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)

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 ("ESTC"), which I have written about here, provides search functionalities that Amazon effectively copied. Chewy ("CHWY", 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.

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.

1/n. Been thinking about Chewy's competitive advantages and reasons why it can beat Amazon, here's the theory I came up with (draft)$CHWY pic.twitter.com/FgzJLcD46L

— mspacey (@mspacey4415) December 12, 2019

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.

A Quick Assessment of Square's Valuation

Here are some comments on Square's valuation, which will also serve to point out its valuation drivers.

Square ("SQ") reports two segments (not in its 10K/Qs but in shareholder letters and earnings calls): 1) Seller ecosystem, 2) Cash App ecosystem.

Seller ecosystem has ~30% adjusted EBITDA margin for 2019 (Note this is provided by management and they express it as percentage of Adjusted Revenue, which is a much smaller denominator than GAAP revenue because the adjusted version excludes transaction-based costs.)

Cash App ecosystem’s EBITDA margin was not disclosed, but apparently it is much lower EBITDA margin. In the 3Q19 call, an analyst asked:

“thanks for the EBITDA margin disclosure on seller, how quickly you can scale the Cash App margins? And can that ultimately approach the margins you're seeing on seller? That is Cash App versus seller.”

To which management answered:

“...we're continuing to invest aggressively into both our Cash App ecosystem as well as our seller ecosystem, and we think we're in the early days there in terms of customer acquisition and in terms of the product road map. So we'd expect to continue to see strong and growing contributions from Cash app going forward.

With respect to margins, just quickly, we see attributes in the cash business that are very similar to what we see in the seller business in terms of efficient customer acquisition, in terms of retaining customers over the long term and in terms of positive revenue retention. And because of that, we've been able to increase cash margins each of the last 3 years, and we'd expect to do the same in 2020. So over the long term, we see a very positive trajectory there as well."

So Cash App has lower EBITDA margins. But this segment has also been growing revenue at over 100% yoy, far outpacing Square’s overall growth rate in the 30%-40% range.

Thus we can infer that the growth of Cash App must have been weighing on Square’s overall profitability.

Cash App actually enjoys high gross margins (~75% vs ~40% for the Seller ecosystem), but somehow it ends with lower EBITDA margin. This is consistent with my guess that most of the discretionary/fixed cost investments in recent years have been in Cash App.

The big question is where does Cash App’s margin end up? I believe that, at scale, Cash App's EBITDA margin should equal or exceed those of Seller ecosystem. Those much higher gross margins matter, and eventually the R&D costs will be toned down while SG&A will be spread out through a larger base.

If the above is true, here are some basic numbers we can run:

• Adjusted Revenue will be about $2.2-2.3bn for 2019. Let’s say it grows ~25%-30% CAGR for next 5 years. 
• That’s about $6.9bn-$8.3bn of adjusted revenue for 2024. At 30% EBITDA margin that’s $2bn-$2.5bn of adjusted EBITDA
• SQ’s stock at $69/share, or $29b-$30bn mkt cap/enterprise value
• So this is trading at ~12x-15x 2024 adj EBITDA

This sounds ok. It’s a lot worse if we consider that these are adjusted EBITDA with huge stock based comp add backs. Another way to say this is that valuation is higher than it looks because of share count dilution overtime.

So far it would seem that Square’s stock is fully valued.

But at least we now know what SQ has to do. It has to maintain the growth trajectory in its Seller ecosystem (by defending against competitors like Clover). It has to continue growing Cash App by introducing new products and monetization opportunities, while maintaining a path to higher margins through operating leverage (i.e. stay out of ruinous competitive spending sprees).


Competitor PayPal (and its Venmo)

What really surprised me is the fact that Cash App actually makes more than Venmo. Cash App has run rate revenue of over $600mm, while Venmo only about $400mm.

Venmo is a competitor app owned by PayPal and much more popular than Cash App (At least in my experience, no one in my social circle uses Cash App, but may use Venmo). Venmo had $27bn of Total Payment Volume (TPV) for 3Q19, or an annual run rate of over $100bn. To put this in context, Square’s entire GPV for 2019 (most of it from its more established Seller ecosystem and not Cash App) will be just over $100bn!

So how is it that Cash App makes more money? The answer is here:

Main revenue drivers for both are 1) fees on instant deposits and 2) rev share on interchange from Cash Card / Venmo Card. SQ offered 1) for years and started charging 1% fee in 2016, 2) launched same year so more mature. Venmo started both in summer 2018, so still ramping

— CORE Dental DDS (@CoreDentalDDS) November 30, 2019

Now that should get you excited about Paypal. Imagine what happens to its stock when Venmo monetize like Cash App does!

Venmo currently contributes 16% of Paypal’s TPV, but only 2% of revenue. Not only that, Venmo grows faster than core Paypal so Venmo's share of total TPV will be increasing. Put two and two together, it sounds like Paypal's profitability is about to go through the roof.

So we failed to develop a bull thesis for SQ, but we may have ended up with one for PayPal!

Why Roku Needs More Than AVOD

I am having a hard time adding to my Roku position. At over $150 a share, the often cited $70bn Ad-supported Video On Demand (AVOD) opportunity is priced in. To justify any upside, we have to look for 1) international penetration (and defensibility of that position), 2) value from SVOD, including not just revenue share, but acquisition value.

What ROKU’s Valuation Implies (at ~$150/share)

Nowadays there's rarely a discussion Roku without someone touting the $70bn connected TV advertising market. Below are some quick numbers to show that opportunity is already priced in.

Let’s go through the Upside case first. 

• $70bn TV advertising spend in US. Let’s say it grows into $75bn in a few years.
• Assume a high % of that will be advertising funded (notwithstanding the current trend of content being subscription based and ad free). Assume ROKU end with 40% of the market and take 30% of ad spend as its revenue.
• That’s $9bn revenue for ROKU. Assume EBIT margin 20% and you get to $1.8bn of EBIT, or 10x EV/EBIT.
• That sounds cheap. But keep in mind that 1) $1.8bn EBIT is assuming a fully penetrated US TAM (so low growth from there on); it will take years to reach and success is by no means assured. 2) Also, this is before time value discounting. 3) I'm not factoring share dilutions which will make enterprise value go up.

Let's just use a quick "Rule of 72" for illustration. If we discount at 8% for 9 years, the present value of those EBIT would be half of what's shown, and EV/EBIT would be 20x/32x/60x, for Upside/Base Case/Downside, respectively. 

So even the Upside case above has little upside. I actually believe both the Base case and Downside scenarios are more likely. Competitors are all upping their game in the CTV space, and I think Roku will end with no more than 1/3 market share (switching cost is low in my opinion since all these players have offer similar content). Take rate of ad inventory will probably have to come down with competition.

The base case and downside scenarios imply 16x or even 30x eventual EBIT, at TAM (again, this is with no time value discounting).

This is U.S. market only. So ROKU has no upside at those valuations - IF it only monetizes from U.S. AVOD.

Where Is the Upside? 

But of course, Roku is more than just U.S. based advertising. First, there is international advertising. Second, don't forget SVOD!

The company is actively making progress in international. Here I can't help but think Roku will be disadvantaged because Apple, Amazon, and Google all have far greater name recognition. There’s also the inevitable rise of local/national champions that will contend with U.S. players. Analysts have been asking about international expansion, but management simply have not disclosed much.

More importantly, investors of Roku have to look beyond advertising dollars and into its strategic value in the value chain. 

There is a streaming war right now and players like Netflix, Disney, Amazon, Apple, HBO...etc are fiercely fighting over the key battle ground of being customer facing modules. 

As this article by @EntStrategyGuy (a "must follow" on Twitter) points out, whoever controls access to consumers gets to extract tremendous value from other parts of the value chain.

"To see this in action, consider the traditional cable offered HBO. For the privilege of distributing HBO to subscribers, of the $15 or so dollars each month paid by subscribers, the cable company kept half. Half!"

The question is what is the consumer's first stop for watching content? That is the strategic choke point, or what @EntStrategyGuy calls the "key terrain". The answer is no longer cable TV or Netflix. Nor will it be independent apps like Disney+ or HBO Max.

The "key terrain" is controlled by Amazon Fire TV, Roku, Android TV, and Apple TV.

Currently, Roku converts that strategic value into monetary gains through revenue sharing agreements with subscription video on demand (SVOD) providers. Ultimately though, we have to think about Roku's value as an acquisition target.

Going back to that article by @EntStrategyGuy, he lists Comcast, Disney, and AT&T as "potential bundlers" - and all three could use Roku to fill out their value proposition.

Comcast, Disney & AT&T – Potential Bundlers
These are all companies who could offer psuedo-bundles. Disney has a bundled price with Hulu, ESPN+ and Disney+. The challenge is it doesn’t have one experience to offer for other streamers, like its own Hulu Live TV offers HBO and Showtime, but no Disney+. (Seriously, why haven’t they started selling this yet?) We need to monitor Hulu here for them to become a true DVBs. The other Disney issue is a lack of device or operating system to leverage. (Roku could be the play here.)

Comcast is much better positioned with their “Flex” box, and integrations with Amazon Prime and Netflix. I’m not sure they sell subscriptions, but that could be added for other streamers fairly easily I’d assume. They already have the infrastructure to do these sales. (Also, I’ve seen speculation that Roku could help Comcast’s technology base and ad-sales.)

AT&T, like Disney, is a wildcard. They’ve launched a vMVPD, and control wireless customers but not devices and don’t have an operating system. But they’re thinking about this. If they weren’t so cash strapped, Roku would be an obvious play here. (Turns out, buying Roku would help lots of streamers stand against Apple and Amazon.)

There you have it. The much hyped $70bn U.S. AVOD market is not enough to justify Roku's stock price. For investors to get more upside, Roku will have to execute on international advertising, as well as monetize its value to SVOD streaming providers - including its potential as an acquisition target.

Twitter's Levers: Driving Engagement and mDAU Growth

I started a position on Twitter (TWTR) a few weeks ago and took a hit from last week’s blood bath. I added a little more. In spite of the “bug” of misusing user data leading to over-earning, I believe the overall theme of higher engagement still holds.

As I wrote in my last post, Twitter has an “irreplaceable position in our culture and that should command a higher floor multiple than usual.”

Twitter is mostly used as 1) online discussion board, 2) source of near real time news. As an investor I’m intimately familiar with the former use case.

Twitter as an online discussion board provides unparalleled access. Where else can you debate with, and learn from the Nobel Prize winners like Paul Krugman? (yes, I know it’s easy to hate on him nowadays, but still…) Many of these thought leaders will patiently reply to your questions. Even without participating in discussions, just following the debates on Twitter can be more educational than years of reading textbooks.

Twitter is also the irreplaceable source of real time news. The best example I can think of is when Turkey was going through its failed coup a few years ago. Instead of waiting for mainstream media, people went to Twitter. From our computers and cell phones, we saw Turkish citizens flooding the street; we saw civilians unarming soldiers in tanks; we saw the momentum turning in favor of Erdogan and the ultimate coup failure. It was all live on Twitter.

So we have an incredibly differentiated asset here. What is something like that worth? At $30/share, the stock is still trading at ~17x LTM management adjusted EBITDA (big stock based comp add back here). It’s not cheap for sure. But there is a floor and at any given time, operating momentum can turn and the stock could go on a run. All I can do is hold and wait.

Where are We on Value Drivers?

Twitter makes money from advertising. The main financial drivers are:

• Number of advertising engagements

• Price per ad engagement




As can be seen above, ad engagements growth has decelerated in recent quarters while ad prices have been less negative over time. This is price elasticity in action. The market took its time to find the right price for Twitter’s ads.

It’s worth noting that much of the gains in ad engagements come from gains in mDAU (monetizable Daily Active Users). To see this, we further break down ad engagements into 1) number of users (mDAU), and 2) ad engagement per user



As seen above, mDAU growth reaccelerated in recent quarters. On the other hand, growth in ad engagement per user came down to mid-single digits yoy. It’s not clear why this is the case. I think part of it is tough comps. Another reason could be new users have not turned into “power users” yet. I believe product upgrades can re-accelerate this metric.

Which brings me to Twitter’s levers.


Upside Levers - Engagement Growth

Twitter is accelerating its pace of product development.

The company really cleaned up its user interface the past few months. Visible improvements include: lists are much easier to create, organize, and use; searches are easier to access; bookmarks are now in the main menu. The whole app is just better organized in a common sense sort of way.

These are low hanging fruits – fixes that’s should have been done long time ago. There was no reason why accessing lists should require 3 clicks instead of one.

The point though, is Twitter is finally waking up and getting things done. Combined with its "health" initiatives (reducing toxic tweets), these changes reduce friction and make it easier for users to find the content they want. This can lead to better engagements per user.

The upcoming interest based list is an example of reducing friction. We might follow specific users for their stock analysis, but it gets annoying when that person spend 20% of his time talking about his favorite politician. A list based on specific interest/topics (just stock analysis in this case) would side step that issue. This is easier said than done. How will Twitter curate only quality tweets? We’ll have to see how Twitter executes.

Upside Levers - User Growth

Twitter is also trying to increase mDAU and drive TAM expansion with new products. The most important ones are 1) sports events/highlights, and 2) live videos.

First, Twitter is now regularly showing sports events at the top of the app. Clicking into these you can see sports highlights and the latest commentaries. This is a proprietary format if you think about it. Sports highlights are not unique. Comments are not unique. But near real time sports highlights, with humorous takes from like-minded people – that is an unique format.

Second, and somewhat related, is live videos. After failing to integrate Periscope for years, Twitter is now actively showing live videos at the top of the application. Since live videos are at the top of the app, it is essentially guaranteed views, and will incentivize more creators to make more live videos. More supply will in turn draw more demand. Presidential candidate Andrew Yang took advantage of this a few weeks ago by broadcasting a live Q&A session.

Sports highlights and videos represent different use cases from old Twitter. As Eugene Wei noted in his classic essay Invisible Asymptotes, the traditional power user of Twitter are infovores who thrive on the texts. However, this group is a small subset of the overall population and represent limited TAM. I think video products can break that limitation by appealing to a different type of audience.

The levers discussed above are opportunities just within the Twitter application itself. Twitter can also let third party developers build on top of its one-way follow infrastructure and take a cut of revenues.

There are so many possibility for Twitter that I believe a paid subscription model should be the last resort.

I can see Twitter increasing its revenue mid to high teens CAGR for the next 5 years. A reasonable base case would be something like 5%-10% growth in mDAU, 5%-10% growth in ad engagement per user, and flat ad pricing. If TWTR just shows a little operating leverage (this is a software company after all!), it’s not hard for the stock to double.


Notes: 
1. Vergecast did a nice podcast with TWTR’s product head recently and talked about product opportunities. You can find it here. 

Journal For Week Ending 10/12/2019: Bought SMIT, Passed on UBER (and Others)

In the past 2 weeks, I continued to accumulate the Trade Desk (TTD) (thesis as stated in my last write up here). I also jumped on Schmitt Industries (SMIT). There's not much to say about this company. It’s a simple cigar-butt play as summarized in my tweet here:

wow. $SMIT just sold its main biz.

Waiting to see use of proceeds.

market cap <$12mm. What's left of the company?

Measurement segment, 3 buildings in Portland (40.5k sqft), big NOLs, ~$12mm of cash (including sales proceeds), and a CEO who really knows how to invest https://t.co/0PKB2tTBVA

— mspacey (@mspacey4415) October 10, 2019

So basically I’m buying a $12mm market company with $12mm in cash. I essentially get a bunch of stuff for free: buildings, NOLs, and measurement business. It's not that hard to imagine the whole thing could be worth more than $20mm, or ~$5 per share (Stock is trading around $3 at the time of this writing).

I also took smallish positions in TWTR and ROKU.

Twitter is something I personally find incredibly useful for learning and research. The stock is not cheap but the company has been making user interface improvements that I believe can increase user base as well as engagement levels. Twitter has a irreplaceable position in our culture and that should command a higher floor multiple than usual.

Roku is more of an opportunistic trade. I have been researching the whole connected TV space (along with Trade Desk) and thought ROKU was a good company, but held off from buying because it’s expensive. So when the stock price came down and filled some technical gap I took a gamble on it.


Some Stocks that I Passed On

I passed on a bunch of stuff the past 2 weeks. The most prominent ones are Uber, Chewy, and Spotify. They are all tempting buys as they are entrenched businesses with strong brands. All these stocks looked to be bottoming too.

Here I will comment on why I passed on Uber. Perhaps in a later write up I’ll share the same about Chewy and Spotify as well.

Uber

I am mostly concerned about the sensitivity of margins to prices (that consumers pay).

In 2Q19, management mentioned loss of $100mm for Ride Share. We can back out the fixed cost and see that this implies 20% contribution margin for core Ride Share business.

The thing is, this 20% is off their 20% take rate (as in Uber gets 20% of what riders pay). As a percentage of consumer spend it’s really 4% contribution margin.

Yes you can make up for low margins with volumes and still have great profit dollars. That’s not the problem. The problem is sensitivities - any change in pricing (or take rate) could wipe out the economics.

So far I’m talking about current data, but the real question is this: What does fully ramped economics look like?

We know this 20% contribution margin in Ride is a mix between a) fully ramped, very profitable cities like San Francisco, and b) not yet ramped loss making cities. What can we infer about fully ramped margins? Let’s plug in some numbers for illustration purposes.

• Let’s say 60% of tickets come from fully ramped big cities that are profitable; assume loss making cities have negative 20% contribution margin.
• So you do 60% x + 40% (-0.2) = 0.2
• Doing the math, this would work out to about 35% contribution for fully ramped cities.

Again, this 35% is off Uber’s 20% take rate, so expressed as a percentage of what customers pay, you’re talking about maybe 7% contribution margin, even when fully ramped.

After deducting fixed cost, you probably have EBITDA margin in the low single digits. Again, a little drop in customer pricing or take rate would wipe out the economics.

When I started my research I imagined Uber to be this high margin money making machine with software economics. That’s just not the case.

Trade Desk (TTD) Can Double: TAM Analysis and Valuation

I think the Trade Desk (TTD) can grow its revenue 5x in 5 years, and the stock can double.

Trade Desk is a Demand Side Platform (“DSP”) in the advertising world. The easiest way to describe TTD is via analogy. When you want to buy stocks you would log into a platform like Interactive Brokers, Fidelity or Schwab to put in your buy orders. These platforms would execute your orders by going to the stock exchanges (directly or indirectly), and you can keep track of your portfolio.

In the advertising world, agencies work on behalf of brands to buy ads from publishers. These agencies would use the Trade Desk’s platform to put in buy orders.

Here’s a simplified lay of the land:



Source here.

In the above diagram, Trade Desk takes the role of “DSP”, and transact in the market place. "Buy” and “sell” here refer to advertising inventories, so that anything from DSP and to the left is considered “buy side”, while anything from SSP and to the right is the “sell side”.


A Bull Market in Connected TV ("CTV")

The entire digital advertising space is undergoing expansion. Advertising has been steadily going digital the past decade, but a large budget for traditional TV ads remained.

That is being chipped away. Content that used to go on traditional TVs are all going online, first with Netflix, then HBO, Disney...etc. Smart TV boxes like Roku and Amazon Fire TV are accelerating that trend by aggregating content and making the user experience more convenient.

The most premium of these services like Netflix will be subscription based. But there is a long tail of contents that needs to go online, and many (if not most) of them will be funded with advertisements.

Ad buyers are increasingly seeing the benefit of CTV advertising - more precise ad placements, better customer experiences (frequency capping), better measures, more flexibility, and so on.

Roku’s streaming hours grew 72% yoy and its platform revenue grew 86% in the latest quarter. Telaria’s CTV business grew 133% yoy. Trade Desk saw CTV spend grew 2.5x yoy.

Now, that’s what I call a bull market!

All three companies mentioned above are buys in my opinion, with varying degrees of risks and rewards. I choose to focus on TTD here because I think it has the most visible future.

Roku is in land grab mode against Google and Amazon to embed its platform into smart TVs. Victory is far from assured given competitors' advantage in voice control technology. Telaria is a sell side platform, which is to say there’s about zero barrier to entry, since there’s always new publishers popping up. Also, a publisher may develop its own sell-side ad tech as it gets big (Opera is one such example). Ad revenues are central to the business of content owners after all.

The DSP's do not have this problem. Advertising spend is important to brands, but not so central to the business that brands would develop its own DSP – at least I have not heard of any such examples. In any case, brands mostly outsource to advertising agencies. There’s only a few of these (Omnicom, WPP, IPG, Publicis, Dentsu), and they have been using the Trade Desk.

Although I focus on CTV above, TTD will also benefit from other factors, including programmatic ad buying taking more share within digital advertising.

There are some moats here. There’s cross-side network effect where ad buyers want platforms that can access the most sell side inventories, and vice versa. In addition, there are only so many platforms that ad buyers would use, maybe one to three, and that’s it. (Go back to the stock buying example, how many brokerage platforms do you use?) It won’t be totally an oligopoly as switching costs and barriers to entry are not insurmountable, but industry structure should be fairly stable and concentrated in a few strong hands.

Trade Desk’s Market Position Within DSPs

Most agencies use 2-3 DSPs. As the “Usage” table below shows, it is basically platforms from Amazon, Google and TTD. Note that even though FB takes a lot of ad dollars they're not a DSP player.



Source: TTD Investor Day

TTD’s position looks even stronger if you consider that Amazon actually let Trade Desk bid on its CTV advertising inventories.

The other credible competitors are Adobe and MediaMath. I consider Adobe to be the bigger threat just from a sheer resource perspective, and I would note that Adobe is an “independent” that doesn’t own content/ad inventory, unlike Google or Amazon. This lack of conflict of interest gave TTD an edge over other platforms, and it might also give Adobe an edge.

We will have to factor in Adobe in the market share assumptions below.

Total Addressable Market analysis (U.S. only)

Note this analysis is U.S. only. I was going to do global but it turns out even just U.S. TAM supports a doubling of TTD’s share price. So I’m content using just U.S. TAM/revenues in my valuation while knowing there’s a huge international upside that I’m not factoring in. 

First, some facts:

• Total U.S. ad spend $207bn in 2018; of which ~$106bn are digital ad spends and ~$60bn are TV ads. (See table below).
• About 2/3 of digital ads go through Google and Facebook (“walled gardens”)
• Only about $60 billion of ad spends are bought programmatically, but that number is growing fast.

Here’s a core assumption in my TAM estimate: eventually close to 100% of ad buying will be digital and programmatic (including programmatic direct which TTD supports). It just makes sense. I have not seen any evidence that this is not a safe bet.

I will also estimate TV and non-TV separately, since the former does not have the “walled garden” domination of Facebook and Google, and thus leaving more room for Trade Desk. Amazon’s opening up its CTV inventories is a strong signal that open internet will be the paradigm here.

So here’s my analysis of TAM/market share/and Trade Desk’s peak revenue, all in 2018 dollars.

1a): U.S. non-TV (~$107bn)

• The big wall gardens like Google and Facebook own about 65-75% of this market. That leaves 25-35% of TAM for the open internet players, or ~$32bn.
• DSP take rates of 15% (current take rate about 20% but I assume it will degrade over the years).
• $4.8bn ($32bn* 15%) of potential revenues for Trade Desk and other DSPs to fight over.

1b) U.S. TV (~$60bn)

• Again, I believe eventually all the ads will be digital and programmatic. No “walled garden” here.
• DSP take rate of 10-15%. I assume a lower take rate here than non-TV because there are multiple layers of distribution and aggregation like Roku and Amazon Fire TV taking their cut already.
• $6bn ($60 * 10%) of potential revenues for Trade Desk and other DSPs

2) TTD's market share and U.S. revenue?

• Non-TV
• 50/50 split between TTD and Adobe (remember this is assuming the walled gardens like Google and Facebook already took their share)
• TTD's revenue = $2.4bn (half of the $4.8bn revenue for DSPs)
• TV
• Split between 5 DSP players: Amazon, Google, TTD, Adobe, and some others
• TTD's revenue = $1.2bn ($6bn / 5)

Add up Non-TV and TV, I project TTD can eventually get to $3.6bn in revenue. The company will likely do ~$650mm of revenues for 2019. So at the current 40% revenue growth rate, TTD can get to this $3.6bn in 5 years.

There are multiple elements of conservatism in the above estimate:

• I'm using 2018 dollars. 
• Remember, that’s just the U.S. TTD is making a big effort to grow internationally, particularly in China, and I believe they will be successful.
• I’m assuming TV ad market size stays the same even with various new innovations. The more realistic assumption would be to assume TAM expansion as technology drives down cost and improve access and adoption.
• I'm not counting audio at all. This is a market that’s going through hyper-growth just like the CTV market.
• The Walled Garden in non-TV advertising could come down due to regulatory pressures on Facebook and Google. This would instantly triple TTD’s opportunity in that area.

Stock Valuation and Upside

Take the $3.6bn revenue from above and apply 30% EBITDA margin and 20x EV/EBITDA (still plenty of growth runway in 5 years, strong market position, software margins…etc) get you ~21.5bn of enterprise value. Assume a little share dilution and stock is a double in 5 years for 15% IRR.

Risks

Take rates can come down to even lower than I modeled.

Notes on GKOS and EVH

So I took a break from writing the past month. It's really hard to focus your mind when your health is suffering. My now 5 month old baby also took up a ton of time, to the point that I was barely working or even following the market. But things are better now, I'm recovering and we found a combination of part-time nanny/daycare. Hopefully I'll have more time to research going forward.

Here are notes on some healthcare companies I have been following.

Glaukos (GKOS) – passed with stock around $60

·        A leader in MIGS (Minimally Invasive Glaucoma Surgery). But I wonder about the next generation product - iDose. I see iDose as basically a drug eluting stent, which is not a particularly novel concept. I’d expect plenty of competition.

·       I question the growth runway of MIGS. In the latest quarter GKOS grew revenue 36% yoy, that is strong but not exactly “tornado” growth, given it was off a small base of $43mm. Glaucoma drugs works and MIGS is used for better compliance. But are you really going to have surgery (however minor and non-invasive) to ensure compliance? 

·       Avedro acquisition is extremely promising but early stage. Avedro’s keratoconus product won’t be enough, even though there’s clearly a niche market for it.

o   Just checking on Reddit, one can see an active keratoconus patient community and Avedro’s procedure is the de-facto standard at least for now. 

o   The problem is it will still be a niche market even if GKOS/Avedro can achieve “epi-on” in the keratoconus procedure (and thus become much less invasive and improve adoption).

·      The real upside for Avedro is the concept of “corneal remodeling” for nearsightedness, farsightedness, astigmatism and presbyopia. Corneal remodeling is an alternative to LASIK surgery. The way I understand it is by analogy – corneal remodeling is like 3D printing to LASIK’s CNC machining. The former is additive – it reshapes the cornea by adding thickness in certain areas; while the latter is subtractive – it reshapes by carving away.

·        Corneal remodeling is a highly differentiated concept with a huge TAM.  But we have to wait for it to take off.

·        So it’s not time to buy GKOS yet.

Evolent Health (EVH) – took a small position around $7.1

·        I got this idea from lsigurd’s blog

·        Have to say I really hated the idea! Yet I couldn’t help myself and bought a small position.

o   I see an undifferentiated company in a fragmented market, subject to regulatory whims. Lsigurd himself even outlined the many risks this company is facing.

·        Why? For the upside of course.

o   Its Passport plan is likely to renew its Kentucky business - that would immediately lift one of the biggest overhangs over the stock.

o   EVH can also easily squeeze out costs from Passport (which it is doing) and show some good financials.

o   Once the situations stabilize, it’s not hard to see the stock can double or a triple.

·        This is the sort of home run-or-bust play I tell myself NOT to engage in!  So maybe this is just FOMO on my part. We will find out soon enough. In October we will know if EVH can renew its Kentucky business.

·        This is a < 1% position for me. But I might add if fundamentals improve.

What Makes a Winner-Take-All Game

What are the industry contexts that leads to a winner-take-all game? Are there industry properties that naturally encourages consolidation and oligopolies? Network effect is the first that comes to mind. But surely that can’t be the only one? I have been struggling with this question.

Then I realized - invert. The question is really “what makes an industry fragmented?” There’s literally a whole chapter in Michael Porter’s “competitive strategy” that answers this question.

Porter’s Causes of Fragmentation

Here’s Porter’s list of causes for fragmentation:

• Low entry barrier
• Absence of economies of scale or experience curve
• High transportation cost
• High inventory cost or erratic sales fluctuations
• So scale is less of an advantage because your plants can’t operate production continuously. Scale may and down
• No advantages of size in dealing with buyers or suppliers
• Perhaps because buyers or suppliers are even bigger
• Dis-economies of scale in some important aspects
• Rapid product/style changes
• Low overhead important
• Diverse product line that requires customization
• Heavy creative content
• Close local control
• Personal services important
• Local image and local contacts are important
• Diverse market needs
• High product differentiation, particularly if based on image
• Exit barriers. This reinforces low entry barrier, as too many competitors can come into the industry and not exit.
• Local regulation
• Government prohibition or concentration
• Newness. This bears a lengthier discussion. If fragmentation is caused by newness, then it may be a temporary condition. The industry may actually be ripe for consolidation.

Simplified List

We can consolidate this list into a few big buckets: 1) low entry barrier (a pre-requisite to be combined with other attributes according Porter), 2) no advantage to size, 3) diverse buyer segments/needs, and 4) distribution friction (high transport cost, local regulation). Of course, regulation is an ever present force.

Invert back. The reverse of the above properties enables winner-take-all dynamics: 1) high entry barrier/low exit barriers, 2) big advantages to size, 3) homogeneous buyer segments, and 4) low distribution friction.

It’s the “advantage to size” that made me say “duh ! Why didn’t I think of that?” Of course there has to be advantages to size! Otherwise what’s the point of getting bigger? The two most prominent types are:

• Network effect: Better value proposition for the customer as you add nodes to the network
• Economy of scale: Unit cost declines as volume increases.

As a firm gets bigger, the former increases customer benefits (“B”) while the latter decrease cost of production (“C”). Both creates a widening gap between B minus C that leads to increasing returns on capital. 

Ideally there’s a positive feedback loop of increasing return to scale: a company grows in size, which gives it some competitive advantages over rivals, this allows the company to gain more market share, and the increased size yields even more competitive advantages. This feedback loop continues as long as the advantage to size overwhelms any advantages to smallness. This is as opposed to the reverse dynamic where a firm’s growth gets constrained by dis-economy of scale (negative feedback loop).

Porter also talked about how to overcome fragmentation and achieve consolidation. His approaches mirror the 4 buckets I gave, with emphasis on increasing scale and using standardization to overcome diverse market needs.

Growth Industries

The last point in Porter's list is "newness". Where the industry is in its life cycle also matters. Winner-take-all games are more likely to happen in fast growing industries facing disruptive innovation. This is because the industry has to create a whole new value chain, and that value chain needs a leader. Ideally the leader pushes forward with standardization schemes, which helps 1) various parts of the chain to interface with each other, 2) customer adoption.


How About Switching Cost and Differentiation?

That’s all great, but how about switching cost and differentiation?

Remember, the above are industry properties that encourage winner-take-all games. They apply to all companies in the industry. But I think switching cost and differentiation are best discussed in terms of how a specific firm can become that “winner”.

Differentiation is obviously a firm specific factor, while switching cost can be both industry-wide and firm specific.

In the industry context, switching cost appears under multiple categories. It is cited as a barrier to entry by Porter and is related to network effect (which I categorize as a form of “advantage to scale”).

Ultimately though, a customer switching from Firm A to Firm B is good for one and bad for another. In this sense the discussion of switching cost requires a company specific perspective. Switching costs can also vary according to company strategy. For example one can increase stickiness by having multiple touch points with its customers.

Naturally, the next question is “how does a company win in a winner-take-all-game”. I’m still thinking through that, so any inputs/comments would be appreciated. Thanks!

Facebook and Google: How Online Ads Will Do In the Next Recession

Investors of Facebook (FB) and Google (GOOGL) have been worried about privacy issues and now anti-trust issues for the past couple years. I think an even more important question though, is how cyclical are their ad revenues?

Theoretically, advertising should be highly cyclical. Advertising acts as weapons in business wars for market shares gains, which primarily happens during an expansion.

Think about all the subscale/unprofitable startups that spend over 100% of revenue on sales/marketing. They’re willing to spend lavishly on advertising under the logic that market share begets more market share (network effect); that they will be able to retain customers, and therefore the lifetime value of those customers should exceed sales and marketing expenses. These companies are generally cash flow negative and depend on external funding. In a liquidity risk-off situation that funding get cut off, and their advertising spends on FB and GOOGL could come to a sudden halt.

In short, companies (especially SaaS guys) are treating advertising expenses as capital expenditures, and thus advertising revenues should reflect more cyclical characteristics.

This points to a downside scenario for Facebook and Google (disclosure: I’m long both). We will at some point hit a recession. Google and Facebooks’ revenues may not just stop growing but actually decline (volume and price both drop). Then you have operating deleveraging, lower margins, and earnings and free cash flow gets destroyed.

What Happened During 2008-2009

The easiest way to see how something might fare in a recession is check how well it did during 2008-2009. There the data is surprisingly good – online ads actually did well during the great recession. Google’s revenue growth slowed but never turned negative. 

Here’s a Harvard Business Review article from 2009 that discusses the strength of online advertising:

“Despite a deepening recession, marketers spent 14% more on online ads over the first three quarters of 2008 than they did over the same time frame in the previous year.”

There are structural and cyclical components to this phenomenon. The structural part is easy - digital ads were in its early innings during that time as people were still moving online.

The cyclical component is also intuitive. Companies become more budget conscious in a recession. They want more measurable ROI and more precise targeting as opposed to a scattershot approach. Both factors favor digital ads over broad based TV ads.

People also lean on their social networks more in a downturn, for job networking as well as emotional support. This resilient usage of social networks makes it a good media for ads. 

Differences Then vs Now, Conclusion

Granted, the current situation has important difference compared to 2008. Online ads are no longer in the early innings – 2019 will mark the first year digital ads make up over 50% share of advertising market. Furthermore, Google’s revenue was growing 50-60% a year heading into the 2007 downturn compared to the mid to high teens growth rate it now shows.

Both Facebook and Google have made strong moves into video advertising, where they still have the advantage of more quantifiable ROI and precise targeting against traditional TV. However, the competitive edge is less overwhelming nowadays with smart TVs like Roku that can also do targeted advertising.

The two companies will also have to fend off new entrant Amazon.

Despite these differences, some of the behavioral patterns should still hold. In a recession I think people will still network more, lean on their social circles more, and probably spend more time online searching for jobs and information.

Weighing these factors, my recession scenario for Google and Facebook is as follows:

• Ad prices should take a hit to maintain ad buyer ROI – (as conversion rates go down in a recession).
• Volume down 5-10%.
• Overall mid teens decline in revenue.
• Margins and earnings will take a hit and stock prices will get punished as well. 

Looking beyond though, there’s no question FB/GOOGL have the balance sheet to survive a recession. Once recession recovers, ad volumes would spike back up.

So for the long term investor, the question goes back to structural growth opportunities. Here the prospects are bright. Both companies continue to develop new products, both for consumers and for advertisers. Both have established strong presences in digital video advertising and taking the lead in trialing new formats to optimize advertiser ROI. From that perspective, they’re still in the early innings.

Coherus (CHRS) Part 3: What Happens After Udenyca Peaks

8/4/2019 Notes

I had a mistake here. Udenyca value should be more than I figured below because its pass-through status does not expire in 2 years as I assumed, but in 3 years.

Original Post:
I want to follow up on my last post about Coherus ("CHRS"). In the end I wrote:

"I do have some reservations about Coherus beyond Monday’s event. They are 1) Sandoz’s version of bNeulasta likely coming later this year. 2) what happens to Udenyca’s revenue after it peaks."

After thinking about it more, I’m not too concerned about Sandoz’s upcoming biosimilar. Sandoz will get its share and I already built that into my Udenyca peak sales estimate - by dividing the bNeulasta TAM between 7-8 players. Also, Udenyca’s superb launch performance should give Coherus some advantage, as the biosimilar market for hospitals has some stickiness.

The bigger uncertainty is how Udenyca will perform after it reaches peak revenue. Starting April 2019, Udenyca benefits from its “pass-through status”, a designation that allows 340b hospitals that use Udenyca to get reimbursed at ASP+6%, compared to the ASP-22.5% if they use original Neulasta. This obviously favors Udenyca and likely contributed to its sales spike starting April.

The problem is this pass-through status expires after 2 years, and then Udenyca would get reimbursed at ASP-22.5% as well.

This would make Udenyca less profitable for 340b hospitals. So Coherus will likely have to cut prices to let hospitals maintain their unit economics. Going from ASP + 6% to ASP-22.5% is almost a 30% cut to hospitals, and Coherus may have to eat that difference to maintain its market share. (Note this is 30% of Neulasta’s ASP, which by then should be fairly close to Udenyca’s ASP).

This is just for 340b hospitals, not non-340b hospital or clinics. But it’s probably safe to say a price cut in one customer segment will spill over to others. For modeling, I would 1) assume some peak revenue by 2020-2021, then 2) step that down by the almost 30% cut in reimbursement, keep revenue at the reduced level for a few years, and 3) use some decline rate afterwards in perpetuity.

So revenue cadence might look something like this (erring toward conservatism) 

• 2019. Already at $320mm runrate by 2Q19! But if Sandoz enters later this year growth will decelerate (but should still grow)
• 2020. Revenue of $350mm. This is too conservative given annualized revenue of $320mm in the second quarter of launch. But we’ll just use this for illustration purpose.
• 2021. Start out at $350mm run rate. But pass through status expires in April 2021 and Coherus could a 30% price cut, thus revenue goes down to $245mm run rate. Blended revenue for the year is about $300mm.
• 2022 – 2026. Revenue of $245mm
• 2027 and onward. Revenue declines 5% a year.

Using a 10% discount rate and 85% gross margin, the present value of Udenyca gross profit is well over $2bn. But to put a value on Udenyca, we have to consider the expenses as well.

So what is it worth, and to whom?

From Coherus’ perspective as a standalone company, most of the expenses for Udenyca will be SG&A, as there are little R&D expenses left. Using $140mm SG&A expense and 10% discount rate, I get to about $530mm of present value for Udenyca. Once they have other drugs in the market (bHumira for example), we can attribute less SG&A to Udenyca due to cost synergy, so the value for Udenyca would be much higher.

What is Udenyca worth in the marketplace though? Potential acquirers who already have the sales and marketing infrastructure can buy Udenyca and capture the bulk of gross profit. As we stated earlier, the present value of that cash flow stream would be over $2bn. This means Udenyca could be worth well over 5x peak revenue, even taking into account the expiration of pass through status and the price drop that will likely come with it.

CHRS’ market cap of $1.4bn compares favorably to this potential. That's not even considering pipeline value and platform value. So I will hold my core position, and trade around the incremental shares I added last week.

Coherus (CHRS) Part 2: Thoughts on Monday’s Price Action

On Monday 7/8/2019, Coherus (“CHRS”) pre-announced revenues of $79-$84mm for 2Q19. This represents more than 100% increase over last quarter, and is well above consensus revenue estimate of around $50mm. It also blew away my own estimates. In my write up last week, I estimated Udenyca peak revenue of $300mm. Now, only in the second quarter of launch, Udenyca is already at annualized rate of $320mm! 

Yet the stock tanked, at one point down 20%. It bounced back slightly later in the day to sustain above its 50 day moving average. A couple days later it is back above $20 - still a material drop from peak of ~$23.

Thoughts on Monday’s Price Drop

So what might be the problem? No one knows for sure. But usually when something like this happens it’s due to 1) growth deceleration, 2) industry bad news, or 3) competitor did something.

Let’s review these possible causes one by one.

First is the question of growth deceleration. Udenyca’s volume spiked shortly after 1Q. Using Udenyca’s April pace of sales alone, I was able to project around $70mm in revenue for 2Q19. Some analysts had data that says May is even better. I can certainly see someone extrapolating the April and May growth into June, and came up with something like $90mm for 2Q19.

Viewed this way, 2Q19 revenue landing at $79-84mm does imply a slowdown in Udenyca sales for June. Take it a step further, does the slow down imply that previous revenues were boosted by some sort of inventory/channel pull forward? That’s certainly possible.

But I don’t invest base on monthly trends. If anything, given Udenyca’s way above expectation performance, we should be upgrading our estimate of peak sales. If some slowdown in June is the reason for the stock drop, then I’d say it’s a buying opportunity.

Second, industry news. I don’t think this is it. Trump made some noise about cutting drug prices, but it’s just that – noise. In fact, government effort to cut drug costs may actually be bullish for Coherus if it means pushing for more biosimilars.

Third is if there are any news from competitors. CHRS's next product in the pipeline is bHumira. On Monday, Samsung Bioepis's Imraldi (biosimilar Humira) received an updated EU label, allowing them to doubles the days of storage. So Samsung's bHumira could actually be better than the original Humira! This is not good for Coherus.

But does this matter that much? Coherus’ own bHumira doesn’t launch until 2023. It’s possible the company can still adjust the product to match whatever product advantage that Samsung Bioepis has. It’s also questionable if longer storage days really matter much to customers.


I concluded that none of the above factors have a material impact on Coherus’ big picture prospects. So I added a little bit to my position.

But I’m nervous. Stock dropping on good news is usually a bearish signal, and the vehemence of the sell-off tells me “someone knows something I don’t know”.

I do have some reservations about Coherus beyond Monday’s event. They are 1) Sandoz’s version of bNeulasta likely coming later this year. 2) what happens to Udenyca’s revenue after it peaks.

I will post some thoughts on these in the next few days.

Coherus (CHRS) Could Be Worth $30-$40 a Share

Coherus Biosciences ("Coherus", “CHRS”) is a pure play biosimilars company. With recent controversies regarding sky high biologic prices, biosimilars are looked upon to enhance market competition, contain prices, and broaden patient access.

Coherus currently has one product that just launched – Udenyca (biosimilar Neulasta). It also has a bunch of stuff in the pipelines, with the next product being CHS-1420 (biosimilar Humira) coming around 2023.

The stock trades at $22.5 at the time of this writing. Some quick estimates of revenues for bNeulasta and bHumira are enough to show that the CHRS can get to $30-$40 a share.

TAM and revenue estimate for Udenyca

A reasonable revenue estimate should factor in 1) lower revenue due to lower prices, 2) original brand's own retention, 3) market share, 4) OnPro (a separate discussion to follow). 

Here are some facts and baseline assumptions:

• Neulasta is a $4.5bn market.
• Mylan prices their biosimilar Neulasta ("Fulphila") @ 33% discount. So does CHRS’s Udentyca.
• Assume Amgen retains 20% of market post all the biosimilar launches.
• Assume about 7 players to evenly split the biosimilar Neulasta market.

So I estimate Udenyca peak revenue to be 4500 * 66% * (1-20%) / 7, or about $340mm. If we assume 8 players instead of 7, that’s still $300mm for Coherus.

This estimate is conservative for a couple reasons. First, I’m saying TAM for biosimilar Neulasta is 4500*.66 = $2970mm. Essentially I’m shrinking Neulasta market size by biosimilar pricing discount, while not taking into account that lower price should lead to greater patient access and greater volume.

Second, I assume market shares are split evenly. This will likely prove to be too conservative for CHRS. Now, maybe big guys like Sandoz would take disproportionate share, but CHRS is far from the weak hand here. Udenyca’s 1Q19 result was maybe the strongest biosimilar launch in history. The hospital market has some stickiness because biosimilars are not complete substitute for each other and the administrative cost of switching is high. I’m also counting competitors such as Cinfa and Accord Healthcare (raise your hand if you ever heard of these guys…) 

More On Udenyca – the Onpro discussion

Udenyca is a prefilled syringe. But some 60% of Neulasta revenue is from “Onpro”, the on-body injector version of Neulasta. That leaves only 40% for the pre-filled syringe market. So should I treat Onpro as a totally separate market, and therefor apply 60% haircut to my Udenyca revenue estimate?

I believe this was a big worry for the investment community, until 1Q19 results and commentaries changed that narrative. I also think that, along with higher than expected gross margins, explain the recent stock run up.

Udenyca brought in $37mm of revenues in its launch quarter (1Q19) – that’s a run rate of almost $150mm. This blew away estimates and would hint that Onpro is not a totally separate market immune to prefilled syringe competition.

The earning call gave more indications that OnPro will not be a barrier. Management said 40% of the biosimilar gains actually came from OnPro. They also confirmed that Coherus will go after the entire market and will have their own on-body device.

So I’m sticking with my $300-$340mm sales estimate for Udenyca because: 1) they are already taking share from Onpro. 2) CHRS plans to go after the entire Neulasta market including Onpro, and confirmed they will have their own on-body device, 3) Onpro itself packs a prefilled syringe and does not seem that hard to make, and 4) OnPro is a single use device, the main benefit being that patient do not have to return next day to get an injection. That seems to me a marginal benefit CHRS can overcome with the right pricing incentives.

Biosimilar Humira

So I think Udenyca gets to peak revenue of $300mm. I will use that exact same number for biosimilar Humira, the next in Coherus’ pipeline.

Humira market is a multiple of Neulasta’s ($20bn versus $4.5bn), so this should be conservative enough. Offsetting that is the possibility of more competitors for bHumira compared to for bNeulasta. Sandoz, Boehringer, Amgen are all FDA approved while a few others including CHRS are still in pipeline. Also, unlike in Udenyca’s case, CHRS will not be one of the earliest to market. 

I think these factors offset, and peg the combined peak revenues for Udenyca and bHumira at $600mm. This should happen around 2025-2027 timeframe.

Valuation

Coherus' market cap of ~$1.5bn look cheap compared to my estimated peak revenue of $600mm. Keep in mind this is a business with gross margins over 90%. Also, I have not assigned any value to other pipeline products such as biosimilars for Enbrel and Eylea.

As a sanity check, below is what I think normalized EBIT might look like once biosimilar Humira hits market. I assume gross profit of 85%, normalized R&D as trials tail off, and higher SG&A due to sales force expansion. Again, projected EBIT of $170mm would make current enterprise value of $1.6bn look cheap. 

As for the upside, I will simply take this $600mm revenue and apply a typical 4-5x revenue multiple for biopharma stocks. That gets us to $2.4bn-$3bn market cap, or around $30-$40 a share depending on your assumptions for cash burn and equity dilution.

Finally, CHRS will approach cash flow breakeven in an year or so. So there won’t be too much dilution that makes stock more expensive than it looks.

Elastic (ESTC): SaaS Transition Kills Open Source Debate, but Too Early

Elastic N.V. (“ESTC”) provides elasticsearch, an extremely popular open source search engine that’s used for search, infrastructure monitoring (including logging), and security. An excellent background is provided here, written by “CMF_Muji”. He did a great job covering the basics of the company, product, and use cases. I will not repeat that effort here.

For the purpose of this article, I will refer to Elastic the company as “ESTC”, as distinct from elasticsearch the product.

Elasticsearch the product is well established. No one questions the product is great, or that it’s a de facto standard (at least in areas like logging); or that it has a long growth runway ahead of it. So let’s get to the point.

Amazon’s Attacks on ESTC

The biggest problem for ESTC investors are threats to its open source business model, as exemplified by Amazon’s recent moves. In this post I will explain the nature of Amazon’s attacks, and why I think this highlights ESTC’s vulnerability to other and future threats.

Amazon's attack has two fronts: 1) Amazon's hosted service (“Amazon Elasticsearch Service”) competes with Elastic's hosted service (“Elasticsearch Service”). This actually has not been a huge problem. Despite the obvious potential for naming confusion, ESTC’s own service is growing nicely. 2) Amazon’s “Open Distro for Elasticsearch”. This stems from Amazon’s complaint that ESTC mixes open source and proprietary code in its default distribution.

Of the two, Amazon’s Open Distro is by far the bigger problem. This article gets to the crux of Amazon’s criticisms.

The issue is a bit of “he said, she said”. Note that ESTC actually let you download an all open source version with no proprietary features. So arguably Amazon fails its attempt to claim moral high ground. Granted, ESTC's OSS version is compiled version and not the source code, and that a developer who want to work with the open source code from Github will have a hard time avoiding the proprietary code. Still, if you’re a developer who just wants to use the ELK stack, you’re not going to fiddle around with the source code in Github, you’ll just download the binary anyways. So I’m not sure this whole debate matters for the average user.

ESTC also says it’s all very clear what’s what, according to the article.

“All of the code for our proprietary features are kept in a separate top-level folder called “x-pack,” to avoid any mixing or confusion. We also include a header on every source file, indicating whether it is licensed under Apache 2.0 or the Elastic License, to prevent any ambiguity”

Non-existent Barrier to Entry

If this debate is purely about open source versus proprietary, then there’s an easy way for ESTC to put it all to rest. They can simply provide a version that only has free open source – the source code, not the binary.

But that’s not the only issue. Amazons Open Distro actually has more functionalities than ESTC’s "all open source" version. It is closer to ESTC’s premium distributions, but all for free.

With the first release, our goal is to address many critical features missing from open source Elasticsearch, such as security, event monitoring and alerting, and SQL support,” Cockcroft wrote.

Will these extra features be enough to sway developers toward Amazon’s version? Who knows? Does it matter?

The point is, this could just be the start. Anytime ESTC comes up with some premium proprietary feature, AMZN can fork it and come up with a free and open source version. Perhaps they’ll even add features that are better than those in ESTC’s premium paid version. It would then be up to ESTC to match those features in price (as in zero, free), and release them under open source Apache 2.0 license. Will they have to do that? I don’t know. The potential for an ugly spiral to the bottom is certainly there.

The underlying problem is ESTC’s “Open Core” model. There is next to no barrier to entry. Source codes for the core functionalities of elasticsearch are on Github for all to see and use. Forget Amazon, an enterprising startup can take those codes, add their own features (open or proprietary) and created their own version. “open source” is more like open season for wannabe competitors.

Adding to that pressure, selling software is not Amazon’s core business, nor Netflix’s, nor Expedia’s. Elastic charges for their service by “nodes” and it gets expensive real quick. Big corporate customers won’t hesitate to hurt ESTC’s business if that gives them an edge in negotiating and pushing down those licensing costs. For ESTC this could be an ugly race to the bottom – everything for free.

Transition to SaaS Makes this Debate Moot

Now let’s go back to CMF_Muji’s article. One of his best insights is that ESTC’s acquisitions all have something in common, which is these are applications built on top of elasticsearch itsef. ESTC can then easily integrate them into its own platform and offer SaaS products.

Note I’m not talking about the so called “SaaS” that shows up as revenue in ESTC’s income statement. ESTC counts Elasticsearch Service as “SaaS”. But that’s really just hosted service, still very much a “build it yourself” approach. It’s more akin to IT infrastructure/platform (see notes for various product lines). What I mean by “SaaS” here is end users getting the application functionalities without having to interact with the underlying infrastructure stack. Think of SaaS like SalesForce, like Workday.

That’s not ESTC, at least not yet. For now they are primarily a vendor of on-premise, self-managed software, with offers to host that on the cloud (but still have customers build their own apps on top). And even that hosting, “Elasticsearch Service”, is still under 20% of revenue.

ESTC is moving in the SaaS direction though. With a series of acquisitions, ESTC is well positioned to shift away from selling infrastructure software/source code and toward being an enterprise application vendor. App Search Service (powered by Swiftype which they acquired), Site Search Service, and the new Enterprise Search Service – these are all closer to what I would consider SaaS products. ESTC also just acquired Endpoint, and will use it to security application space.

CMF_muji correctly points out that this “true” SaaS approach is an upside option for ESTC. I think it’s more than that. It’s a way out of this whole “existential threat to business model” quandary.

This is a step function change in business model – selling application instead of selling enabling infrastructure. Your value proposition is different. The customer’s mindset is different. The SaaS user will focus on fulfilling the business case and ignore the infrastructure. They will not play around with Github and source codes.

At that point the whole debate of open source versus propriety becomes moot.

That is a promising thought, but one that is a long way off. The value proposition, customer set, as well as ESTC’s sales and marketing approach all have to change. This is by no means an easy move.

What I'm doing with the Stock

ESTC is a company with optionality, but also one whose core business model is threatened and will likely have to undergo a big transition (no easy feat). It is also trading at some 13x revenue. 

For that, ESTC goes into the too hard pile.

When would I revisit? I would when actual SaaS revenue (ex Elasticsearch Service) shows a clear pathway toward being half of total revenue. I will also rethink this if stock shows technical support in low $60’s.


Notes: The product set

ESTC’s offerings consist of 1) on premise and self-managed, under which there are free and premium versions, and 2) cloud offerings, which include ESTC managing the infrastructure for you, as well as what I consider “true SaaS” application offerings.

• On premise/self-managed products
• https://www.elastic.co/subscriptions
• Free versions. The default distribution ("Basic") includes open source as well as proprietary features (but still free).
• Paid versions. The Gold and Platinum versions include support as well as advanced features.

• Elastic Cloud. https://www.elastic.co/cloud/
• Elasticsearch Service - this is their hosted service (can choose AWS, GCP)
• Elastic App Search Service
• Elastic Site Search Service
• These are cloud software, but not all are SaaS. ESTC counts all 3 to be SaaS, but I would only count the latter two (App Search and Site Search) as real “SaaS” in the sense of how market uses the word. Elasticsearch Service (for now the bulk of revenue in this segment) is still "build it yourself" software.

• Elastic Cloud Enterprise
• https://www.elastic.co/products/ece
• This is confusing naming because this is very much an on-premise solution. Sure, it can be deployed on public or private clouds, but if someone wanted to deploy on public cloud, they would have just used ESTC or Amazon’s hosted service instead of installing this.
• here's the description: Elastic Cloud Enterprise, or ECE, is the same product that powers the Elastic Cloud hosted offering, available for installation on the hardware and in the environment you choose. ECE can be deployed anywhere - on public or private clouds, virtual machines, or even on bare metal hardware