Google: Value Hiding in Plain Sight?

In its simplest form, I view Google as the “gateway” to the internet. The company’s core search tool is one of the most relied upon utilities in the world, processing 3.5bn searches per day. It’s creation has truly revolutionised the way human beings access information and has made us incredibly more efficient. In addition to search, Google has six separate products with over 1bn users including Chrome, YouTube, Gmail, Google Maps, Google Play Store and Android (which just hit 2bn active devices).

In most cases, Google’s products are superior to alternatives (particularly in search) and offer an incredibly high value proposition for users. When combined with the fact that they are generally free, their mass adoption seems logical.

  • Search is essentially a monopoly with around 90% share across desktop and mobile
  • Chrome is the number one browser for both mobile and desktop with 54% share
  • Android is the leading operating system for smartphones globally with 86% share

Google’s Edge

I believe the company’s success can be primarily attributed to three core advantages: culture, mindshare and data. From the outset, Larry Page and Sergey Brin have always been focused on solving big problems and creating an incredibly valuable user experience. Their initial motivation was not driven by an interest in selling ads, but rather their mission to better organise the world’s information. They have always sought the best talent and had an ability to think in terms of decades, not quarters. I believe the importance of corporate culture is often overlooked and in Google’s case is extremely valuable and difficult to replicate. It has enabled the company to stay on top for the last 20 years and build up significant brand equity (Google is currently estimated to be one of the worlds most valuable brands). This is crucial for an online technology platform such as Google. The assumed superiority of Google’s search tool, and the associated decision to use it, are effectively subconscious thoughts. I believe that Google’s mindshare and user search habits will prove very difficult to change overtime, and in effect, provide huge barriers to any competitor in the search arena. These barriers are further strengthened by the firm’s data advantage. In essence, each additional user for search (and also Google’s other products) widens the moat, as more users means more data. This allows Google to further improve their products and deliver even greater value for users. I think of this as a data feedback loop and believe its helps explain why competitors have not been able to make a dent in Google’s market share. After years of effort and billions of dollars spent by Microsoft, Amazon and others, there still remains no acceptable substitute for Google. It’s also important to understand that Google’s dominance in browsers (Chrome) and mobile operating systems (Android) were, and still are, key to protecting its competitive position. By becoming the market leader in these areas Google effectively captured users entry points to the internet and enabled Google search to be provided as the default option.

The Ad Market

In 2017, the global advertising market was circa $580bn, with digital advertising making up ~40% at $230bn (up 21% YoY). Looking at these numbers it’s clear that Google is already capturing a large piece of the pie (~44% of digital ad spend comes their way). To me this is not surprising. Google’s ability to mine data across its properties makes it the most effective advertising channel in the world. By creating targeted ads that result in better conversion rates for advertisers they become the number one option online. I believe that the shift from traditional to digital will continue at a healthy rate and as more commerce shifts online (particularly in EM countries) additional advertising spend will follow suit. Whilst I acknowledge that digital ad growth will likely moderate from its recent 20%+ growth rates, I think it will remain well above average for many years to come. This will enable Google to grow larger and for longer than the market currently anticipates.

Valuation

So, what are you paying today for the search business? In my opinion, not much. At first blush, the company appears somewhat expensive, trading at 26x 2018 earnings. However, there are a number of things going on behind the headline multiple.

Lets start with the $43 in earnings that Alphabet is expected to generate this year. This includes ~$4.7/share of investments in what they refer to as “other bets”, that is Waymo (autonomous cars), drones, health care and AI etc. In my mind, the fact that it’s simply expensed through the income statement means that the current financials understate the true earning power of the current business. As we move forward, either these “other bets” will emerge as viable businesses or they will simply be terminated. Hence, I view normalised earnings as closer to $47/share.

Then let’s go to the balance sheet side. Firstly, the company is by no means short of cash and come the end of this year will have ~$150/share in cash. Then we have YouTube, a remarkable business in its own right. If we were to value YouTube in a similar fashion to a traditional cable company (i.e. at 80c per hour viewed), we would come to a valuation of $550 per share. As a point of reference, Netflix is currently value at ~$3.30 per hour viewed. But to be extra conservative, let’s apply a 50% haircut and assume YouTube is only worth $275/share.

So… bringing this all together. The market is currently asking me to pay $1,100 per share for Alphabet. This gets me $150/share in cash and conservatively $275/share with YouTube. That’s $425/share of value that contributes a trivial amount to current earnings. Stripping that out of the stock price, and I’m paying $675 for Google’s core business that will earn ~$47/share this year. That is a PE of just 14x. This is remarkably cheap and well below other dominant companies with durable franchises that are growing at 20% p.a.

In my view, Alphabet is incredibly cheap and provides investors with an opportunity to own one of the worlds most successful and innovative founder led companies with an extremely strong competitive position. I believe the company has the ability to compound its intrinsic value (earnings power) at 15%-20% over the next few years with minimal risk of disruption.

Some Thoughts on Netflix

As Netflix’s share price continues its unabated journey to the moon, it seems timely to consider what exactly is baked into its valuation. Competition in the space is rapidly heating up and the company’s cash burn continues to worsen. At 14x sales the stock appears to be priced for perfection – and then some. Whilst I do think Netflix is a decent business, I don’t believe it will come anywhere near living up to the hype implied by its current valuation. For me, the company’s financial position and valuation are massive red flags. At this point in time I have no interest in investing, but for those that do, below are a few observations that I think are worth consideration.

Content obligations continue to outpace revenue growth. Since 2010, content obligations have grown at 42% p.a. while revenues have grown at 24% p.a. This trend is clearly unsustainable. In the long run the true cost of Netflix’s business model will become apparent as capitalised production and licensing costs drag on earnings for years to come.

The company’s financial position and negative cash flow are concerning. In addition to $9.0bn of debt, Netflix has an additional $17.7bn in streaming content obligations off-balance sheet (~$8bn of which is due within 12 months). In effect, Netflix has effectively mortgaged its future success, meaning that any stumble could prove disastrous. As content obligations continue to increase, the firms cash flow only grows more negative – with OCF going from negative $1.6bn in 2016 to negative $2.0bn in 2017. In its current state, the company is reliant on continually tapping the junk bond market in order to fund it’s operations.

Valuation makes no sense. There is a striking valuation gap between Netflix and other TV networks such as Disney, CBS, Viacom, and HBO parent Time Warner. One could argue that Netflix deserves a premium over these other stocks due to its first mover/data advantage, however I don’t believe this will prove durable in the long-term. Simply moving faster than everyone else won’t lead to a defensible moat.

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To illustrate the extent of Netflix’s overvaluation let’s consider an extremely optimistic scenario – Netflix is able to grow its revenue at 20% p.a. for the next 10 years and triple its operating margins to 22%. EBIT would be $15.6bn in 2027. If we assumed that Netflix (1) could earn this into perpetuity, and (2) had no debt (highly unlikely), and (3) a 10% discount rate, then we would get a future valuation of $156bn or $360/share. Assuming a 10% hurdle rate, we arrive at a present fair value of ~$140/share (i.e. less than half the current share price of $350).

NVR Inc: Anything but Your Average Homebuilder

Long NVR @ $2,700 – 

  • NVR’s unique capital light business model allows them to deliver superior returns whilst assuming the least amount of risk in the industry
  • The firm has effectively taken market share from competitors while improving its profitability – growing EPS at 26% p.a. since 1994
  • Management is focused on the long term and is firmly aligned with shareholders
  • Cyclical tailwinds over the next 4-5 years provide the perfect environment for NVR to outperform

BACKGROUND

NVR is the 5th largest homebuilder in the United States, concentrating on a 15-state region from Pennsylvania to the north and Florida to the south. Its primary brand is Ryan Homes, and across its brands it focuses on affordability and first-time homebuyers. NVR also has a mortgage banking and title services company which principally services its homebuilding operation.

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OPERATING MODEL

Homebuilders are typically overlooked due to the capital-intensive nature of their business and the cyclicality inherent in the industry. In downturns, homebuilders are inevitably left with large inventories of unsold land/properties – the unlevered builders then suffer large inventory write-downs while the levered builders go into bankruptcy. However, NVR’s highly efficient process around land acquisition separates them from other builders. In 2009 the three largest US homebuilders (Pulte, D.R. Horton and Lennar) reported a combined $3bn in losses, whilst NVR made a quarter billion in profit.

NVR’s unique business model is predicated on two main features:

  1. NVR acquires control of land inventory through option contracts that give them the right to buy finished lots from developers. The cost being between 3-10% of the aggregate purchase price. NVR also pre-sells nearly all of its homes.
  2. NVR is geographically dense and highly focused on obtaining and maintaining a leading market position in each market they serve.

Feature #1 enables NVR to avoid the speculative practice of land purchase/development. The firm is able to control large blocks of land (~5 years’ worth) whilst employing less capital to do so. As a result, NVR has much lower capital requirements, less inventory risk and is able to generate far superior returns on invested capital. Feature #2 effectively leads to local economies of scales, as NVR develops greater leverage with local developers and is able to be more efficient and low cost in the markets in which it operates. For instance, NVR can usually deliver a home in <90 days, often 60-70 days (compared to ~100-120+ industry average).

NVRs unique capital light business model and operational efficiency have produced exceptional results

  • Growing revenues, earnings and OCF at 15%, 24% and 17% p.a. respectively over the last 5 years
  • EPS has grown at 26% p.a. since 1994 (helped by steady, sizeable share repurchases)
  • Industry leading ROIC – 27% in 2017, averaged 19% over the last 5 years
  • Superior margins – GPM 21%, EBITM 14%, NOPATM 9%
  • Growing market share – since 2005 NVR has doubled its market share to 5%
  • Pristine balance sheet – company currently has a net cash position

As exceptional as NVR is, it remains valued at just 16x forward earnings – an attractive price when considering the quality and track record of the company.

THE OUTLOOK FOR US HOUSING IS POSITIVE

As with any cyclical business, the current dynamics at play in the industry are paramount. When looking at the data I believe there is no question that US housing is likely to be one of the strongest sectors over the next 4-5 years.

  1. Single-Family Housing Starts remain depressed relative to historical cycle precedents. At current levels, the supply of new homes is dramatically below household formations and Single-Family Housing Starts are still 63% below the average peak levels (Ref. Chart 1 below).
  2. Current Existing Home Inventory data is sitting at an all-time low. Existing Home inventory is significantly below the 6-months of inventory level that’s generally considered a “balanced market” (Ref. Chart 2 below). This dynamic is being driven by a combination of (continued) strong demand and an accelerating decline in unit inventory growth. Historically, when inventory levels fall in the bottom decile of the historical range, as they are now, home prices have tended to rise at double digit rates (i.e. roughly double the current 6%).
  3. Demographics suggest that a significant increase in demand is coming from the millennial generation. In the US, the average age at which an individual will rent their first home is 26/27 years old and the average age at which individual will buy their first home is 32/33 years old. Knowing this fact and looking at the current population distribution in Chart 3, one can anticipate that there is the potential for a massive influx of would be first-time homebuyers over the next 4-5 years.

 OTHER CONSIDERATIONS

  • Intelligent allocation of excess capital: cash is primarily used to buy back stock. NVR has reduced its share count by 30% over the last 5 years, compared to a 10% increase for the average builder.
  • Executive compensation plan: in addition to NVRs CEO and Chairperson having sizeable holdings in the company, their bonus payments are based on return on capital and vest over a 4-year period. A much more favourable structure than peers, many of whom have a primary focus on maximising profits over the NTMs.
  • US tax reforms: one important change starting in 2018 is that homeowners can only deduct interest on mortgages up to US$750,000, down from a previous cap of $1,000,000. This will have very little impact on NVR given that they focus on the starter home market with an average sales price of just US$382,000.

THE BOTTOM LINE

NVR Is a high quality, best-in-class homebuilder with a superior business model that was resilient to the worst residential real estate market in the last 80 years (profitable every quarter but one). The firm has exceptional management and cyclical tailwinds should provide a favourable operating environment over the medium term.

If we assume a somewhat conservative scenario where (1) settlements growth moderates from the current 11% p.a.to circa 8% p.a. over the next few years, and; (2) ASPs are flat for 2018 and then grow at the rate on inflation (~2.5%) thereafter, and; (3) no improvements in gross or operating margins going forward, and; (4) prudent capital allocationI as NVRs history would suggest, I estimate that an investment at current levels should generate an IRR of ~20%.

CHART 1

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CHART 2

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CHART 3

Screen Shot 2018-04-18 at 6.41.25 pm.png

Australia: As Safe As Houses

It’s often difficult for many Australians to consider investment options beyond property. And to be fair, it’s hard to blame them. Australia’s 27-year run (and counting) without a recession driven shock has led to exceptional returns for banking and property investors alike. A generation of uninterrupted house price growth has created the seemingly irrefutable but equally concerning mantra ‘as safe as houses’.

However, the longer the uninterrupted expansion continues the larger the risk within the Australian banking system grows. Since 1991, Australian banks have increased loans to the housing market from $85bn to $1.5tn, representing loan growth of 12.2% p.a. This growth has been much greater than any other type of lending, and as such, housing loans have gone from 20% of all bank loans to 60% today. Australia household debt now sits at over 200% of income, making the country one of the most leveraged in the world. As a point of reference, this metric hit 128% in the US in 2007, prior to the GFC.

Screen Shot 2018-05-16 at 11.32.51 am

Where we go from here is anyone guess. The point of the above is not to try and predict a housing crash (I’ll leave that to people selling newsletters) but to illustrate how late in the game Australia is. With wage growth currently tracking at around 2% p.a. I believe an ‘optimistic’ scenario would be 3-5 years of flat/minimal growth (in real terms). This is clearly what the RBA is hoping for with Phil Lowe, the Governor of the RBA, openly stating that he’d like to see a “run of years” of little to no growth in household debt.

The Power of Compounding

“Compound interest is the eighth wonder of the world. He who understands it, earns it. he who doesn’t… pays it.” Albert Einstein

At the heart of it, I’m looking to invest in durable, high quality companies at attractive prices. However, it’s important to note that for long-term owners of businesses, quality will prove much more critical than price. This is due to the simple math behind compounding.

Allow us to illustrate with an example where we have the following companies:

  1. Re-investment Co. produces 25% ROIC and can reinvest 100% of its earnings. Currently earns $10/share and trades on a multiple of 20x
  2. Undervalued Co. produces 10% ROIC and can reinvest 25% of its earnings. Currently earns $10/share and trades on a multiple of 10x

If we assume a 10 year holding period and that at maturity both businesses will trade on a multiple of 15x, we get the following results.

Screen Shot 2018-05-11 at 2.21.47 pm

As you can see, despite Undervalued Co’s multiple increasing 50% and Re-investment Co’s multiple shrinking 25%, Re-investment Co is by far and away the superior investment option.

Examining the numbers it becomes clear that (1) the longer your investment horizon, the closer your return will be to returns of the underlying business, and (2) whilst the price paid matters, it’s often not as important as people think.

Why I Love Whole Foods but Can’t Buy the Stock

I want to start by saying that I love shopping at Whole Foods. The retailer offers a superior customer experience and provides an extensive range of natural produce. However, despite the company being well positioned to benefit from the long term structural growth trend in organic food consumption, I just can’t bring myself to purchase the stock.

Last week, the company announced that same-store sales had turned negative, down 0.2% for the quarter. While total sales increased 6%, this is still the weakest results since 2010. In addition, the company indicated that comps will probably stay flat next year. Margins also remained under pressure – gross margins declined 96bps due to an increase in cost of goods sold.

These disappointing numbers are not overly surprising. Whole Foods operates in an intensely competitive industry – one where switching costs are virtually non-existent. Their success over the last few years was bound to attract new entrants. This has certainly been the case as competition has intensified from firms like Trader Joe’s, Kroger, Wal-Mart, and Costco. In light of this, it seems logical that Whole Foods would be eager to reinvest heavily in the business. The company has flagged it plans to increase spending in numerous areas, including its online presence, the cloud, point of sale systems, customer loyalty programs and 365 by Whole Foods. This reinvestment will prove vital as it will be the key to ensuring Whole Foods can maintain their price premium and sustain traffic in the future.

However, the one thing I can’t understand is why the company is using its current free cash flow (and borrowing an additional $1bn!) to buy back stock… Its hard to believe that buying back a substantial amount of stock is really the best use of capital for a company that has under invested and needs to “get back to basics” (as Co-CEO John Mackey put it). To me, leveraging the balance sheet to boost EPS is a short term play – and one that is hard to justify when the stock is trading at 19x.

In any event, the question becomes can Whole Foods return to being the phenomenal growth company it once was?

The Allure of Apple

Long AAPL @ $110 –

  • Market expectations are far too brearish.
  • Apple currently offers a 10+% FCF yield – which has historically represented a good entry point.
  • After adjusting for net cash, Apple trades at just 10x 2015 earnings, providing an exceptional opportunity for a new money investment.

Quality at a bargain price

Apple’s track record of success speaks for itself. Over the past decade, its growth and operational performance has been remarkable.

  • Revenues, earnings and OCF have grown over the last 5 years at 29%, 30% and 36% respectively;
  • ROIC has averaged 30% over the last 10 years;
  • It boasts superior margins – GPM 40%, NPM 22%, FCFM 30%;
  • Generates huge amounts of free cash flow – OCF yield 12%, FCF yield 10%; and
  • It has an A-grade balance sheet – company currently holds $150bn in net cash.

Considering these impressive numbers, it’s hard to believe that after adjusting for net cash, Apple is trading at just 10x E2015 earnings (keeping in mind that the S&P 500 currently trades on an average PE of 18x).

The stocks cash flow metrics also paint a similar picture. Apple’s FCF margins are ~30%, which is outstanding given FCF/S greater than 15% are considered superior. Despite increasing competition, Apple has been able to maintain its margins and continually grow its free cash flow. Apple currently has a FCF yield of ~10%. Looking back over the past decade (see chart below), there have only been two other occasions where Apple has traded with a FCF yield of 10+% – December 2008 and March 2013. Both instances proved to be great entry points for long term investors.

AAPL FCF

The above argument is the obvious case for going long Apple – an exceptional company at a bargain price. However, the more pertinent question becomes what growth can investors realistically expect going forward?

Growth prospects

Back solving a DCF, we can determine that the current market price implies flat to slightly negative growth – an expectation that I believe is far too bearish. Whilst I concede it’s unlikely Apple will be able to maintain the exponential growth rates experienced over the last decade (if not least due to the law of large numbers), I still expect iPhone sales will continue to grow. Future growth will come from both the addition of new customers to iOS (EM and US) and the retention of Apple’s existing premium iPhone customers, where the company’s moat will play an increasingly vital role.

Critics claim that as a ‘typical’ hardware company Apple’s competitive advantage is built on shaky ground. However, I would argue that Apple is much more than a ‘typical’ hardware company. Apple’s strength lies in its experience and expertise in integrating hardware, software, services, and third-party applications into differentiated devices. Additionally, Apple has devoted considerable time and resources to develop its ecosystem, which effectively creates a tangible switching cost after Apple has locked consumers in. This creates a loyal and self-sustaining customer base – a very important aspect of Apple’s business model which leads to recurring revenues. Apple has very high retention rates (churn of ~7%) and an average upgrade cycle of approximately 29 months. The upshot being that roughly two thirds of Apples annual iPhone sales currently come from its exiting installed base of 400 million (of which only 27% have upgraded).

Furthermore, a recent development that received little attention was Apple’s new direct sale and phone lease program. For $32/month, a customer can now lease an iPhone 6s, with AppleCare, and upgrade within 12 months. This has the propensity to materially shorten the upgrade cycle and drive sales. If the upgrade plan is successful and produces an incremental 20% in total iPhone sales for North America, I estimate that EPS would increase by ~$1. So whilst it will take some time for this new upgrade plan to play out, there is potential for earnings to receive a material boost from a shorter upgrade cycle.

Apple also continues to have success in gaining market share from its competitors. In Q3 2015, Samsung’s market share declined 0.8% to 23.7%, while Apples market share rose 1.4% to 13.6%. Despite all the negative headlines and speculation, Apples sales in the greater China region grew 99% year over year to $12.5bn. A remarkable feat, especially considering that China’s smartphone market struggled over the period.

Between first-time smartphone buyers, people switching away from Android and repeat sales to current customers, Apple’s iPhone business still has potential for future revenue growth. As the global smartphone market continues to grow at ~10% per year, I believe Apple can realistically achieve mid-to-high single digit revenue growth in the medium term. This will deliver modest earnings growth in the vicinity of 5-10% (assisted by share buybacks), which is materially higher than what the current market price implies. Given high retention rates, a superior ecosystem, and a multi-product advantage, I believe that earnings power of $10+ and FCF of around $70bn pa is sustainable in the long term. That is to say, I anticipate Apple will trade well above current all-time highs in the years to come.

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