Thoughts On Sales and Marketing Effectiveness and Return on Capital

The best companies in the world are those that can invest large amounts at high returns on capital.

ROIC and RONIC (Return on Invested Capital, and Return on New Invested Capital) both use measures of "invested capital", where "capital" refers to capital expenditure and to a lesser extent working capital. (footnote 1)

In new economy industries though, and software in particular, “investments” take not the form of “capex”, but more often sales and marketing expenses to build up a customer base that will then bring recurring revenues. Salesforce.com, for example, persistently “invests” 40%+ of revenue on sales and marketing. Okta, another cloud native, spends (or “invest”?) 50-70% of revenue on sales and marketing. In contrast, traditional "capex" requirements for these companies can be relatively little.

So thinking about returns on capital for these companies is essentially thinking about sales and marketing ROI.

One Way to Measure

This is the unspoken premise behind Theta Equity’s post on Slack. A key component of that paper is measuring returns on sales and marketing with the following procedures (a very high level simplification here):

Sales and marketing ROI = Post Acquisition Value (PAV) divided by Customer Acquisition Cost (CAC)

• PAV is a function of 1) retention, 2) revenue dynamics, and 3) variable margin. First you work out the revenue curve for each acquired customer, then assume some 1) cost of service, R&D, and G&A to get a variable margins curve per customer. Then you discount that at the weighted average cost of capital (WACC) to arrive at PAV.
• For CAC, we can simply take sales/marketing expense and divide that by number of customers.

This is really great work. However, data about customer counts and cohorts are often not available, so here’s my even simpler way to not so much quantify, but think about sales/marketing effectiveness.

Simple Way to Just Think about Sales & Marketing ROI

I  basically compare sales and marketing expense as a percentage of revenue against the revenue growth rate achieved. Then I subjectively judge the recurring nature of that new revenue gained, and conjure up a ball park incremental margin.

I’ll go straight to a hypothetical example. If you spend 50% of this year’s revenue on sales & marketing, and revenue next year only grows 30%, is this a good “investment”?

Of course, the answer depends on lifetime value of that customer. In this example, you start with $100mm of revenue in year 0, and spending $50mm of that on sales and marketing gets you $130mm in revenue next year. This is $30 of incremental revenue for the $50mm sales and marketing “investment”. Now consider the two scenarios:

• A: Assume this new customer give you 3 years of revenue stream, which has 40% incremental EBIT margin (excluding sales and marketing cost).
• Then you would have $30 * 3 * 40%= $36mm of EBIT contribution (again ex sales/marketing cost)
• So you're spending $50mm to get $36mm back. Even without time value discounting, we can say this is no good.

• B: How if that customer life run 10 years, instead of 3 years?
• Then you’re getting $30 * 10 * 40% = $120mm. You spend $50mm to get $120mm (albeit over 10 years). This is much better! 

The income statements give us sales/marketing cost in year 0, as well as the incremental revenue in year 1. So what we have left to figure out is 1) average duration of customer lifetime, 2) margin contribution (ex sales/marketing costs).

There are ways to get ballpark estimates. If the company says customer attrition rate is 10%, you may say customer life time is roughly 1/10% = 10 years. To get margin contribution, you can use data from comparable companies that are more mature.

But still, it would be unwise to simply take empirical data and assume they stay the same. If in the past customer lifetime is 10 years, would you really be comfortable that the new product launched this year will also have 10 years life? The competitive landscape would surely have completely changed during a decade, particularly in the fast changing world of technology.

This is where quantitative data hits their limitations. Your analysis would now shift to focus on qualitative considerations like competitive landscape, market positioning, switching cost, network effects, and so on.

Footnote 1:
Traditional ROIC calculation implies a clean delineation of “capex” and “opex”. These are all just accounting identities though.

In the real world, what matters is cash in and cash out. You incur cash outflows for say 3 years, and expect to get cash inflow for say the next 7 years or even perpetuity. The cash outflow part we call “investment”, the cash inflows parts we call “returns on capital”. In the old ways “investment” is mostly some manufacturing facilities (what counts as capex), but in the broader sense this “investment” could also be a software intellectual properties, brands, customer relationships, or whatever that generates the cash inflows later (“returns" on capital).

A Follow up on Zillow: Tracking Strategic Progress

I fleshed out my thoughts on Zillow (“Z”, “ZG”) more since my last write up and I will share them here. This includes a clearer idea of the strategic game that Zillow has to play, as well as how to track progress. Using these criterias I added a little to my position after the latest earning.

The Long Game

As a reminder, we're playing a very long game here. What matters strategically is being closer to end customers and the transaction itself. Achieving that would flip the power dynamics of the industry in Zillow’s favor.

Here’s a tweet storm I put out a while back on how Zillow has to change its role in the transaction flow.

1/x. Everything Zillow $Z $ZG does (inc. iBuyer and lending) should be judged on how it helps them get closer to consumer and transaction. This goes hand in hand with how data flows through the value chain.

— mspacey (@mspacey4415) April 3, 2019

As a clarification, Zillow Offers will help generate listings instead of “stealing” them from agents (as the accusations go). Here’s how.

Prospective sellers can check out binding offers from Zillow before awarding that listing to an agent. At that point two things can happen: a) if they sell to Zillow, then Zillow obviously controls the seller listing for that property; b) even if they don’t sell to Zillow, Zillow would have came across this clear intention to sell before the agents - a “pre-seller listing” if you will. This is incredibly valuable information in the industry.

In short, by beating agents to listing generation, iBuyers change the entire power dynamics of real estate value chain.

This shift in leverage toward the platforms is why even Keller Williams is getting into iBuying, as seen in this article:

“I feel like I have no choice now,” CEO Gary Keller said during a presentation in January. “I can’t allow Opendoor or Zillow to go out and be the only player in the iBuyer space and then begin to dictate terms and build brand around ‘they buy houses.’”

The key words are "dictate terms". Once you win the game and control the listings, there are many options for monetizing. For now investors are still worrying about Premier Agents, but in a few years what matters won’t be Premier Agent, but "Premier Listings" or whatevers Zillow choose to call their product.

How to Track Progress; Status from 1Q19 Earning

In judging Zillow’s strategic progress, I’m looking for a few things. First, I want to see the iBuyer market taking off. Second, I want to see ZG mitigate the pressure to sell inventories at inopportune times (most likely by addressing holding cost via renting). At some point down the line, I also want to see proof that iBuyer proliferation is giving Zillow greater leverage over the value chain.

Regarding the 2nd point, here’s another tweet storm (sometimes I find the condensed format of Twitter explains things better).

1/x. Today's Barclays report on $Z $ZG has a good point - if you try to flip homes but it's on market too long, then selling price & iBuyer margins are going to take hits.

— mspacey (@mspacey4415) March 15, 2019

So how are we doing? The latest quarterly earnings from Zillow and Redfin showed clear signs of market demand for iBuying. Zillow Offers revenue ramping from zero to ~$130mm to $240mm for the coming quarter is no small feat. More importantly, inbound seller requests are impressive:

“In Q1, we received more than 35,000 seller request and that demand is rapidly accelerating. We now receive one request every two minutes, which is nearly $200 million in potential transaction value per day.”

Redfin’s program, although on a smaller scale, also shows strong market demand.

“From the first quarter of 2018 to the first quarter of 2019, RedfinNow quadrupled the number of homes we sold. This was still less than 50 sales in a quarter, so we are far from the scale of competitors… Demand in Dallas and Denver, the markets we opened in December and March, has been stronger than we anticipated.”

That’s enough for me to conclude that iBuyers are gaining traction, and that the game is changing in Zillow’s favor. So I added to my position.

What I have not seen so far is the second progress criteria - mitigate pressure to sell by controlling holding cost. On the other hand, this could actually be an upside opportunity for the stock. The day Zillow announces some single-family-for-rent REIT is the day that bear thesis of “Zillow is getting into capital intensive home flipping game” goes away.

Remaining Questions

There are some remaining questions I'm still considering. The biggest one is how the game works in a multi-polar iBuyer world.

The iBuying game is on, and obviously Zillow can’t buy all the homes for itself. So this will not be some winner-take-all, monopolistic market. In that world do you really have power over agents? Yes, iBuyers will control a good chunk of listings, so agents have to go to them. But won’t agents pit one iBuyer against another?

The answer is to be determined, but I would say in any case Zillow will still have better power vis-à-vis the agents, and thus profit potential, compared to now.

Buy the Dips for Bright Horizons (BFAM)

I have been following Bright Horizons (BFAM) on and off for years now, back in 2015 I even had a post arguing why an expensive stock works for them.

The problem is I never bought. I kept waiting and waiting for a "cheap enough" valuation that never arrives. A few years later the stock has tripled, while that long awaited recession never came either. (Yes it’s beyond frustrating.)

Here I would recommend accumulating BFAM on the next 10-15% pull back.

Summary Upside

• Sustained high single digit/low double digits top line growth.
• Margin boosts from operating and financial leverage.
• Ability to roll up small operators using high price stocks = "equity leverage" / reflexivity.
• Option to open up centers to unsponsored families.
• Possibility of franchising /capital light model in the future.
• Stability from solid free cash flows. 

Summary Downside

• Corporate sponsored model would be hit in a recession
• Trend toward smaller companies and work from home could hurt BFAM

Business
Bright Horizons operates almost 1,100 child care centers, about 70%/30% split between North America and Europe. North American centers have an average capacity of 126 children per location. European centers can cater to 81 children per location.

Instead of going direct to consumer, the company finds employers who want to subsidize childcare for employees. Typically the employer builds the center, while BFAM manages the operation.

The employer based model allows BFAM to attract parents/kids in bulk, so the company enjoys efficient sales and marketing costs. But it exposes BFAM to the job market as well as trends in corporate market.

• Anecdotally, there is political will to rein in, or even break up big corporations, the type that’s most likely to provide these childcare benefits.
• In general there is a trend toward smaller companies or startups – these are less likely to be BFAM clients.
• The trend is also for more working from home / remotely. Both would decrease the need for child care centers near office sites
• M&A among clients can lead to consolidation of work force or child centers. This can lead to closures for BFAM.

BFAM has two operating models for real estate. In the employer sponsored model (that’s most centers), an employer sponsor funds the development and ongoing maintenance of the center, and BFAM has an operating contract to manage the center. In the lease/consortium model, BFAM leases the property itself.

Next, let’s take a look at valuation and analyze if BFAM can grow into the valuation.

Valuation
After several years of unsuccessful waiting, I’m starting to think BFAM’s valuation is not so bad.

A nice chunk of capex is growth capex. If you deduct only maintenance capex, management says they expect ~$250mm-$275mm of free cash flows for 2019.

So at ~$130.5/share or $7.6bn market cap, this is about 29x FCF. That’s actually not too bad in today’s environment, if growth can continue for the next few years.

Remember, this is the sort of consumer facing stock that never gets cheap. If fundamental performance holds up, floor multiple is probably around 20x FCF. If that FCF grows ~15% a year (which it does right now), then in 3-4 years this grows into floor valuation – i.e. you get your principal back and the rest is upside.

An expensive stock actually juices earning growth for BFAM, as it allows management to pay for acquisitions accretively (e.g. buying a center that has earning yield of 10% and pay with stocks that yield 3% will grow your EPS). It's also a competitive advantage whether BFAM is trying to enter a new market or further build out its presence in existing markets and go for local density.

Despite fairly frequent acquisitions, management did a great job the past few years keeping debt controlled while using buybacks to decrease share count.

But let’s be very clear - this is a valuation that requires growth, so that's what we will discuss next.

Drilling down on growth
There are 4 sources of revenue growth. The first three increases enrollments: 1) new centers, 2) natural ramp, 3) cross selling. The last is price increases.

• New centers. This could be new employer clients, or existing clients adding locations. Going to market via corporations requires a dedicated sales force.
• Cross selling. One way to do this is to add backup care to existing full service centers to increase utilization. BFAM can also open up its existing centers to non-employer sponsored families.
• Natural ramp of existing centers (takes 4 years to reach full utilization)
• Price increases. Could be 3-4% a year.

The company has a long way to grow before fulfilling its total addressable market (TAM). In the latest earning call, management estimated that there are about 14,000 work sites in the U.S. that could use an onsite childcare center. To put that in context, BFAM has less than 800 centers in U.S. now.

Looking at these drivers, I’m fairly comfortable that Bright Horizons can continue to grow its revenue. With its operating and financial leverage, margins should increase as well. Sure, a recession could hit, but that would be a temporary setback as opposed to the end of growth.

How Bright Horizons Can Navigate a Recession

The only worry is corporate clients scaling back, which BFAM is especially vulnerable to in a recession. This is why I never liked their corporate focused model, even while fully acknowledging its benefits.

Ultimately though, BFAM has options. In a recession if corporations pull back, it’s possible for BFAM to 1) take over the real estate responsibilities, 2) open up to non-corporate sponsored public.

Most sites operate under the employer sponsored model where employers own or lease the property. In the event that an employer client want to close down its location, BFAM can take over the real estate, perhaps by bringing in a triple-net provider like STORE Capital (where STORE would own the real estate and lease to BFAM).

In that case Bright Horizons can keep the center open, but will still lose employee clients and employer subsidies, so BFAM would have to open up the center to the public and charge parents full price. But child care demand should be fairly consistent even in a recession. As long as BFAM can keep utilization at an adequate level, it can keep cost and price under control.

Even more drastically, BFAM can pursue the direct to consumer channel and do it via franchising. It certainly has a strong brand name it can leverage.

In conclusion, BFAM has years of growth ahead. It's not immune to a recession, but it has plenty of options to mitigate a recession's impacts and perhaps come out stronger. I believe the stock can grow into its expensive looking valuation.