Greater respect for consistently profitable companies

When I was young and stupid, I had unrealistic expectations of my investments. I thought I would find very small companies that would barely be profitable at the time I'd buy them, but then would make huge profits after I bought them.

After turning over many rocks and looking at hundreds of companies, I have discovered that many financially-upside-down companies remain in that state for a long time. And that many companies that have demonstrated success in the past continue to do so in the future. In other words, many companies do not revert to the mean. I think this is one part of why owning the index works so well -- the index contains companies that have demonstrated success in the past.

There is a bias in many value investors against popular names (or names in the index). Take AAPL for example. Many "value" investors would avoid it simply because they think it's too popular. Instead, they would rather buy some unknown micro cap that is barely profitable or a turnaround story. But if you look at AAPL objectively, you will see that from a pure numbers point of view, it is an outstanding company. Not many companies in the world can boast a 22% net margin and a 26% CAGR growth in EPS for 10 years.

The more I look at average companies that are present in the index, the more respect I have for such outstanding companies. Companies like V, MA, ROST and ODFL are rare gems in a sea of mediocrity. If you try to wait to buy these companies, you need a lot of patience, because crown jewels are rarely on sale. My strategy now is to buy a small piece of the company as soon as I recognize the quality of the business. And then I wait for the price to become cheap to increase my position to a full position. Such a strategy should work out over time, and I'll post an update in a few years after examining the results.

Ulta Beauty: Beautiful Figures

Retailing is generally a tough business. There is a lot of price competition that keeps margins low. There is also inventory risk. Still, even in tough environments, some retailers manage to stand out and earn good returns on capital. ULTA is one of them.

ULTA is a specialty retailer that sells beauty-related products to shoppers. This includes cosmetics, haircare, skincare, etc. products. They are the largest beauty-related retailer in the US and have experienced stellar growth in the past:

10-year growth CAGR figures:

Revenue: 19%
Operating Income: 34%
EPS: 37%

Interestingly enough, shares outstanding only went from 59M to 62M during this time and total debt went down from 106M to 0! So all of this growth was financed mostly from within the business.

While past growth has rewarded past shareholders, we care about the future. I think there is plenty of growth still to be had for ULTA:

1. Number of physical stores can double from 1k to 2k.
2. Ecommerce sales can grow at double-digit CAGR for the next 10 years.
3. There should be operating leverage at play.

In 5 years (by 2023), I expect revenue to be $8B, up from the current $5.8B. Net Income should be 12% of that, which means $880M. Share count may be around 58M which means EPS will be $15. A multiple of 18x seems reasonable to me, which means the stock will trade at $270.

At a current price of $250 or so, the stock doesn't offer very attractive returns, but it should be a buy around $150 or so. I wish I had read the annual reports of ULTA a few years earlier!

Amazon - An Outstanding Company at an Outrageous Price

Amazon claims to be Earth's most customer-centric company. And they have evidence to back that claim: American Customer Satisfaction Index consistently ranks them amongst them top when it compiles its list.

A laser-like focus on customers has enabled them to grow like a weed. Here are some measures of growth over the last 10 years:

Revenue/Share: 26% CAGR
Operating Income/Share: 11% CAGR
Book Value/Share: 27% CAGR

I believe that by having this customer-centric approach, Amazon has created a lot of value in the world. They have connected many entrepreneurs with customers through Marketplace, developers with datacenters through AWS and aspiring authors with readers through Kindle Direct Publishing.

Most of the created value is redeployed back into the business, at "high" rates of return, as claimed by CEO Jeff Bezos. So the company doesn't have much of an accounting profit (it has massive depreciation expenses from prior years' CapEx). I don't believe that the company will have an accounting profit for the next 15 years or so. Whenever it makes any efficiency gain, it passes those savings to customers. Without an accounting profit, it is difficult to place a value on Amazon.

How does one value Amazon? We can get some hints from the shareholder letters. I believe that Miss Market is valuing Amazon on the basis of cash flows far into the future (15+ years probably):

"Why focus on cash flows? Because a share of stock is a share of a company’s future cash flows, and, as a result, cash flows more than any other single variable seem to do the best job of explaining a company’s stock price over the long term." -2001 Letter to Shareholders

Amazon had operating cash flows of $6.8B, $11.9B and $16.4B in 2014, 2015 and 2016. I believe these do not take into account stock-based compensation, which is a real expense. Also, it is difficult to project these far into the future (given that they are consolidated figures). So let's try a sum-of-parts valuation instead.

Let's break down the business into: Retail (North America and International) and AWS.

North America had $80B of sales in 2016 and $2.3B of operating income. Growing at 25%
International had $43B of sales in 2016 and $-1.2B of operating income. Growing at 24%
AWS had $12B of sales in 2016 and $3B of operating income. Growing at 55%.

Optimistic Scenario after 15 years

Let us assume the current growth rates are sustained over the next 15 years.

Total Retail will grow to $3.5T.

Note that the total world retail spend is around $23T. Assuming it grows at 6% CAGR, it will be $55T in 15 years. So Amazon will be 6.3% of total global retail spend.

Also, Amazon US retail will be $2.2T and if US retail spend is $7T in 15 years, Amazon will be 31% of all US retail spend.

Assuming an operating margin of 5%, operating income from retail will be $175B.

Current rate of AWS doesn't seem sustainable to me (44%), so let's assume it will also grow at 25% CAGR for 15 years. Sales of AWS will be $341B in 15 years. Assuming an operating margin of 20%, operating income will be $68B.

Assuming multiples of 10x operating income for retail and 15x operating income for AWS, the total valuation comes out to be $2.7T.

The current market cap is $700B, so the rate of return is around 10% CAGR.

"Realistic" Scenario after 15 years

I suspect growth rates of 25% are not sustainable for 15 years. To me, something like a 15% sales growth for retail and a 20% sales growth for AWS seems more realistic (though it is no small feat).

Assuming the same multiples as described in the "optimistic" section above, the market cap in 15 years will be: $1T. Given the current $700B market cap the return will be a meager 3% CAGR.

Valuation Matters

15% sales growth for retail and 20% sales growth for AWS for 15 years is excellent. Any other company would be very happy to hit 15% sales growth sustained over 15 years. The reason for the meager returns in the "realistic scenario" above are because of valuation contraction.

Given the current market cap of $700B, it seems to me that Miss Market is putting a multiple of 100x on AWS operating earnings and 70x on hypothetical retail "operating earnings" at a 5% operating margin.

So the negative CAGR for "valuation contraction" that Amazon as a stock has to fight is -12%. So while I am bullish on Amazon as a business, I am not sure whether there is enough margin of safety for Amazon as a stock. Anything positive CAGR that Amazon as a business has to produce will have to overcome the -12% CAGR valuation contraction.

What else is Miss Market thinking?

Why is the multiple so high for Amazon? I suspect Miss Market is thinking about Amazon entering new businesses and applying the same "customer-first" mantra to seize market share. If she is not thinking about Amazon creating new businesses, she must be assigning a very high growth rate for retail and AWS.

From Jeff Bezos' commentary, it seems they only want to enter businesses that are highly scalable and have high returns on capital. Online retailing seems to pass that bar while physical retailing does not:

"I often get asked, “When are you going to open physical stores?” That’s an expansion opportunity we’ve resisted. It fails all but one of the tests outlined above. The potential size of a network of physical stores is exciting. However: we don’t know how to do it with low capital and high returns" - 2006 Letter to Shareholders

So apparently back in 2006 physical retailing did not pass the "returns bar" for Amazon. If we take Walmart as an example of a retailer with operational excellence, we can try to estimate the height of the "returns bar". Walmart's ROIC is around 12% or so. So I am guessing Amazon will only enter an industry where the ROIC is greater than that. My hunch is that their bar is perhaps 15%-20%.

A study by McKinsey ranks industries by median ROIC. We can look at industries whose median ROIC is > 15%: pharma, consumer products, software services and media. Amazon has already entered software services and media. They could enter consumer products or pharma next. To me consumer products seems more likely as pharma tends to have a wider range of returns on capital than consumer products. They already have the AmazonBasics brand that they can build up upon.

Facebook: megacaps can grow too

Facebook as a business owns the facebook.com website along with some other social media properties like Instagram and WhatsApp.

The main revenue driver is the facebook.com website. Within facebook.com, the most important revenue source is the news feed.

The news feed is a list of articles that is customized to each user that shows the activities of their friends. Sprinkled within that news feed are ads that are also tuned to the user's likes.

The numbers

2016 Revenue: 28B

2016 Net Income: 10B

Net Margin: 35%

2017 Estimated Revenue: 36B

2017 Estimated Net Income: 17B

Net Margin: 47%

This is an extremely capital-light business. 2016 property and equipment was only 9B. They have 0 long-term debt.

The fundamentals behind the numbers

Net Income is a function of the following variables:

MAU = monthly active users

ARPU = average revenue per (monthly active) user

Net Income = MAU x ARPU x net margin

MAU is about 2B.

Worldwide ARPU is about $18 currently. In the US ARPU is close to $75.

Net Margin is about 47%, which is outstanding.

In the base case, in 5 years:

MAU goes up to 3B, i.e. ~8% CAGR

ARPU goes up by 5% CAGR to $23 (global GDP goes up 2%; 3% is secular shift from traditional to digital ad spend)

Net Margin expands due to operating leverage by 1% CAGR.

Valuation comes down from 25x to 20x, i.e. -4% CAGR

Share dilution of about 3% CAGR

In this scenario, the net income will increase by 14% CAGR. Due to valuation decrease and share dilution, shareholder return may only be 7%.

In a realistic scenario, I think ARPU will go up more than 5% CAGR. To me, 10% or so CAGR seems realistic so the final ARPU would be $28 in 2023. This may be because of higher ad load, or more tuned ads. Also, the valuation may not shrink (and if it shrinks, I suspect it will be because the benchmark valuation also shrinks). In this "realistic scenario" the earnings CAGR would be 19% and the shareholder return will be 12%.

In optimistic scenarios, worldwide ARPU can go up to $50 or more. While this can happen, it is unlikely due to more users joining from geographical locations where ARPUs are much lower than worldwide ARPU. Here are the 2017 approximate ARPU figures by geography:

US&Canada: $75

Europe: $24

Asia-Pacific: $8

Rest of World: $6

Side Note: There is quite a disparity between US and Europe, which cannot be explained by difference in GDP per capita alone. Europe / US GDP per capita = 65% while Europe / US FB ARPU = 32%. Perhaps this difference is cultural (Europeans may have fewer friends, or are less interested in friends' activities). It would be interesting if Facebook provided some insights into these trends in their annual reports.

The next billion users to be added will surely come from Asia-Pacific and Rest of the World. US MAU growth rate is ~5.7% while Asia-Pacific is ~26% and Rest of World is ~15%.

The drivers behind the fundamentals

We can dream up any ARPU or MAU figures, but ultimately these will be as a result of happy users engaging with the facebook.com platform. The platform must provide meaning and value to users' lives in order for users to keep spending time on it.

Ultimately, users want platforms to stay in touch with friends and family. So that will likely not change in the future. The relevant question to me is what platform they will use to stay in touch with friends and family. While there are many choices (Snapchat, Facebook, Instagram, Google+, etc.), I think facebook.com will remain the platform of choice because of network effects. Users will want to stay there because their friends, photos, comments and other digital memories are there (likes, stickers, etc.). Starting a new social network is not easy (think of Google+) because your friends aren't already there.

How does one estimate future ARPU? I think the key factors involved are:

1. average time spent per user per year
2. average "engagement" (think of this as how much the user enjoys looking at the posts on their feed): are users skimming through the feed, or are they looking at it with concentration
3. number of ads shown in the news feed (though this knob has quickly diminishing returns)
4. quality/relevance of ads shown in the news feed (ads should be tuned to the user's tastes)
5. how much the advertiser is willing to pay for an ad

(1) and (2) depend on the content of the news feed which is user-created. Facebook only has indirect control over those and can provide tools to improve on this (like auto tagging, filters, etc.). Facebook has direct control over (3) and (4) and especially (4) is likely to increase a lot in the future due to advancements in machine learning. Plastering too many ads by increasing (3) can actually cause (1) and (2) to go down, so that knob may be saturated. Growth in (5) can be attributed to two components: GDP growth and advertisers moving their budget from TV/newspapers to facebook.

At the minimum ARPU will grow inline with GDP + secular trend of ad budgets moving from offline to online.

Other factors to consider

Other positive or negative factors to consider are:

1. Buybacks may increase in the future. Current buyback is rather insignificant at $6B which is ~1% of market cap.
2. Company is run by the CEO who is an owner-operator. I like that he sacrifices short-term results for long-term results.
3. WhatsApp is totally unmonetized right now. This may take a long time to monetize though.
4. Management may get distracted with money-losing acquisitions or ventures. I thought paying $20B for WhatsApp was a very high price but if they can have an ARPU of $2 there (with 50% net margin), they paid 20x earnings which seems reasonable.
5. Longevity in the technology business is rare.

Bottom Line

FB is currently a great company and the price of the stock also seems reasonable at 28x forward earnings (where the S&P500 is trading at 19x).

My estimate of forward S&P500 returns is around 6% CAGR and FB should be able to beat this by 5% CAGR as long as user engagement doesn't drop.