Shopify gets a cut of all those fees flowing through.

I’ve used the same web host, same WordPress platform, same domain name host for 4 years and I sure as hell am not uprooting from it, given all the hassle I’ll face if I do so.

Although I’m not on Shopify, if I am and they take care of all my traffic load, security matters, create value for me with additional functionalities to bring in more sales and better track inventory, etc, you can rest assure I’ll stick with Shopify for a long long time.

In short, I believe the marketing expenses are truly and largely for growth purposes. Customers who sign up and gets the first dollar of revenue rolling in likely stays for a long time. In other words, these customers have long lifetime values. On the topic of lifetime value, it is also important that it drags on as long as possible. As an example, say dating apps like Tinder, there is a natural attrition when a user enters into a serious relationship with a new partner. In most cases, he or she is not likely to utilise it again during the relationship until a breakup occurs. They may never use it again if the parties get married. Each iteration of marketing and advertising efforts serves to retain a certain customer count and the business is left running on a treadmill. In fact, the irony is that the better the dating app is at matching, the faster users drop off from the platform. Qualitatively, Shopify undoubtedly has a better business model and greater staying power from these perspectives.

The other consideration of the switching costs or likelihood of customers being retained on Shopify or any other platform would be the repercussions if they stopped using it. If Shopify customers want to move their sites elsewhere and recreate the previous site experience which their users are used to, to an extent, they may be able to export or recreate certain segments of their site but overall, the effort will likely be Herculean, if not a total nightmare especially for customers without the technical expertise.

Financials and valuation

Financials wise, revenue and gross profit grew almost 90% and 85% respectively between FY2015 and FY2016. Revenue was US$389m and gross profit was US$209m in FY2016. Losses widened from US$19m in FY2015 to US$35m in FY2016.

Sales and marketing expenses were US$129m in FY2016 and makes up the largest part of operating expenses of US$247m. This will not be a direct and most accurate comparison but if we take a peek at Verisign’s sales and marketing expenses, it makes up about 8% of revenue as compared to Shopify’s 33%. Verisign holds the monopoly to the .com and .net top level domain, has a quality of customer retention that is probably among the strongest I know and has a very slow and steady revenue growth pace. At 8% of revenue in sale and marketing expenses, I would think it probably is a good floor reference. Assuming Shopify requires a normalised equivalent of 10% to achieve a slow steady rate growth, that would translate to US$39m in sales and marketing expenses. R&D for Verisign makes up about 6% of revenue. Verisign, as the .com and .net monopoly hardly needs R&D so it probably is a lowball percentage. Shopify definitely needs a much higher percentage and this is arbitrary but I believe 10%, which is double that of Verisign’s should be fair for Shopify to achieve a slow steady rate growth. That translates to US$39m in R&D expenses for Shopify.

Assuming minimum sales and marketing expenses of US$39m and R&D of US$39m, would give us US$88m in normalised operating profit. There will probably be quite alot of NOLs for claims given the accounting losses Shopify made over the years. This would mean that Shopify may not need to pay taxes on incoming profits for some time. Assuming Shopify incurs effective Canadian tax rate of about 26%, it would generate about US$65m in normalised net profit or a net profit margin of about 17%. Not so unprofitable now eh?

This is where things take a much more arbitrary turn. Shopify had been growing at crazy rates and has near-guaranteed growth in the future given the secular trend of rising e-commerce volume. By exactly how much, it’s hard to tell but I do think 30% compounded over the next 3 years isn’t out of the question since the existing infrastructure has been built out and the incremental cost of a new customer who signs on isn’t that high. In fact, 30% CAGR over 3 years is probably conservative. I would slap on a 25 times EV multiple as a reasonable exit multiple down the road to pay for such a high quality, strong moat and high growth business.

Assuming earnings for the next 3 years grow at the 30% CAGR, at the end of year 3, earnings will be US$143m. At 25x exit multiple, That comes up to an EV of US$3,575m. To get the equity value, I’ll also add back 75% (arbitrary again – I assume the company needs about 25% for working capital) of net cash (US$296m) as at 31 Mar 17, and we get an equity value of about US$3,871m.

This is way below Shopify’s current market cap of US$7,800m and I could be too conservative about Shopify’s prospects in terms of financial projections. Sometimes, one does need to take a leap of faith to invest in compounder businesses with a wide moat. However, I am still pretty much a value and numbers driven investor as opposed to a story driven investor. As such, I find it hard to jump in with both feet into an investment with too high a valuation.

 

Conclusion

Ultimately, I may not be buying Shopify anytime soon. Nevertheless, I thought this was a great exercise to pen my thoughts down and build a framework to uncover potential investment gems with similar high quality moats and earnings that are obscured by expenses largely relating growth.

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Kimly – Missed opportunity, lesson and alerts

As an update to a previous post on Kimly being a potential investment opportunity at S$0.42 and below, its been about 2 weeks since Kimly’s listing. Of course I knew there was no way it would trade anywhere near the IPO price of S$0.25 that day. It surged more than 100% at the opening bell before closing at S$0.44 on the day of the listing. As at 31 March 2017, the stock price was S$0.48.

The only time the stock price reached S$0.42 and below – prices at a margin of safety I was comfortable buying at – was in the morning and early afternoon of 21 March 2017. Unfortunately, I wasn’t able to get my hands on the shares. I was attending a prayer session held for my late grandmother during that time and my usual brokerage’s (Standard Chartered) trading platform was accessible only via a desktop/laptop.

By the time I got to a computer, the opportunity had vanished as the price had climbed back up. The price closed at S$0.46 that day.

I could make all these excuses but the fact was that I wasn’t there to pull the trigger when the opportunity presented itself. While the Standard Chartered platform did not allow trades to be done through a phone app or a mobile site, I could have utilised another brokerage although the fees were higher. I could have put a good-till-cancelled trade through other brokerages days prior even though Standard Chartered didn’t allow it. I could have gotten a close friend who would have been behind a desk at that time to login with my details to Standard Chartered and put through the trade.

The lesson I’ve learnt is this. When I’ve got the conviction to buy at a certain price once I’ve done up the necessary research, it makes sense to be well prepared in the event the trigger needs to be pulled. If there are restrictions, apply a little creativity to seek workarounds.

I’ve set an alert via the SGX app I downloaded. I’ll get a notification on my phone if the price falls to $0.42 and below. This will free me from having to check the stock price and in taking action only when the occasion arises. I also found a useful feature that the app is equipped with. It has a feature that alerts me to specific companies’ announcements when they are released. Instead of the usual ‘pulling’ of announcements as and when I decide to check, they are now ‘pushed’, which makes it more timely than before.

IPO Opportunity – Kimly

Every now and then, some interesting IPOs with palatable valuations pop up such as HC Surgical Specialists and Advancer Global which I wrote about previously. At the point of their respective IPOs less than a year ago, they each had respective offer prices of S$0.27 and S$0.22 per share. At the last done prices on 15 March 2017, their per share prices reached S$0.58 and S$0.36 respectively. There certainly are opportunities to profit from IPOs if they are the right business and if their valuations are compelling.

This time around, the IPO in question is Kimly Limited (“Kimly”), a company that runs a chain of coffee shops and bills itself as ‘the largest traditional coffee shop operator in Singapore’. The offer document can be downloaded off Catalodge on the Singapore Exchange (“SGX”).

I have jotted down some points below which encapsulate the key matters of the IPO, the business, valuations, etc.

About the IPO

  • No. of offer shares to the public: 3,800,000
  • No. of placement shares (private investors): 170,000,000
  • Price per offer and placement share: S$0.25
  • Gross proceeds from IPO: S$43,450,000
  • Net proceeds from IPO: S$40,363,000

About the business

2 main business segments:

  • Outlet Management Division (64 outlets)
    • 54 outlets under Kimly brand
      • 51 coffee shops
      • 3 industrial canteen
    • 5 outlets under third party brand
    • 5 outlets under “foodclique” brand
  • Food Retail Division (121 food stalls)
    • 36 mixed vegetable rice stalls
    • 10 rice garden stalls
    • 2 teochew porridge stalls
    • 29 seafood “Zi Char”stalls
    • 1 live seafood stall
    • 43 dim sum stalls

For the Outlet Management Division, Kimly is the master leaseholder of the food outlets. For the segment, Kimly leases food stalls to tenants and provide cleaning services to tenants of the food stalls and charges utilities. Other than that, the segment also sees Kimly self-operating some of the most profitable parts of the food outlets, including the drinks stalls.

For the Food Retail Division, it consists of Kimly self-operates the Mixed Vegetable Rice, Seafood “Zi Char”, Dim Sum and Teochew Porridge stalls at several of the food outlets that it operates and manages.

Contrary to what some people might think of Kimly, it does not actually own the coffee shop real estate. Instead, it is largely an asset-light business, with a part of the Outlet Management Division being essentially a spread business (master leasing the property and then subleasing it to tenants). The real estate of the 51 coffee shop outlets under the Kimly brand are leased in the manner below:

  • 14 outlets from the Housing Development Board (“HDB”)
  • 17 outlets from a related-party (more explained under ‘Obscure matters in the offer document that matter’)
  • 20 outlets from third-party landlords

What I like about the business (qualitative, quantitative and moats)

  • Nature of business: Deals in consumer essentials, lowest cost producer
    • High resilience and very likely to stay afloat during times of high economic stress
  • Nature of business 2: Cash business
    • Reduces concern over managing receivables and impairments
    • Cash generative, with excess profits for reinvestment, dividends, buybacks
  • Capex frequency: Typically conduct refurbishments for each outlet once every 10 years
    • Less capital requirements as compared to restaurant businesses which need more frequent updating
  • Capex quantum: Less need for fanciful design and materials for each refurbishment phase
    • Less capital requirements as compared to restaurant businesses which need nicer look and feel to attract patrons
  • Occupancy rate: 98% occupancy rate over a total of nearly 500 stalls within the 64 food outlets under management
    • Lower risk of vacancy and correspondingly, lower lost revenue
  • Central kitchen: To prepare sauces, marinades and semi-finished products that require only reheating or minimal cooking at Kimly’s self-operated food stalls (under Food Retail Division)
    • Reduces overall manpower and operating costs and enables higher margins through scale, as compared to small/standalone competitors
  • Management’s stake: Post-IPO, Lim Hee Liat, Executive Chairman, will have 42.42% stake and ‘other employees’ will have 14.12%
    • The collective 56.54% stake of insiders aligns interest of minority shareholders
  • Management’s age: Most are in 40s, with Executive Chairman being 51 yeas old
    • Relatively young age of management means longer operational runway with less disruption to creating value for shareholders
  • Reasonable lease agreements: HDB leases (14 outlets) and from an interested-party – LHL Companies (17 outlets)
    • The majority of the leases are either likely to be reasonable (HDB – since the government is less incentivised to maximise profit) or structurally favourable due to restructuring exercise as discussed under ‘Obscure matters in the offer document that matter’

2 key qualities of the business which I like are the capex frequency and quantum. As such, I’ll spend a little more time expounding on the matters.

All F&B businesses have to spend a certain amount of capex to refresh the look of their premises at some point. In that regard, the coffee shop business comes out way ahead of a typical restaurant business.

Unlike restaurant businesses which have to spend a relatively large amount of capex due to the more sophisticated design and materials required to appeal to patrons in order to justify the higher prices they charge, most coffee shops do not have such problems. The design and materials are pretty basic and typically, patrons do not care much about how spanking new it is as long as the food is good and affordable.

Restaurant businesses also need to update the look and feel of outlets more frequently. This means higher frequency of capex which comes probably every 3 to 5 years whereas the aesthetics of coffee shops’ typically stay the same for many more years and most look like they are about to fall apart before the operators touch them up or go for an entire revamp.

One ironic observation is that the older the coffee shops’ aesthetics are, the larger the crowd is. The newer looking it is, the smaller the crowd it seems. This likely arises from older hawkers having established themselves in a particular location over many years and have earned a reputation for themselves, thus, drawing snaking queues while the coffee shops themselves continue to reflect the era when the hawkers first started out. Contrast this with the restaurant business. A shabby looking restaurant or food court in a shopping mall is almost sure to turn patrons off. Walking into an air-conditioned mall comes with expectations of spanking new facilities and a nice environment to dine in.

In short, the lack of a double whammy of higher quantum and frequency of capex invariably raises the profitability of coffee shops as compared to restaurants.

Interestingly, only S$3.0 million of the IPO proceeds are allocated to ‘Refurbishment and renovation of existing food outlets’, representing just 7% of total proceeds.

Moats

2 core moats seem to be in action here:

Economies of scale – Scale allows more efficient transportation of goods (drinks, semi-finished goods from central kitchen), mass preparation of semi-finished goods to self-operated stalls, bargaining power against suppliers (food, drinks, cleaning, etc)

Intangible (leases) – Limited supply of real estate available for food outlet operations due to regulation dictating usage of specific properties. Successfully securing a contract is almost equivalent to a money printing press from the recurring income stream from the spread business of master leasing and sub-tenanting out, and the self-operations of the most profitable stalls by the master lessor

 

Obscure matters in the offer document that matter

kimlytrendinfo

Source: Kimly Limited offer document

These two statements under the ‘Trend Information’ section caught my eye as I was going through the more than 400 pages of Kimly’s offer document. That led me to relook further in the ‘Restructuring Exercise’ section of the offer document.

Revenue increase in FY2017

For (a), interestingly, it really means that Kimly will be master leasing 17 outlets as part of an agreement with LHL Companies, which is essentially controlled by Lim Hee Liat, Kimly’s Executive Chairman. In other words, LHL Companies (or if you wish to see it in another way, the Executive Chairman) will be the landlord that collects rent from Kimly, the listed entity,  for the 17 properties. Lest you think this interested party transaction is dodgy, it may not be the case. On K-13 to K-14 of the offer document, it appears that Kimly will be paying below market rate in rent (on average, 13.3% below market rate) to LHL Companies, with a 4 years + 4 years leasing agreement. Following the expiry of the first 4 years of the agreement, the rate will be adjusted to ‘not more than Market Rental Value and not lower than 75% of the Market Rental Value’. The 100% upper limit on the market rate of the master leases provide minority investors with a degree of comfort that the Executive Chairman will find it hard to milk Kimly through unreasonably exorbitant lease agreements.

For the past financial years – FY2014 to FY 2016 – the financial figures does not include the master leasing agreements as the LHL Coffee Shop Leases agreement was only set in motion after the restructuring exercise on 1 October 2016. This also means that revenue (from rental income collected from food stall tenants) and correspondingly, costs (from master leases paid to LHL Companies) will increase, enabling Kimly generate profits from this spread. Not to mention, Kimly will likely benefit from the favourable below market rate leasing contract agreement with LHL Companies. It is also useful to note that through the years, Kimly has paid LHL Companies certain food stall rental fees (S$3.2 million), cleaning services (S$0.4 million) and utilities charges (S$0.9 million) in FY2016. While Kimly wasn’t the master lessor in FY2016, the expenses arose from Kimly’s operation of the drink stalls in all 17 outlets as well as some other individual food stalls through its Food Retail Division. These will have to be normalised in that the expenses will be part of the overall monthly master lease amount to be paid to LHL Companies. Overall, this should lead to an increase in profits.

Higher taxes in FY2017

For (b),  Kimly’s effective tax rate had been abnormally low at between 4.5% and 5.5% over FY2014 to FY2016. The statutory corporate tax rate in Singapore is 17%. The much lower effective tax rate then was mainly due to the large number of small entities Kimly group controlled (eg. one coffee shop under one legal entity) which, under the tax system, allowed for partial tax exemptions as long as an entity does not exceed a certain profit level). Given that the restructuring exercise would have amalgamated the entities to give rise to larger entity sizes but a lower number of overall entities, Kimly’s overall effective tax rate should rise. Consequently, this should impact profit going forward.

Financials

Income statement

 

kimly_IS

Source: Kimly Limited offer document

Cash flow statement

kimly_CF

Source: Kimly Limited offer document

Overall, the income and cash flow statements appear to be good. In fact, it is better than good. The business is generating boat loads of operating and free cash flowsRevenue and all profitability metrics appear to grow at a good pace over the last 3 years. Considering that Kimly spent relatively small capex amounts and F&B businesses are relatively slow growth, the set of numbers definitely look favourable. Below is a simple table I generated, noting the growth of the key revenue and profitability line items for quick reference.

Kimly_growthExcel.PNG

Source: Kimly Limited offer document and Leith Street

There really isn’t much to quibble about. While there are certainly factors that led to a boost in profits across the 3 years (eg. Lim Hee Liat’s remuneration in band D – S$750,000 to S$1,000,000 in FY2015 as compared to band B – S$250,000 to S$500,000 in FY2016) which would tell a fuller story, in general, it looks fine.

Balance sheet

kimly_BS.PNG

Source: Kimly Limited offer document

One of the key things that jump out of the page is the size of Kimly’s cash position at S$29.5 million as at 30 Sep 2016. It is the largest line item (other than share capital) on the balance sheet. It also has has zero bank borrowings – all hallmarks of a cash-rich, asset-light business.

To find out the approximate cash Kimly will have on 20 Mar 2017 (date of listing) and given that the cash holdings as at 31 December 2016 was S$34.2 million as stated in the offer document, we will need to account for:

  1. Inflow – S$5.7 million from cash generated between 1 Jan 2017 to 20 Mar 2017 (78 days) (free cash flow for 365 days in FY2016 was S$26.7 million)
  2. Inflow – S$5.0 million from draw down of convertible loans (pre-invitation investors)
  3. Inflow – S$40.4 million from net proceeds from IPO
  4. Outflow – S$11.0 in conditional dividends to be paid out to previous shareholders upon listing

Assuming there were no borrowings taken on between 31 Dec 2016 to 20 Mar 2017, Kimly’s net cash should be approximately S$74.3 million on 20 Mar 2017.

ROIC/ROE/ROA

The business runs on negative invested capital since cash exceeds equity for every single year and has zero bank borrowings. As such, there isn’t an ROIC to speak of. On a ROE and ROA basis, Kimly generates close to 100% and about 50% respectively for each of the 3 financial years.

These are highly impressive numbers. The only concern is whether there are sufficient areas for the reinvestment of capital, which I am rather skeptical with regard to organic means.

 

Growth

kimly_growth.PNG

The above is a screenshot from the offer document on how Kimly intends to grow. I am skeptical that investments in technology will move the needle for them. In any case, only a small portion of the IPO proceeds were allocated for that purpose.

What is interesting is that a large chunk of S$30.4 million from the IPO proceeds has been allocated for business expansion. I have doubts Kimly  will be able to seriously muscle in and outbid incumbents presently leasing space from landlords. There are a couple of scenarios I can imagine Kimly utilising the firepower of what S$30.4 million can buy. The first is Kimly intending to be a landlord. While possible, it would defeat their asset-light strategy and will be pretty weird, especially since they have chosen not to inject the 17 LHL Companies-related real estate into Kimly. In any case, given the current environment, coffee shops real estate aren’t exactly the cheapest stuff on the market. As such, my opinion is that there is a low chance Kimly will pursue this path.

The other strategy I can foresee if Kimly acquiring a similar but smaller operator so as to raise Kimly’s overall scale. Other acquisitions such as coffee shop cleaning services or complementary businesses that helps Kimly to scale vertically could also be possible. These appear to be the most plausible reason for the S$30.4 million in allocation. Should that be the case, assuming the deal(s) is/are done at a reasonable price, it would likely be beneficial for Kimly.

I suppose we can check back in a year to see how this pans out.

Valuing Kimly

Normalisation

Going forward, Kimly will incur expenses as a listed company it did not have to bother with in the past. These will impact its financials, along with a number of non-recurring or prospective line items that will need to be adjusted. Other than the 17 new food outlets from the LHL Companies, I am assuming zero growth from Kimly’s existing businesses.

For ease of formatting and explanation, I have typed the line-item adjustments into Excel and provided a screenshot below. Since Kimly’s operating/free cash flows and profit after tax have tracked rather closely, there is little risk of accounting gimmicks. As such, I used profit before tax in FY2016 as the starting line for the work done on adjustments:

Kimly_normalisation

Enterprise value

Given that the market cap will be S$288.7 million and net cash will be about S$74.3 million (negligible finance leases) on 20 Mar 2017, we get an enterprise value of S$214.4 million.

Yield and valuations

An enterprise value of S$214.4 million and normalised adjusted profit after tax of S$20.3 million gives us an EV/earnings multiple of 10.6x or a yield of 9.5%. By itself, the yield appears to be favourable.

On a P/E basis, with a market cap of S$288.7 million and FY2017 adjusted earnings of S$20.3 million (EPS of 1.76 cents based on 1,154,786,732) and FY2016 earnings of S$24.2 million (EPS of 2.10 cents), we get a forward P/E of 14.2x and a historical P/E of 11.9x (not exactly representative because of expenses not incurred as an unlisted company in FY2016).

There aren’t any direct listed peers in terms of coffee shops businesses listed on the Singapore Exchange (“SGX”). However, there are a number of SGX-listed restaurant and F&B businesses that could provide us with a reasonableness gauge of Kimly’s valuation at the IPO price of S$0.25 per share.

Kimly_PeerComparison

Most of the companies on the peer list are expected to have a relatively slower pace of growth, other than Jumbo. While a large part (S$33.4 million) of the net proceeds are allocated for expansion, I can’t be certain of Kimly’s growth profile although the prevailing view of a number of people I spoke to are skeptical of its growth prospects.

That said, Kimly has a much enviable margin and is in a more defensive sector (coffee shops and food courts) of the F&B industry compared to the rest of its peers yet is priced at the lowest valuation and will have one of the highest dividend yield. As such, I would argue that Kimly should deserve a premium above the market multiple.

Assuming Kimly trades at the industry average P/E multiple of 22.8x, it would equate to a price per share of S$0.48. This represents a 47.9% margin of safety or an upside of 92.0%.

For a business like Kimly’s and without even accounting for the optionality of the business utilising the IPO net proceeds to achieve further growth, I would be comfortable with a margin of safety of 10% to 15%. For simplicity’s sake, let’s take the midway of the 2 numbers – 12.5% – as the margin of safety. The price to buy would be S$0.42 and below.

This is the first time I tried balloting for an IPO’s offer shares. However, it was unsuccessful, although it was hardly a surprise. With barely a million dollars worth of shares available to the public, there isn’t sufficient supply going around to fulfill the demand from public investors. Those who were fortunate to have applied and received placement shares, totaling S$42.5 million, are likely to see an immediate pop on the opening bell at 9am, 20 Mar 2017.

Should the share price be below S$0.42, it could be a good opportunity to accumulate some shares of Kimly.

Risks

  • Depressed free cash flows due to large capex to refurbish food outlets right after IPO
    • Appears unlikely as allocation of IPO proceeds for the purpose at only S$3.0 million
    • Compares favourably with annual capex of S$1.0 to S$2.0 million per annum over past 3 financial years
  • Increase in leasing rates by 20 third-party landlords, squeezing Kimly’s margins
    • A very real issue, although it is mitigated by the fact that the bulk of landlords are either the HDB (less likely to be exorbitant in increases) or LHL Companies (fixed and below market rate leases)
  • Outbid by competitors for current HDB and third-party sites
    • A real potential problem of competition
    • Unable to completely mitigate risk
  • Increases in manpower costs 
    • Affects every industry player
    • Utilisation of technology to raise productivity, with S$2.0 million of IPO proceeds allocated (I have doubts on the extent it will help)
  • Bad hygiene leads to regulatory action to suspend outlets and/or food stalls
    • Usually a small impact, unless systemic problems of cutting corners on cleaning fees
  • Competition from online food delivery services
    • Threats are probably unwarranted. Just the other day, while ordering takeaways at a nearby coffee shop, I noticed a online food delivery staff collecting food packets from the same stall I was ordering from. I came to realise that the online food delivery may not be much of a threat to the coffees shop business and in fact, is complementary to it since hawkers still need a place to prepare, cook and sell their products

Reflections on Value Walk’s interview with Greenhaven Road’s Scott Miller

I came across an interesting interview with Scott Miller of Greenhaven Road Capital a couple of days ago, conducted by Value Walk.

Without replicating the entire interview in full, I thought it would be useful to extract some key points which I found to resonate with me and which led me to reflect on experiences and thoughts. As such, I also typed out in italics some notes to accompany the extracted points.

 

On your brain being suitably wired for successful investing

As a person who can usually find an angle and has a contrarian streak, investing held great attraction. As for the value discipline, I think it is how my brain is wired. Not only do I have trouble paying retail, I enjoy items bought on sale markedly more than those for which I paid full price. Value is all that makes sense to me.

My notes: Similarly, I try my best to avoid paying full price for items or try to seek cheaper alternatives as much as possible. When I do have to buy clothes, gadgets or books, my first pit stop is always the internet to find the best deals. To save a couple of bucks, people are increasingly doing the same so that habit isn’t much to shout out about.

What I can say could be a little more unique is that when I am out in town after midnight when most normal buses and trains have stopped operations, I think nothing of taking a 10 minutes walk to a bus stop which has a late-night bus service operating, then waiting for another 30 minutes for the bus to arrive so that I can hop on for a 40 minutes long-winding ride back home. If I had hopped on to a cab, it would take much less than half the time to get home but at six times the cost. I find it hard too fish that kind of money out of my pocket, especially if I am not in a rush to get home. That said, I recognise the time cost involved. That is why I almost always bring a physical book or my iPad (loaded up with books) with me when I head out so that I can do some productive reading while travelling on public transport – money saving and good for the mind.

 

Juggling a day job and managing a fund

There was a ten plus year period where I was working a full-time job building in an operating business and investing on nights and weekends. Given my concentrated portfolio of approximately 15 companies and low turnover, I am only looking for one investment idea a quarter. Most days I don’t buy or sell anything. I am not trading news flow, so my investment style is conducive to investing in off hours.

 

For the first four years of the fund, I continued investing “on the side” one or two days a week with a near full-time, other job. I honestly think having other non-investing responsibilities did not hurt performance at all.

My notes: I realised that too much idle time available can be a doubled edged sword in investing. A couple of years ago, when I had a fair bit of time on my hand away from my day job, returns in my personal portfolio started going downhill.

With idle time, I turned over more stones and seek out new, undervalued opportunities. On the other hand, it affected my mind, in that I became increasingly worried about my positions and returns. I felt that I needed to safeguard those returns achieved by turning over the portfolio to lock in gains. I also fell prey to the sunk-cost fallacy. Having done research on a number of different opportunities, I felt cornered to put capital to work even though the ideas were not the most compelling ones and checked the stock prices of my portfolio a lot more often than I should. This fed into the loop of being nervous about returns.

That period was one of the formative periods in my investing journey. I am glad that over time, those demons have been suppressed. Through that episode, I learnt that having too much idle time on hand can be very damaging for one’s portfolio if the mind has not been properly disciplined. 

 

Fund structure and choosing aligned investors 

Greenhaven Road is modeled after the early Buffett partnerships. I don’t take a management fee. I do earn an incentive fee of 25% on returns above 6% with a high water mark. I like to say that I make money with my investors, not off of them. In a year where I am up less than 6%, not only do I not make money off of my investors, in fact, I incur some costs. I only get compensated if I provide returns to investors.

 

In August when the world was blowing up, many funds were holding hands of their LP’s convincing them that everything would be alright. My situation was far more positive. The only email I got from an investor was asking if he could nearly triple his investment in the fund. I was able to look for opportunities, not worry about redemptions. So from a structural perspective – small size, terms that are aligned with a long investment horizon, and a like-minded investor base are a great foundation.

My notes: It looks like other than Monish Prabai, Scott Miller is one of those other few managers who has tapped on the original Buffet partnerships to structure their funds. If I do ever set up a fund, it will likely be of a similar structure.

My opinion is that the typical 2/20 structure of funds will end up incentivising most managers to become asset gathers instead of being motivated to generate real after-fees alpha for investors. Even for those well-meaning managers who do have the initial aim of doing good for their investors, I suspect that those structural chains of incentives to move towards asset gathering will eventually be too hard for the managers to break. It is thus important to set up the structure to be aligned right from the start.

In times of market stress, the opportunities are probably the greatest, while existing positions if bought at reasonable valuations should continue to do well over the long-term if there aren’t any permanent impairment to the business. It is precisely during this time that capital should not be pulled out. Having came across a number of horror stories of investors who do not have the right temperament pull out of funds at the worst possible time when a manager should be investing heavily, Scott Miller’s words of being selective of clients and having like-minded clients is an important reminder of what to do and what not to do.

 

On idea generation

Like most investment managers, I spend a lot of time reading. In particular, I love fund managers’ investor letters. If there is ever a time for a fund manager to put a good foot forward and present their best ideas, it is in their fund letters. Some of my favorites are Jake Rosser at Coho Capital and Eric Gomberg at Dane Capital [interview coming soon]. Voss Capital, Arlington Value, are great as well. The Value Walk daily email is also a very helpful source of letters. I scan it every day. Another place I go every day is Value Investor Club. The discussion and quality is the best I have seen on the internet.

My notes: Other than Arlington Value, I have not heard of the rest of the other funds. Will definitely be checking them out. A few months ago, I set up a bi-weekly calendar reminder on my phone to visit Value Investor Club to read through the high quality investment ideas for 2 reasons. The first is in hope of finding interesting actionable opportunities. The second is to improve my craft by reading and understanding the thought processes of analysis done by investors who are way better than I am.

 

Evaluating opportunities and being selective

I have a couple of checklists that I run through that date back to my private equity experience. In particular looking closely at the product, market, team, and execution risk – really just getting comfortable with how good a business it is.

 

This process of making a decision can take a day or a month, but I have a very good sense if a company is a very likely or very unlikely investment in under 30 minutes. Given I only make a few investments a year, I end up with a huge, “too hard” pile – which is for opportunities that could be good – but I just cannot get there.

My notes: A good reminder to walk away from non-compelling opportunities. If the opportunity does not jump off the page, is way outside of my circle of competence and/or has elements that makes me very uncomfortable, such as excessive debt load and/or governance issues, I should dump them into the ‘too hard’ pile. The pain of errors of commission will be greater than errors of ommission.

Favourite Brain Food Links

There are certain corners of the internet I visit on a regular basis to get my dosage of brain food.

Whether the sites’ contents are  investing-related or on other matters, they are almost always thought provoking and well worth the time spent on reading them. I have put together the links to my favourite sites below for easy reference and did a replicated page under the navigation menu (Favourite Brain Food Links page).

Naturally, I will add on to the list going forward. If there are any high quality and interesting sites, please feel free to share under the comment section!

Investing blogs

Investor letters

Mental models

Newsletters

Expounding on ‘Quality’ of the QVG framework

Under the Investment Philosophy page, I mentioned that I assess moat-type investments on a Quality, Valuation and Growth framework (QVG). In this post, I’ll expound in greater detail on the assessment of ‘Quality’.

As different variables and scenarios arise from each investment opportunity, it will be hard  to list each and every condition to determine quality. To simply matters, other than the key conditions I look out for, I have also laid out the ideal situations which would likely lead me to invest in a quality business.

Broadly, I categorise quality into 2 buckets – the qualitative and quantitative aspects.

I have also included a diagram or flow chart of sorts to summarise the below-mentioned points for easy and future reference.

quality-chart

 

Qualitative

One of the first things I try to identify is the type of economic moat(s) a business possess(es).

“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.” – Warren Buffett

The moat, in a way, refers to competitive advantages. Its usage in the world of investing appears to have caught on after the repeated usage by Warren Buffett in the Berkshire letters and during interviews.

If Warren Buffett was the father to popularising the ‘moat’ term, Pat Dorsey would be the intellectual offspring who expanded the topic on moats. Pat Dorsey was the director of research at Morningstar and wrote the wonderful books, ‘The Five Rules for Successful Stock Investing’; and ‘The Little Book That Builds Wealth’. In these books, he covered in great detail how to analyse moats, what makes them great and has a number of examples to show for.

Type of moat(s); 2 is better than 1

To keep the long story short, Pat Dorsey identified 4 economic moats that exist in strong companies generating excess profits:

  1. Intangible assets – Brand, patent, license (eg. Coca-Cola)
  2. Customer switching costs (eg. Adobe)
  3. Network effect (eg. Facebook)
  4. Economies of scale (eg. Walmart)

Plenty has been written about the topic so I shall not go into the nitty gritty details of each moat. I have included in brackets above, my own examples of well-known companies that fall into each categories.

Over the years, I came to realise that for a business to be truly great, 1 standalone moat is insufficient. Although one moat is typically more dominant than the other, there usually needs to be a strong combination of at least 2 moats concurrently driving the business. As an example, while Coca-Cola definitely has the dominant intangible – brand moat driving its success, its operations also has huge economies of scale at the global level. This helps the company to generate greater profits (stemming from lower cost per unit) in excess of what another strong beverage brand that is just a small local player may otherwise achieve.

Sustainability of moat(s)

Once the type(s) of moat(s) is/are ascertained, the next step – which is a crucially important step – is to assess how sustainable the moat(s) is/are likely, measured in number of years. The more sustainable the moat is, the longer the duration of excess cash flows flowing into the business that will ultimately benefit shareholders.

Determining the duration is not an exact science and there is a large element of guesswork. However, there is one clue to this. The reality is that the most likely source of disruptive force affecting any business stems from technology.

As such, one of the key questions I seek to answer for each investment case is the chance of technology disrupting the dynamics of the core business. In the case of gum chewing, the internet and pace of technology change is unlikely to disrupt consumers’ habits. In my opinion, I think there is a high degree of certainty that in 10 to 20 years from now, I will continue to chew pretty much the same Wrigley’s gum I do today as I did decades ago.

In comparison, I cannot be certain my laptop will be from Acer. In fact, given the pace of change in the field of electronics, I cannot even be sure I’ll be using a laptop in the next 10 to 20 years, not to mention that I already have an iPad tablet. In short, the further away the core product of a business is away from having a remote possibility of being affected by high technology, the slower the rate of change and the higher the odds of investments being safe.

That said, I am not advocating staying away from all technology-related stocks. That would be foolish since technology is going to feature in a larger part of our lives in the future. There are some truly great businesses that have stood the test of time, such as Microsoft and Adobe. As an example, Sapiens International, a insurance software provider which I wrote up on, has its software deeply embedded in its clients’ core operations. Once the mission-critical software is installed and the employees of its customers are trained on it, it becomes very hard for the software to be ripped out without its clients’ suffering downtime. Thus, while Sapiens International is a technically a technology firm, these huge switching costs and the customer stickiness that comes with it, should extend the business’ sustainability and correspondingly, the duration of the cash inflows.

Ideally, the sustainability of a great business’ moat should last at least 20 years.

The ultimate test – pricing power

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” – Warren Buffett

Ultimately, the essence of assessing the strength and sustainability of moats boils down to finding out if the business has pricing power. Strong pricing power, in my opinion, is the true test of a business’ quality. I have found it useful in answering early in the analysis, the question of whether a business has pricing power. It acts as a quick sorting filter on the quality of businesses

As shared previously in the post, ‘Pricing power – The rocket fuel to any investment thesis’, businesses with true pricing power has the advantage of ‘raising prices (revenue) without a corresponding increase in its cost base (expenses). In other words, the extra boost in revenue falls directly to the bottomline and provides a magical boost to profits without lifting much of a finger.’

 

Quantitative

Income statement and cash flow

It goes without saying that in an ideal situation, a quality business would see revenue, profit and operating cash flows rise annually at a good clip over at least the past 5 to 10 years, and is expected to do so going forward. The definition of good clip could at times be subjective. Generally, I would be satisfied with a consistent 5% to 15% annual growth rate for the top-line and a correspondingly similar or higher clip for the bottom-line. Too low and it may call into question how good the business and the sector really are; too high and it will surely attract excessive competition that will eventually drive down returns.

In a way, when it comes to assessing financials, I prefer a Goldilocks approach, not too cold and not too hot.

On profit margins, I am agnostic on whether it is low or high on a standalone basis. Profit margins by themselves do not tell much about the quality of a business as the levels are very much dependent on the nature of the industry and business. For example, even though a supermarket business has low margins, it should not warrant striking it out as a potential investment. The nature of a supermarket business (eg. Walmart) is that of low margin, high volume. In comparison, a luxury goods business (eg. Tiffany’s) has the exact opposite features – high margin, low volume. Both can be fantastic businesses.

When it comes to assessing margins, the real test is to benchmark them to its peers within the sector and industry. Needless to say, a high quality business’s margin should be within the top quartile of its group.

To draw inspiration from Lord of the Rings, the one financial metric to really rule them all is the businesses’ returns on capital (“ROC”). ROC, in my opinion, the one metric that will tell a strong business from a mediocre one, regardless of whether the nature of a business is high or low margin. The topic will be further discussed under the section below.

It has been said that profit is opinion, cash is fact. To avoid companies with potentially aggressive profit recognition, accounting gimmicks and to seek out businesses with good working capital management, operating cash flows should ideally exceed net profit in most years.

Balance sheet; and return on capital (“ROC”) – The one financial metric to rule them all

The safest of scenarios from a balance sheet perspective would be a net cash position. Very often, it is not the case and I am not averse to investing in companies with a net debt position. I do not have a thing against net debt on the balance sheet. It is just that the levels have to be reasonable. My general rule of thumb is that it should not exceed 3.5 times normalised free cash flow (adjusted to exclude growth capex).

On other aspects of the balance sheet, it is hard to pinpoint specific measures due to balance sheet items differing from industry to industry. However, one of the more general metrics I assess would be whether inventory and account receivables drastically exceed that of revenue growth. These are usually respective tell-tale signs of excessive inventory build-ups that could translate to impairments from obsolescence; and disproportionate rise in account receivables that could spell bad debt write-offs coming soon.

In the previous section on ‘Income statement and cash flow’, I mentioned the ideal situation of a quality company having rising top and bottom-lines. That condition doesn’t exist in a vacuum. After all, capital is not free. With unlimited capital thrown into a business, almost any business can grow its revenue and spin a favourable-looking set of financials that is low quality in reality.

The key differentiating factor is the capital structure and the efficiency derived from the capital employed. Truly great businesses should have the ability to generate high returns with little or at least, reasonable amounts of capital. In particular, the high quality capital-type should come in the form of retained earnings rather than from debt. Rocketing debt levels that accompany revenue and profit growth are certainly red flags that deserve greater scrutiny.

This brings us to the next point – ROC. One of the quickest filter to screen for quality businesses would probably be high ROC, which is a hybrid metric that utilises income statement and balance sheet figures. The key difference between ROC and return on equity (ROE) is that ROC takes into account the full capital structure, which includes interest bearing liabilities – debt.

ROC performance is usually one of the key metrics I look out for, since over the long run, ROCs have to exceed the business’ cost of capital in order for value to be created.

An example of a great business with the trait of utilising little capital while generating disproportionate cash flows and growth is Moody’s. In the 10-year period from 2005 to 2015, Moody’s generated about US$7.5 billion in total free cash flows as compared to only investing additional capital of merely about US$0.8 billion. In reality, very few businesses in the world can do this. The public knows this and the valuation of such businesses are usually bid up sky-high. However, every once in a while, when uncertainties arise such as in the case of the US government suing Standard & Poor (“S&P”) over its role in being less than honest about the ratings it gave to clients, there could be opportunities to load up on S&P and its counterpart, Moody’s, when the stock price got beat down over fears of astronomical fines they may have to incur.

I typically start to get interested in a business when the ROCs consistently exceed 15% annually. In the most ideal situation, ROCs would have increased over the years and are expected to continue growing. At the very least, ROCs should at least be stable.

The exception that I will make on ROCs being below 15% is when ROCs have been on an uptrend over the past few years. This trend could be a clue that operations are improving. Importantly, it would warrant further work on investigating if the business has an emerging moat. If it is indeed the case, beyond being just an emerging quality business, this could be an opportunity to get in at the ground floor of a business that may be a compounder for a long time to come.

I would usually go a step further and utilise the DuPont analysis to determine if the source of stable, rising or declining ROCs – margins, turnover and/or leverage. The highest quality of the source of rising ROCs would undoubtedly be margin expansion (most sustainable and in part relates to pricing power) and asset turnover (efficiency in managing resource), followed by the usage of leverage to finance its operations which would be the lowest quality of sources.

ROC.PNG

Selling Verisign puts

My past experience with options has always been in purchasing call options. About 2 weeks ago, I put through my first trade of selling put options. The key objective for selling options is to generate income for the portfolio. A safe bet tends to be the selling of put options at a strike price which one does not mind owning the underlying stock, in the event the counter party exercises the option.

About Verisign

The underlying stock in question is Verisign which I have held for more than a year. I continue to like the business immensely. Verisign holds the .com domain monopoly – Warren Buffett’s proverbial toll bridge. To put it simply, every company in the world that wishes to register a .com, whether it’s Apple, Google or Microsoft, ultimately has to pay an annual fee indirectly to Verisign.

Recent development

In my investment thesis writeup on Verisign, I noted that the agreement with the Internet Corporation for Assigned Names and Numbers (“ICANN”) to maintain Verisign’s monopoly is ironclad since there is an automatic renewal mechanism as long as Verisign does not screw up its maintenance of the root zone files. On 20 October 2016, that agreement was extended till 2024. The agreement was originally due for extension only in 2018. That it will ultimately be extended isn’t a surprise for me, but to the rest of the market, the renewal probably provided extra clarity and was a nice surprise given how early it got renewed.

That event sent the stock price up 6.5%, from US$76.56 to US$81.56 though it has since came back down to US$76.47 as at 26 December 2016.

The meat

The details of the option in question is a premium of US$3.50 at a strike price of US$65.00 and has its expiry on January 2018 or about 12 to 13 months from now. At the point of selling the put options on 19 December 2016, the stock price was about US$78.20. The stock price has to fall about 21% from US$78.20 to US$61.50 before the puts will be exercised by the counter party.

Given my belief that Verisign’s business will continue to be strong and generate the adjusted free cash flows at more or less the same amount even in bad times, I would be glad and very comfortable owning the stock at lower valuations. The way I see it, Verisign’s stock is a bond-like instrument with a small growth component embedded.

At a stock price of US$78.20, it is trading at a rather acceptable EV / adjusted TTM FCF (excludes stock-based compensation) of 13.9x or a yield of 7.2%.

Should the stock price fall 21% to US$61.50 when the put options become exercisable, the stock’s yield would now be about 9.0%. This compares favourably to the risk-free 10-year and 30-year US government bonds yields of about 2.5% and 3.1% respectively. While I know perfectly well that these are not exactly apples-to-apples  comparison, and that Verisign isn’t risk-free (though I think it comes quite close), I thought it is still useful and a good enough shorthand to know that Verisign will be yielding about 2.9 to 3.6 times that of the risk-free rate.

All in all, the premium collected will amount to an annualised return of about 5.2% based on the capital-at-risk.

Conclusion

5.2% is certainly nothing to shout out about as compared to most option traders’ double digit annualised returns. However, the structure of this trade is one that I can go to sleep at night soundly in even if the put options are exercised. Considering the insomniac I am, I would rather choose this over nail biting and exhilarating option trades that will leave me sleepless at night.

I am not sure if Verisign’s stock price will fall below US$61.50 over the next 12 to 13 months but even if it does, I would be a happy camper, assuming there aren’t significant adverse changes to the nature of the business. In the meantime, I’m glad to sit around and collect my US$3.50 in premiums!