Resources

Wednesday, January 29, 2020

CTV's "Walled Garden Risk" and Implications for Trade Desk

A few months ago I did a write-up about Trade Desk (TTD) here. That article focuses on TTD's upside and provide some context for this post. Here's a quick note on what I consider the biggest risk.

The long thesis is heavily predicated on the development of Connect TV (CTV) market, so any risk should focus on that area as well. Specifically, I'm watching out for any signs that the CTV market becomes vertically integrated walled gardens, which could shut out third parties like Trade Desk.

It is a somewhat theoretical concern. The idea is that a nascent industry needs vertical integration to maximize efficiency and work out the kinks, and that firms can "modularize" too early.

I wonder if CTV is that case. This is a risk not just for TTD, but for all independent 3rd parties like Telaria and Rubicon.

Are there in fact some advantages to vertical integration? There are signs the answer is yes. I'm just not sure how strong these advantages are and if they are enough to force the entire CTV industry to go walled garden.


Where Aggregation Happens, and Advantage of Integration

A couple discussion points below:

1. Here's an article on how Amazon has been pushing its SSP. This could be viewed either way. 

The negative take is that Amazon sees potential fragmentation coming to the CTV industry (not just Amazon Fire, Roku, Apple TV, Android TV but also players like Xbox, Samsung, Playstation, Comcast...etc). In case viewership fail to aggregate at the CTV platform level, Amazon wants to be able to aggregate them at the SSP level. 

As Amazon Publisher Services (APS) signs up more CTV platforms, this aggregation of eyeballs gives it negotiating leverage over ad buying platforms like TTD.

The article also indicates that Amazon's SSP is best used with Amazon's DSP. Whether Amazon extend that optimization to its partnership with TTD remains to be seen. Again, Amazon has the leverage here.

The positive take (for TTD) is if Amazon's SSP could be used on say Xbox or Playstation, that further shifts CTV industry away from walled garden approach. Also, APS actually allows ad buying from Trade Desk, so the more platforms APS hooks up with, the more TTD benefits.

2. Here's a discussion on advantages of vertical integration.

Basically the SSP can send data to some DSPs and not others. This would allow those DSPs to target better.


Signals of Changes in Industry Structure

The strongest CTV platforms are Roku, Amazon Fire, Apple TV and Android TV. Their decisions will determine the industry landscape.

For a while Amazon appeared to be going away from walled garden model with its deal with Trade Desk and Dataxu. But it recently dropped Dataxu after the Roku deal.That leaves TTD the only DSP capable of buying CTV ads on APS. This makes me wonder about Amazon's commitment to the open internet model.

The publishers have a say as well. It's important to know that Amazon's SSP actually owns only a portion of Fire TV ad inventory. As long as publishers can use their own SSPs, it's hard for the CTV industry to go totally walled garden. See comment on Reddit below:

TTD and DataXu are the only ones with access to Amazon fire inventory via Amazon SSP (or Amazon Publisher Services or whatever they call themselves these days). That makes up probably 20-30% of Amazon hardware CTV inventory. Publishers like Sling TV, Xumo, Pluto TV, etc., who have Amazon CTV apps still can sell that inventory via whichever SSP they choose to work with - SpotX, Telaria, FreeWheel, etc., and those SSPs offer access to DSPs other than TTD and DX

Source here


In conclusion, we need to watch out for 2 things on vertical integration: 1) Do CTV platforms allow publishers to use 3rd party SSP's?  2) Do those SSP allow 3rd party DSPs?

The answers to both have to be "no" for the industry to go "walled garden". So for now I think the probabilities are small.

If 3rd party SSP's like Telaria get bought out by a CTV platform, say Roku or Google, that would indicate a shift back toward walled garden, and be negative for TTD.

Experiment

I'm going to do an experiment. 

I got a list of companies from $1bn to $10bn market cap, growing revenue >20% a year with decent gross margins (>20%). The objective is to look for stocks that has potential to go up 3x or greater within that universe.

I ran a screen from Fidelity. The result is about 185 names and I will commit to knowing each of them over the next 2 months. So going over 3-5 companies a day would do.

This should be very feasible. I probably know some of these companies already. The challenge is to go through them with a fresh set of eyes and abandon any preconceived notion, ("Wayfair?!  that's a no!"), and really try to think big about what the upsides are for each.

A year from now I'll see how many home runs I missed.

Maybe there will be 0 home runs out of these 185 companies. That's possible too. But I'll try to get as many as I can.

I would love it if someone wants to join me in this effort. If you would like to help, please reach out in the comments or DM me on Twitter.  Thanks!

Monday, January 20, 2020

Funko - Quick Flip Ok, Not Long Term Investment

At $15.6/share and 12x PE, Funko (FNKO) is cheap enough that I wouldn't mind buying it for a quick flip. But I do not see this as an investment to hold for the long run. This article explains why. (hint: one of the themes I have been exploring is an "overfit" between a firm's competitive advantages and its markets)


Funko make pop culture figures like these.

Contrary to what you might think, Funko's target audience is not children.
Our demographic is a 35-year-old, 50% male 50% female who is buying our products for themselves, not for other people, for no special occasion. And I said that could not be more -- any further from who is in the toy aisle buying a present for a kid for their birthday party or for Christmas. 

Regardless, Funko's product is an affordable luxury. No one NEEDS this stuff. But they just want it. I'm not sure I'd call it a fad - the big headed style is a niche that has always existed, even before Funko - but revenue growth clearly has a large cyclical component to it and can easily fizzle out.

What's more interesting is Funko's value proposition to IP owners. Funko helps them keep contents relevant, in view at stores and in conversations. Often the contents are hit driven and content owners want to keep the conversation going between hits. An example would be Marvel superhero movies. Marvel built a franchise of inter-related characters, but there's significant downtime in between movie releases. Funko figures is one of many ways to keep those characters in consumer mindshare.



Barrier to Entry

Making pop culture figures is obviously not rocket science. Nevertheless, there are some barrier to entry and I'll list them out.
  • Relationship with content owners. This is not easy for anyone to come in and replace.
  • Process advantages. Funko have a group of creative people who are great at detecting pop culture trends and come out with product quickly.
  • Retail distribution relationships. 

Funko's Place In IP Monetization Chain

I would say relationship with content owners is the most important one. In the grand scheme of things though, Funko is just one small part of the content monetization value chain.

Below is a little diagram I drew up.



IP is at the bottom of everything. The second layer in the diagram shows monetization schemes such as movies, theme parks, toys, T-shirts..etc. In this example, Disney (inside the dotted line) owns various IP and produces movies and theme parks, but outsources the production of toys and t-shirts to third parties. Funko (and Hasbro and others) monetizes for Disney in the toy category, and has relationship with distributors and retailers.

Who has negotiating leverage here? I would say it's clearly the content owner and not Funko, since 1) Funko's products are not the only to monetize IP,  2) it's often a minor revenue stream for content owners.

Perhaps due to this lack of bargaining power, Funko's licenses are usually not exclusive even within the toy category (for example Hasbro and Funko both have Mandalorian products). This further dilutes Funko's bargaining power.

I can also easily think of scenarios where, in order to access the hottest character licenses, Funko has to pay for a bundle that includes far less marketable characters. Effectively they would have to pay premium for what they want.

In short, Funko's relationship with content owners enables its business model, but will also limit its upside in terms of margins.


Process Advantages

As far as process advantages go, here are a few excerpts from transcripts that stood out to me:
  • Low start up cost
  • Absolutely. So for us to develop a new SKU, it really costs us between $5,000 and $7,500, which means I really only have to sell about 2,500 units or so in order to just break even. And that gives us a lot of flexibility to look at niche properties, niche licenses that we can go after and then see how they resonate. It allows us to be very authentic, which is important to us in terms of connecting with that end consumer and casting that wide range.
  • And a great example of that is we saw some tailwinds or whisperings around Bob Ross a year or so ago. And so we called up the licensor and said hey, we want to sign up the license. It was a $5,000 minimum guarantee. The licensor is like, well, how many units do you think you are going to sell? And we were like, well, it's really hard for us to sell fewer than 20,000 to 30,000 of anything that we put out there.
  • We announced it; it caught fire from a social media perspective. It ended up with an end cap at Target. And before the product was even manufactured, we had presold something like 600,000 or 650,000 units.
  • Agility
    • (regarding Game of Thrones) That was on a Sunday night. By Wednesday, we had that item digitally sculpted and colorized and were pre-selling it online and sold several hundreds of thousands of units to fans. And everyone said, oh, you must have known that was coming. We had no idea.

Low startup costs and agility both reinforce Funko's long tail of minor/niche characters; and as such they are inter-related.

The low startup costs (and thus low breakeven) means Funko has the flexibility to experiment with new ideas and take risks. Agility means if said idea does not work, Funko can quickly shift to another idea, keeping its opportunity costs low. Both helps Funko cover maximal ground with minimal monetary and opportunity costs - important if your market is long-tailed in nature.

Agility also ties in to relationship with IP owners as well as distributors. After all, putting out a product in 3 days requires high degree of coordination - both upstream and downstream.

So it seems Funko's process advantages are highly suitable for its specific market. Not only that, they are related to other moats, which makes the sum greater than its parts and thus hard to duplicate.



Conclusion - Investor Perspective

The questions is how scalable these advantages are beyond the niche of pop culture figures. If these figures turns out to be a fad and consumer interests fizzle out..would Funko be able to take these resources and processes and do well in another market? Is there even another market that fits so well to Funko's advantages? What would that be? Clothes? Bags? Games? Fashion?

If yes, the stock could be a multi-bagger. If not, the stock will languish in mediocrity. For now, I think it's the latter.

Funko clearly has competitive advantages that will allow it to dominate its particular niche. But 1) the sustainability of this niche is questionable, 2) the IP relationships weigh on margins, and 3) the competitive advantages are so tailored to the specific market that I'm not sure they can scale to another market easily.

Funko is still growing fast (the company plans to more than double its EBITDA in a few years). But it is unlikely to get a high multiple for reasons above.

Friday, January 10, 2020

Changes I Hope to Make to This Blog

Happy New Years! There are some changes to the blog I hope to make this year. They are based on why I write and what I want to get out it.


Why I Write

I had a few objectives in mind when I started writing this blog a few years ago:
  • Keep track of my own ideas and evolution as an investor.
  • Facilitate discussion to get feedback and sharpen investment ideas.
  • Discipline. I’m a full time, individual investor. While that freedom is great, I want to have some sort of weekly deliverable to impose discipline and focus on myself. The blog is that "deliverable".

How did that work out the past few years?

This blog is only ok as a place to track my own ideas. I'd write maybe one post for every 30 ideas I explore. That’s because most ideas were filtered out pretty quickly as not worth my time. And increasingly I'm writing posts that have no definite buy or sell implications.

The "facilitating discussion" objective completely failed. I have not gained any sort of consistent readership, and that means no feedbacks for my posts. Instead I've discovered Twitter, which has served that purpose wonderfully.

The “discipline” objective sort of worked. Although I’m not posting on a weekly basis as originally intended. One reason is as mentioned above- most ideas I explore are not worth a deep dive. In any case, much of investment research revolves creating a hypothesis and disproving them. I’m not sure presenting all these failed hypothesis makes for good blog content. The other reason is I’m not a good writer, and turning my existing notes (primarily in bullet points) into paragraph format takes a lot of time. That’s time detracted from my research and investment activities.


Changes

I think a few changes can address these issues.

First, aim for smaller but more frequent posts. 

I’m thinking like avc.com where a post can just be a couple hundred words and a simple observation. So the blog would be more like a journal where I just record whatever I learned, instead of feeling like I have to write a complete buy/sell thesis on a specific stock.

I'm already posting on Twitter just about every day, so a lot of blog posts this will be elaborations of those same tweets.

Second, I want to try out new formats, particularly videos. I keep a ton of notes during research, but they are in bullet points and it's time consuming to turn them into paragraph/blog format. It may actually be easier to post a video where I show a couple powerpoint slides and just talk through them.

Comments are welcome!

Saturday, December 28, 2019

What I Like and Dislike about Trupanion (Part 1)

Quick Summary
  • Can see valuation upside.
  • All the pieces fit. Large under-penetrated TAM means long growth run way. Unique value proposition. The activity/value chain is specifically tailored to that value proposition and hard to duplicate. 
  • On the other hand if your entire value chain is tailored to a value prop that's not appreciated by market, that’s a problem!

Trupanion (TRUP) has been a fascinating company to look into. This post will sketch out Trupanion valuation upside, as it's not so obvious. A later article will discuss more qualitative considerations.


Is This Worth Our Time? Sketching Out The Upside

Trupanion will have about $380mm revenue for 2019. The company plans to keep spending on acquisition cost such that it grows 20%-30% a year. This is possible due to an under-penetrated TAM (penetration rate in single digits).

Even if they undershoot that growth CAGR, I can see them reaching $1bn revenue in 5-6 years.

What will margins look like? Trupanion targets 15% margin before acquisition cost, depreciation/amortization (“D&A”), and stock based compensation (“SBC”). This is broken down into 70% claims payout, 10% variable cost, and 5% fixed cost. TRUP is already close to those targets.

We need to figure out what normalized acquisition costs look like once they reach scale and exit growth mode.

How Will Acquisition Costs Look At Scale? 

In other words, how much will Trupanion have to spend on acquisition cost to keep its pets enrollment steady?

The company gives its dollar acquisition spends each quarter. That and other pieces of data allow us to back out the quarterly acquisition and attrition as follows. 




Quarterly additions and attritions are about 8% and 4%, respectively, of pets at beginning of each period. 

To maintain its number of pets, Trupanion would scale down its acquisition spend, such that its pet additions matches its attrition rate. Since attrition are mostly 50-55% of additions, they can scale down their acquisition by that ratio.

Acquisition spend runs about 9% of revenue. Scaling that down means TRUP needs to spends ~5% of revenue to maintain its pet enrollment. 


Upside 

Trupanion appears to be on its way to reaching its target of 15% margin before acquisition cost, D&A, and SBC. We just estimated that they need to spend another 5% on acquisition cost to maintain pet enrollment.

That means about 10% adjusted EBITDA margin. Take out another 3%-4% for D&A and SBC leave us 6-7% EBIT margin.

$1bn revenue at these margins means $60-70mm of GAAP EBIT, or $100mm of adjusted EBITDA. At $36/share, TRUP has under $1.3bn market cap. It has little debt. So it’s trading at <13x 2025 adj EBITDA or 20x 2025 EBIT. I think there’s upside at these valuations, given the long growth runway even when we get to 2025.

Depending on market conditions, an established market leader with steady subscription revenue and long growth runway can easily be at 20x EBITDA. That would be 50% upside but spread over several years. More if you’re willing to look further out in time. 

This is not a ton of upside, but I like this business enough that I'd be interested at a lower price. I will share more of what I like in a later post.


Note: In reality TRUP’s EBIT will be lower at 2025, since it will spend more than 5% of revenue to grow, not just keep subscribers steady. But the market should value the company on future profitability outlooks (which are the 6-7% EBIT / 10% EBITDA margins)

Thursday, December 26, 2019

How Small Beats Large

How does a smaller company beat a large company with seemingly unlimited resources?

This is a problem I have been struggling with, and here are some thoughts (basically a synthesis of Porter and Christensen).

The problem has to be looked at from both sides, let's call them SmallCo and BigCo. The SmallCo's strengths alone are not going to be enough, nor the BigCo's weaknesses. It's only when the former's strengths match the latter's weaknesses that you have a David beats Goliath situation.

So let's look at it from both sides, starting with BigCo.

Just because a company has the resources to fight and win on any given single front, does not mean it can do so on all fronts, simultaneously. At some point every empire overextends itself. Where's the weak link?

A large company can have weak points where it lacks a) willingness/motivation, or b) ability to compete.
  • Lacking willingness/motivation to compete. Perhaps because
    • a) under the radar situation. The market in question is unattractive at the surface, or too small to move the needle for BigCo. 
    • b) requires trade-offs. Examples would be if the market takes away resource from BigCo's favored customers, doesn’t match corporate value, or leads to cannibalization of opportunities. In his book "Seeing What's Next", Clay Christensen cited example of a firm that counts on post sale service agreement not being interested in an off-the-shelf /self-service product.
  • Lacking ability.
    • Perhaps because BigCo's activities and processes are not tailored to the value proposition offered by SmallCo.
    • BigCo may have difficulty replicating SmallCo's value chain.


Moving on SmallCo's side. How does SmallCo take advantage of BigCo's weaknesses while avoiding its strengths?  
  • Distinct customer segment and value proposition that does not match BigCo's. 
    • SmallCo would target over-served customers, under-served customers, non-customers (creating new market)
  • Tailored value chain supporting that value proposition. The value chain should show 1) uniqueness, 2) internal fit, 3) independence from BigCo.
    • Uniqueness. It has to be different from BigCo's. Otherwise you will just be overwhelmed by brute force.
    • Internal Fit (interdependency). The value chain should fit together in a way that’s hard to replicate. Ideally the parts are interdependent on each other. This way your competitive moat compounds and is hard to replicate.
    • Independence. Separate value chain. If parts of the value chain overlap, then SmallCo could be forced to play by BigCo's rules.

Basically if your David, make sure you can afford to NOT play by Goliath's rules.


A Short Example with Elastic N.V and Chewy

These are two companies that compete with Amazon in two completely different industries. The differences provide them different strengths and weaknesses relative to Amazon.

Elastic, which I have written about here, provides search functionalities that Amazon effectively copied. Chewy (as discussed here) is an online pet food/supplies provider. 

Which has a better chance against Amazon?

Amazon's Motivations

I would say Amazon is much more motivated to go after Elastic's search market, which competes with Amazon's AWS segment. This segment of Amazon not only provides more profitability than its e-commerce segment, but it is also growing much faster. A quick look at Amazon's earning releases shows tremendous focus on developing AWS's capabilities. Overall, Elastic's search/indexing market looks strategic to Amazon.

On the other hand, pet e-commerce is seen as a fairly steady, slower growth market. Pets are hardly ever mentioned in Amazon's earning calls. 

Verdict: Amazon is much more motivated to attack Elastic than Chewy.

SmallCo's Value Chain

Chewy has its own distribution facilities, call center, and service reps. These fit together in a way that reinforces Chewy's niche strategy (as discussed here). In terms of pet products, its suppliers does overlap with that of Amazon's, and that could be a problem.

Elastic though, actually deploys its hosted service on AWS! Talk about NOT having an independent value chain! Elastic belated realized Amazon meant harm and started diversifying to Microsoft Azure in addition to Google (GCP), but the damage has been done.

Verdict: Chewy's has a more distinct value chain from Amazon.


We can go further, but this is enough to show that Chewy will have much stronger defense against Amazon's invasion.

Friday, December 20, 2019

Chewy's Competitive Advantages

In my 10/15/2019 post I mentioned that I passed on Chewy and Uber. Over the past few weeks I ended up buying into both.

Here’s a thread I recently tweeted out on Chewy (CHWY). It's a hypothesis of Chewy's "flywheels". I am definitely not wedded to the idea so this is an attempt to crowd-source my thinking process.



For your convenience, here is the expanded thread (lightly edited and reformatted for blog).
Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft):
To fend off Amazon, we have to answer how the value chain is different and how those pieces fit together in a way that competitors: a) can't copy, b) not willing to copy.

I think the answer is Chewy's vertical Focus strategy.

Start with right hand side of diagram:
  • Niche focus allows Chewy to optimize supply chain (e.g less product variation means easier arrangement/picking at fulfillment centers .. saves space/time/cost..etc)
  • Chewy can invest cost savings into customer service (focus strategy reinforces this. e.g knowledgeable reps)
  • Good service drives growth/retention. More Autoship customers enhances predictability -> more efficiency. (See original tweet for screenshot of management comments on this topic)
  • Reinvest that saving into service = closes the loop on right side of diagram
Move on to left side of diagram:
  • CHWY has built up a lot of fixed costs (fulfillment centers..etc). 
  • Customer experience drives growth. 
  • Growth + fixed cost = operating leverage & economy of scale. 
  • Reinvest cost savings into customer service closes the loop
We are already seeing this reflected in CHWY's financials:  more active customers, higher % of Autoship customers, higher gross margins..etc. 
Again, I think it's all enabled by focus strategy, which won't be matched by Amazon.

Feedbacks and Conclusion

Overall reactions to the thread suggest that people are quiet negative about Chewy (even after the stock's recent run up). This makes me uncomfortable as I don't consider myself a contrarian.

The most notable response is from @CharlieZvible. He argues that CHWY's limited TAM means its margin needs to be more than low/mid single digits to justify valuation. He questions if that can be achieved.

"...The TAM is pretty well defined. $65bn if I remember correctly. Remaining share split mostly between wmt, cost, tgt, Amzn, pets. Didn’t look at Q3 but guessing $ sales added still flattening out. Think you need HSD margins to be good stock-high for consumables"

This is definitely a good point that needs to be considered. I'm inclined to disagree after doing some basic calculations. Here's how I think about it.


  • At the time of this writing, CHWY trades at about $29/share. This represents <$12bn enterprise value. 
  • CHWY is on track for $5bn of revenue a year and growing ~37% for the year ending 1/31/2020.
  • They can easily reach $10bn revenue in a few years. A 5% EBIT margin on that is $500mm. CHWY would be trading at 24x EV/EBIT. 
  • I would not be surprised that in 5 years it's more like $15bn revenue. At the same 5% EBIT margin, the current price implies ~16x EV/EBIT.
  • Well known consumer stocks usually trade at high multiples so these are not far fetched.  

Going back to the TAM limitation. A $15bn revenue would imply 25% of the $60bn TAM cited. That sounds like a lot. Too much? I'm not sure. The whole point of the "flywheel" discussion above is to assert that Chewy's competitive advantages reinforce themselves overtime, so that the company gets stronger relative to competitors, and thus can grab a disproportionately large market share.

It's also possible that the $60bn TAM is not fixed, but in fact expanding due to secular trends ("humanization of pets"). It also seems logical to me that the convenience of e-commerce should expand TAM by converting previous non-consumers. New product innovations is another factor that can increase market size. Along that line of reasoning, I would note that the above is not counting the pet healthcare business.

So I'll leave off here. I bought Chewy under $26/share, as soon as I saw it pop above MA50 on huge volume. The discussion above was to decided whether I should add, hold, or exit. My decision, at least so far, is to hold.