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

Framing the Questions for GOOGL

Wall Street Journal has a good article that spells out the various products underlying Google's search advertising platform. It is an excellent five minute primer. Here's the link.

The search advertising business is not one product, but various components that interact to make a market place. The article shows that Google owns and dominates all sides of that market:

• Sell side (for publishers to publish) 
• Publishers use "ad servers". These ad servers has information on what spaces on media properties are selling ad placement. The ad servers provide that supply info to the market place.
• Large publishers typically use its server, commonly known as DoubleClick for Publishers. (DoubleClick for Publishers and AdX are now tied together in one product called Google Ad Manager.)
• Smaller publishers often use Google’s AdSense.
• Mobile app publishers use Google’s AdMob.

• Buy side (provide ad purchasing tools)
• Google Ads (formerly known as “AdWords”) for buyers to bid for search ads placement on Google (its own property)
• DV360 for (for Display and Video) for buyers to bid for video ad placement. This does placement even outside of Google properties.

• Exchanges 
• Googles owns AdX which is the largest exchange with about 50% market share

• Media Properties
• Google search
• Youtube
• Others

• Analytics

There's plenty of firepower for regulators and antitrust guys here! 

For one, how can you have a market where all participants are owned by the same party? There are numerous other issues. Just as an example, the bundling is problematic. Google Ad Manager is a bundle of 1) DoubleClick for Publishers and 2) AdX. Combining a sell side tool with an exchange is not good optics, since the exchange can favor its own publishers.

Another example is analytics. This is an issue because it acts as the "referee" of the effectiveness of other Google search products. I can easily see regulators demand Google separating this out.

In short, plenty of ways regulators can cut them up.


The question then, is what pricing power or otherwise benefits did Google derive from owning all of this?  If this is all broken up, would GOOGL suffer economically? if so, how much? 

I suspect these questions are unanswerable. Google (and its parents Alphabet) is just not very transparent, particularly for a megacap. I cannot tell how much money they make from Ad exchange versus their own property selling ads, versus the various buyside/sell side tools (including ad servers?).  

If anti-trust is going to be the big overhang over GOOGL stock, then not having the transparency to answer these questions is not going to help. 

For now Google does not even break out Youtube. So they have a long way to go. 

Radcom: Creation of New Market Plays to Its Advantages

Executive Summary

• Radcom failed to “cross the chasm” in 2016-2018, but they have worked to further rounded out their product portfolio.
• Rakuten’s greenfield project potentially creates a whole new set of customers and represents a TAM expansion for all NFV vendors.
• This new customer segment is small and new enough that Radcom’s small size is not a disadvantage. It is also a niche where customer requirement plays to Radcom’s strength and negates incumbent’s advantages.

Background on Radcom (RDCM)

Radcom (RDCM) provides software based service assurance for telecom networks. This is software that measures how networks perform from customers’ perspective in real time so network operators can react accordingly.

The stock had a great run up during 2016-2017 after they revealed AT&T as a major client. Back then AT&T was starting out its network function virtualization (NFV) initiative, replacing dedicated hardware with software, with RDCM’s product being one of the winners. But the AT&T project has not translated to sustainable revenue growth, and the disappointment crashed the stock.

At its peak around mid-2018, Radcom was worth almost $250mm in enterprise value. When I bought it recently, (around $8.6/share), it was only worth around $60mm of enterprise value.

So what happened? In short, RDCM failed to “cross the chasm” (in Geoffery Moore’s term, see footnote). Instead of advancing NFV into the mass market, the AT&T project hogged up all of Radcom’s resources and paid the company just enough to break even and sustain itself.

Since then the stock stalled, but Radcom kept moving. Despite the setback, they have continued to develop their product expertise and have rounded out their capabilities. Back in 2017 all they ever talk about is vProbe service assurance. Now a look at company website shows that they also have a network visibility / network packet broker service, as well as a higher level network insights product.

Background on Rakuten

In May 2019, Radcom announced a deal to integrate its products throughout Rakuten’s greenfield mobile network project.

Rakuten is the Amazon of Japan. Despite having no telecom experience, it is trying to use cloud based technologies to building out a mobile network quickly and cheaply. Below is a simplified diagram of Rakuten’s network design, and this article from Cisco article helps provide greater clarity. In short it’s virtualization and software everywhere.

Note that the radio access network will be virtualized (vRAN), while the entire core network runs off a common cloud datacenter platform (“Telco Cloud”). All the network functions are implemented as software (“Virtualized Network Functions”, or “VNF”) on top of this cloud platform. Indeed the vRAN itself is simply a VNF, as the case Radcom’s solutions.

A fundamental tenant of virtualization is taking functions done by hardware and modularize into commodity hardware and software. The benefits go far beyond cost savings from replacing proprietary devices with commoditized servers. Replacing hardware with software also result in energy efficiencies, and in general allows for less bulky apparatus and thus alleviates space constraints, and by extension location constraints. This again lowers cost via speed of deployment and real estate flexibility.

Virtualization itself is not new, but Rakuten takes it to the next level by virtualizing the radio access network itself – (vRAN). By splitting the baseband unit into software modules, vRAN enables “small cells”, a key 5G requirement. In Rakuten’s words:

This innovative approach enables deployment of very lean cell sites, with only antenna and remote radio heads, which in turn maximizes opportunities for successful acquisition of cell sites.

An Nikkei Asian Review article reported that Rakuten’s cost of building base stations are only 10-20% of competitor’s:

Rakuten has the lowest cost of base station installation among Japan's four top wireless carriers, an analysis of plans submitted to the communications ministry shows. The company's cost totals about 8.2 million yen ($76,000) per unit, only 10% to 20% of the level for industry leader NTT Docomo.

Rakuten’s Creates a New Customer Segment - TAM expansion for all NFV Vendors

Rakuten’s implementation of NFV– using “telco cloud” and vRAN - could be adopted by not just other cloud companies, but eventually telecoms and even cable companies as well. That would amounts to a massive TAM expansion for all NFV vendors, and particularly plays to RDCM’s advantage.

The ability to build out mobile networks cheaply and flexibly should be appealing to all:

• Cloud companies (Google and Amazons of the world). These guys can build their own network where telecoms do not have strong coverage, or just for leverage against telecoms. For example Google/Waymo might like to push out autonomous car in certain cities, and they’re not going to wait around for AT&T to set it up. Another example could be Amazon building out drone based delivery in certain areas. Amazon can build its own vRAN based system to direct those drones and use that as bargaining chip to talk down Verizon charges.

• Cable companies. These guys have to get into wireless data. Their video business is dying from cord cutting and over-the-top video competitors. Once mobile data plans become the norm for home usage, it will be game over for the cable guys. As it turns out, they recognize this threat and are trying to offer mobile data services as well. Satellite companies are facing the same threat and are also getting into mobile. The vRAN is one way to deploy mobile networks cheaply.

• Telecom. The vRAN could be a way to accelerate telecom’s move toward NFV.

So Rakuten’s effort can open up the NFV game to not just telecoms, but cloud companies and cable companies, and that means TAM expansion for all NFV players. 

New Customer Segment Plays to Radcom’s Strengths

The implications are even better for Radcom.

In general, small companies should concentrate their resources on where they have the highest probability of winning. That means aiming for market share dominance in a new and small niche, before leveraging that customer reference and industry position into another segment.

Rakuten deal creates a whole new “cloud based mobile operator” customer segment, and that is an easier segment (compared to massive telecoms) for Radcom to win, if only because it is too small for large competitors to focus on.

The elegance and simplicity of Rakuten’s greenfield, software driven build-out also make it easier for RDCM to leverage what they already have and complete the whole product. There is no legacy infrastructure that RDCM has to cater to. Established competitors cannot neutralize RDCM’s product advantage with some software/legacy hardware bundle. No, this market demands a pure software solution and RDCM is it.

This product-market fit was demonstrated in the way Radcom won this new segment – with minimal work and in record time. Indeed, CEO Yaron Ravkaie says Rakuten was one of the fastest sales cycles he has ever been involved in.

RDCM used to be a small fish in a big pond, now it can be a big fish in a small, but expanding pond. 

Conclusion

RDCM has credibility as a vendor of NFV based network assurance, so a TAM expansion of NFV paradigm beyond telecom increases the probability of success for them.

To be clear, Radcom (and NFV/vRAN for that matter) has a long way to go before hitting mainstream adoption, so buying it here is speculative. But the upside is real enough and they have managed well enough in the recent downturn (low cash burn, strong cash position, no debt, no dilution) that I think they can stick around to harvest that upside. 

The Rakuten deal is already better. It is a subscription deal, as opposed to the project based nature of the old AT&T deals. For all these reasons I think there’s a good chance Radcom is worth a lot more than its enterprise value of $60mm (using $8.6/share) 

So I bought RDCM, and I will be watching Rakuten’s initiatives closely over the next few years.

Notes on "Crossing the Chasm"
According to Geoffrey Moore, early on in the technology adoption cycle, innovative companies are immature and need visionary clients to sponsor it. These visionaries purchase an incomplete product in the hope of developing it and turning it into a dramatic competitive advantage. The market then gets excited about the company winning a big name client, extrapolate rosy success, pumping up the stock price.

However it turns out that the visionary isn’t such a great client – they demand various modifications that cater to the specific client, and hog up all the startups resources. In the end the market fails to go from niche to mass market, thus the company couldn’t leverage the initial client into more clients. The company thus falls into the “chasm” between visionary adoption and main stream adoption.

That is the story of Radcom and AT&T in 2016-2018. The stock chart captures the joy and pain.

The strategy to “crossing the chasm” is to find a suitable, small niche you can dominate, and leverage that market leadership into a related niche, capture that and leverage that into another adjacent. Do this until the collection of related niches turns into a mass market.

As my article indicates, this is what I think can happen with Radcom working with Rakuten.

Checking In on Fidelity National Financial (FNF)

FNF is something I have held for years and written about a few times. I’m doing a quick update here.

The reasons I’m holding remain the same: 1) intermediate term defensiveness, 2) long term upside, and 3) Stewart acquisition synergies. For the next year or so it’s a value/dividend play: number one player in oligopoly; strong cash flow generation at solid valuation; great balance sheet; 3%+ dividend yield. In the longer term FNF has upside from demographic tailwind (millennial reaching prime home buying age). FNF is also in the process of acquiring the industry’s number three player, Stewart, and will benefit from acquisition synergies.

Quarterly earnings will fluctuate and are not my focus. The main things I look for in earning calls are: 1) Stewart acquisition progress, 2) financial health, and 3) any disruptive threats in the horizon. Here are the latest.

1) STC acquisition. Not much update on this front. The deal is still stuck on NY regulators and it may come down to divestitures.

2) Financials. Balance sheet remains very strong. FNF debt outstanding was $837mm (compared to investment portfolio of more than 4.6bn). Debt to total capital ratio was 14%.

3) Disruptive Threats. One of the biggest trends in real estate is the emergence of iBuyers. The risks for FNF are 1) they have relationships with real estate agents who recommend FNF’s services, but iBuyers seek to place themselves at the center of transaction, resulting in channel disruption for FNF. 2) Also iBuyers will have better bargaining leverage compared to regular home owners since they hold large portfolios.

This exchange from 1Q19 transcript shows that FNF may have not grasped the full significance of iBuyer. It’s hard to tell, maybe management is simply being careful about what they say to maintain relationship with real estate agents. That said, it’s still early innings in the iBuyer game and a group with strong tech track record like FNF will likely get on top of it.

Mike Nolan
“…I think what we see at least today is that the real estate agent is still at the center of the transaction. And so while there's disruption potentially in brokerage, I don't know that that's disrupted the agent yet. Now that could change of course. But we're really focused on real estate agents, because that's who gives us the transactions and that's why we've made investments in real estate technology and lead gen and things like that because that's where we're going to continue to focus.

Jason Deleeuw
Got it. And what about the iBuyers and – I mean, how are you relating to them? It seems like it's going to continue to be a growing segment of the market. Is there a change in how you're doing that? Or you're reaching out to them or you're already working with some of them? How is that working?

Mike Nolan
Really both. We're reaching out and working with some of them. They're a customer just like anyone else.

They have transactional volume that they can control. And we'd like to perform that title and closing works. So, we're calling on them. We're working with them. In some cases they might be working with our agents. So by extension we're working with them. But they're really just another type of customer from our perspective.

Overall, title insurance is a sleep industry and the latest quarter was business as usual. I continue to hold a 4%-5% position, and would hold even in the unlikely scenario that Stewart acquisition does not come through.

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.