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[ALGN – Align Tech, SDC – Smile Direct Club] Brand, scale economies, and vertical integration

Below is a transcript of a podcast I recently recorded.  It has been lightly edited for clarity.  You can find the podcast by searching for “scuttleblurb” on Apple or Spotify.

So Align technology is the company behind the Invisalign brand of clear liners. And so those are the clear removable plastic trays that are used to straighten out misaligned teeth. There are somewhere around 14 million malocclusion cases started every year. So malocclusion, by the way, when I say that, that just means misaligned teeth. 80% of those 14 million cases are still corrected with traditional wires and brackets, which implies that Align with 1.9 million cases has 70% share of everything else.

So we’ve all heard of Invisalign. I think we’re all pretty familiar with clear liners by now, but back in 1997, when Invisalign was founded, these clear liners were basically seen as a gimmick. They weren’t really seen as a real orthodontic appliance and orthodontists who were trained in wires and brackets took a lot of pride in doing these cases by hand, and they were generally very skeptical of the idea that you could fix crooked teeth with plastic trays. And so these wires and brackets were sold by companies like Dentsply and 3m Armco. And this was a B2B sale. So patients didn’t know or care about the brand of the braces. And what Align basically did was they created a consumer brand around clear aligner technology.

So they had the whole market to themselves for a while because the incumbents were realizing steady cash flows from selling these conventional braces and they weren’t going to cannibalize that business by making a big speculative bet on a product that nobody believed in. So Align technology with their clear aligner treatment was really like counter positioning against these incumbents.

The two relevant constituents here are the consumers and the doctors. So Align sells the clear aligner treatment to the orthodontists who then mark it up and then sell it to the consumers. And the value proposition for the consumers is pretty straight forward. It has to do with comfort and aesthetics. So instead of having these visible metal wires, they’re wearing a clear piece of plastic that can be hard for other people notice; it’s more comfortable because you don’t have the wires and brackets rubbing up against soft tissue; and it’s more convenient because they don’t have to make as many trips to the orthodontist for these mid treatment checkups.

And then as far as orthodontics go, the, the questions really come down to: does this work, is it economic for me? And do patients want this? So as I said, orthodontists were skeptical of this product at first, but they started feeling the pressure from two sides. Aline was doing a ton of brand marketing, so consumers started asking for Invisalign by name and clear aligner technology got better and better over time and doctors felt more comfortable prescribing it. The economics were also better. So what orthodontists realized was that even though they were paying more for Invisalign than wires and brackets, four or five times as much in some cases, the Invisalign treatments required less chair time because with traditional braces the orthodontist has to tighten the wires whereas with Invisalign, most of the treatment planning is done with software. So I’ll talk a little bit about the treatment flow.

So what happens is the patient gets their teeth scanned at the orthodontist office and that scan is electronically submitted to an Align lab. And at the lab, a technician creates a treatment plan in ClinCheck – and ClinCheck is just aligns proprietary CAD software – so it goes into ClinCheck and then the treatment plan is reviewed by the orthodontist for 10 minutes and the orthodontist and technician will sometimes go back and forth to get the treatment plan, right, but this process still saves time relative to tweaking the wires and brackets. So what that means is that the orthodontist can treat more patients and on a per chair hour basis, Invisalign is actually cheaper once the doctor gets past a certain volume threshold.

So to be more concrete about the savings here with wires and brackets and orthodontist might charge the patient, let’s say $6,000 for a malocclusion case. And the doctor will pay like 300 or 400 bucks for the wires and brackets. So the doctor makes like 5,600 bucks or 5,700 bucks per case. With Invisalign, the doctor charges the patient the same $6,000 and will pay anywhere between $900 and say $1,500 depending on their volumes. So let’s just use $1,500. The profits on a $6,000 case are 4,500 bucks. So for a single case obviously conventional braces are a lot more profitable for doctor. You’re talking 5,700 profits versus 4,500. But the key is that the total chair time is way lower for Align because Invisalign, because there are fewer mid treatment appointments and emergency visits. And there’ve been some studies on this. One of them I read was from 2013 – I think it was from an industry trade journal and I can’t attest to the accuracy of this study – but the claim was that the chair time is basically cut in half when you use Invisalign.

So yea, now with Invisalign you still have to include the time it takes to review the case in ClinCheck, so maybe that’s another 10 or 15 minutes and so maybe you’re not doing twice as many cases but you’re doing let’s say 1.7x as many cases if you assume the typical traditional case takes 180 minutes of chair time.

And also remember this study was done like eight years ago and Invisalign has gotten better and faster since then, whereas the same is not true of traditional braces. So you can frame this as clear liners versus traditional braces, but at a higher level of abstraction, this is also digital versus analog workflows, because really what you’re trying to do is straighten out these teeth as quickly as possible and a digital process can get faster and better the way an analog process cannot. With Align, there’s there’s been more like automation baked into ClinCheck, and that saves time. They rolled out a teledentistry platform last year, that saves chair time. They have a scanner, iTero, that’s gotten better, whereas I imagine it takes probably the same amount of time to do wires and brackets as it did a decade ago.

And then also orthodontists have an added incentive to move more of their caseload to Invisalign in order to obtain Elite status. And so once they get there, the orthodontist only pays 900 bucks per case. And the profit scenario I walked through earlier is obviously even more compelling.

So Invisalign is the dominant player in clear liners. And as I see it, the advantage it has basically comes down to vertical integration, patents, and then having a huge start on the competition. Align was well funded from the start and they used the capital that they got to invest in marketing, direct sales, and manufacturing from very early on. So you might be surprised to learn that Align is the largest 3D printing company in the world. So they use 3D printers to make the clear aligner molds and using these molds, they can mass customize hundreds of thousands of clear aligner trays every day. There’s a lot of small things that go into this. They’ve trained their own machine vision system to read the unique identifiers on the aligners to make sure like the right aligner, it goes in the right package. They’ve got these lasers that can trim the aligners in this very precise way so that they aren’t discolored. And so over the course of 20 years, they’ve just added new technology to their manufacturing process and they’ve gotten better at making these aligners faster, with much less material, and using less labor than their peers.

And then other parts of the process. So they have technicians creating the treatment plans in a remote lab using ClinCheck, which I mentioned earlier; they own the CAD software and there’s more automation being baked in over time; and they even have their own scanners. So it used to be that to get a mold, a doctor would apply this cold PVS goop to your teeth, and then they had to FedEx those to the lab. And those PVS impressions have been largely replaced by digital scanners, which allow doctors to get the images to the lab faster and also dramatically improves the accuracy. And they’re also like a sales tool. So with a scan, you can show the patient, while they’re sitting there in the chair, how their teeth are going to move over time and that apparently improves conversion.

And getting into scanners was a prescient move. They got there by acquiring Cadence in 2011, and this was a pretty unpopular deal at the time. So Cadence was unprofitable. And even if they got to large scale, the margins would be a lot lower than clear aligner because scanners are kind of a commodity, but what Align got early on was that scanners were going to be a key part of doing these cases more efficiently and that would drive more case volumes in the aligner business. Okay. So they got the software, the manufacturing, the scanners, all that stuff integrated, they created scale economies in manufacturing, more accuracy and speed in the treatment planning. And it’s sort of like a classic Clay Christensen right here, they shifted the basis of competition, orthodontia from effectiveness to comfort and aesthetics and then they vertically integrated key parts of this process flow in order to make a big dent in the doctor and the consumer experience.

So that’s the vertical integration piece. And then the second thing is they had just a huge headstart relative to peers. So I think the first serious direct competition was ClearCorrect. And ClearCorrect came on the scene like seven or eight years after Align. They were largely a bootstrapped company. They weren’t nearly as well funded and they didn’t start integrating manufacturing till about 2008, so they were close to a decade behind. And then along the way, Align built up a huge patent portfolio and those patents related to treatment planning; the source code that was used to create the 3d image of a patient’s teeth; the manufacturing technology; and then they aggressively defended these patents.

So there’s this competitor Orthoclear that came up in 2005. It was founded by one of Align’s co-founders and they allegedly stole Align’s IP and trademarks and in doing so, they were able to grab like 20% share of the clear aligner market in the US very quickly, but then Align basically sued them out of existence. They shut down within two years of launch. So Align’s got a lot of things going for it, but in the past it’s actually been subject to a lot of negativity by investors, at least in the circles I roll in. And my sense is that a lot of this kind of ties back to the intuition that, well, “this is just a piece of plastic that moves teeth, anyone can make that, and no one should be earning 25% EBITDA margins on this and when some of their key patents expire, they’re going to be swarmed by competitors who will underprice them”.

So yes, key patents related to digital treatment planning and CAD technology have expired over the years. That’s true and it’s important. There’s this company called uLab that launched a competing CAD software in 2018, after some of Align’s patents rolled off a year earlier, and we’ll talk about that later. But there was always more to the story. They spent years building the brand and getting a consumer adoption. They got widespread buy-in from doctors who habituated themselves to the ClinCheck system. The case volumes brought scale economies in manufacturing, which allowed for reinvestment in marketing and product development, more experience treating harder cases, which in turn drew in more adoption by orthodontists.

At least what I’ve heard from morph does is that Align just saves them time and they just know it’s going to work for most of the cases that they come across. So like why risk moving to another system when this one seems to strike the right balance between efficacy and price? I think there’s just something to be said about the power of incumbency, especially in this industry because orthodontists tend to be resistant to change. And by the way, Align learned this the hard way themselves. I think like in the early days, they invested way ahead of demand. Orthodontists were making a good living on wires and brackets, this is what they were taught in school, and they didn’t really see an urgent need to change.

So it took a lot of education and product improvements and consumer demand to finally get traction. And then the other thing is Align’s always been a pretty innovative company. They were the first ones to get into 3d printing, they built out some of their technology. Management likes to tell this story about how in their manufacturing, they tried some off the shelf, optical character recognition systems to read the identifiers on the aligners, and when that didn’t work, they built their own. Buying cadence in 2011. I talked about that earlier. I think that was a non-obvious forward looking move. I mean, I just think they’ve made a habit out of really understanding the workflow for malocclusion cases and then just like ironing out as many friction points as they can.

And then finally there are a few other possible like growth pockets to the story. They’re on fire in China. So they basically share that market with a local player called Angel Align. If you look back four years ago, China wasn’t even in the top five countries for Align and now it’s like their second largest market. So they put in a lot of resources educating and training doctors, they’re opening permanent manufacturing capacity there and introducing scanners. There really isn’t any other major US player that has made as much progress. And then Align is also making a big push and going after dentists.

Align mostly sells through orthodontists but there are like 10 times more dentists out there in the US. So there’s this metric called utilization that management discloses and it basically refers to the number of cases shipped per doctor. And for orthodontists, that number is 67 per year. It’s more than doubled over the last five or six years, but for dentists it’s only like 10 and that’s only up from seven. This could be an opportunity for them, though utilization for dentists will always be much lower than orthodontists, obviously. And I also think it’s probably a more competitive channel to get after, but we’ll see.

So that’s all good stuff, but here’s some things that worry me about Align. So first of all, something like 70% or 75% of malocclusion TAM is teenagers. And these tend to be more complex cases because their teeth are still maturing and you have to factor in jaw movement. And Invisalign can actually handle those complex cases now but there’s also a compliance issue. The ability to remove aligners…that’s obviously a problem for parents who don’t want their teenagers taking these things off and not wearing them as often as they should and losing them. I mean, you have to wear these things like 20 hours a day and then brush your teeth after meals and it’s just a tall ask for some teenagers. For the vast majority of comprehensive teen cases, as a parent, you might just prefer to like lock your kids in metal braces. So yeah, teens make up less than 20% of Align’s business, so the company is way under-indexed here. And you could look at that as an opportunity because parents tend to want the best for their kids and if parents want to get clear aligners for the kids, they’re going to pony up the five or $6,000 for Invisalign. They’re probably not going to, you know, get Smile Direct Club for their 14 year old would be my guess. But there may just also be a huge chunk of teenagers who aren’t addressable for compliance reasons, in which case what you might be banking on with clear aligners is TAM expansion, where adults who may never have considered braces come into the market.

Then there’s competition. So there are several incumbent competitors out there….the wire and brackets guys have gotten into this, their distributors have gotten into this….3M, Dentsply, Danaher, Henry Schein. I’ve heard good things about Envista.

Envista was spun off of Danaher, ClearCorrect was acquired by Straumann, which maybe gives them an edge in the general practitioner channel. For the most part, nobody has really gotten much traction. I think the reason why they’ve had a hard time breaking Align’s dominance is that they’ve essentially competed on the same terms where they’re selling these aligners that are sort of similar to Align, maybe not as good, for like 30% cheaper. That didn’t work for the reasons I talked about and if it was just those guys, I wouldn’t worry too much about Align’s competitive positioning. But where I do think Align faces some serious challenges now is on two fronts. The first is Do It Yourself treatment planning and the second is direct-to-consumer.

So we’ll start with Do It Yourself and this would be doctors 3D-printing aligners in their office. That’s what I’m talking about. So orthodontists at this point are very familiar with clear aligners. They’ve been trained on them and they know how to use them. Plus the technology has really advanced over the last decade, specifically the accessibility of computing, machine learning, and the cost of 3d printers. So it used to be that technicians would have to manually carve out each tooth in the software, and that took like eight man hours to segment each case. And that was late ’90s/early 2000s. And then fast forward to today and you can use machine learning and software to do it.

There have also been big advancements in manufacturing. So 15 years ago you would have these huge, expensive milling machines that would make the aligner molds, and they could make one model per hour. And you compare that to today, you can have a $4,000 3D printer print a model in like five or six minutes. These printers will get better and better and the regulations around this will change for the better I think. I believe right now 3D printers are technically able to print aligners directly, it’s just not FDA approved. The way it works now is you’re printing out the mold and then wrapping the thermoplastic around the molds. But from what I understand, the FDA has approved direct print of retainers and they’re going to soon allow for the direct print of aligner trays I think, which should save the doctor and the patient some time. So there’s this company called uLab that takes advantage of this technology. uLab was founded by the former CTO of Align in 2015, and it makes the CAD software that orthodontists use to design the clear aligners.

And that software integrates with third-party 3D printers. So their model is that they give away the software for free and then they charge the orthodontist per aligner. So you have, as the orthodontist customer, you have like one of two options here. You can have uLab make the aligners in their manufacturing facility in Memphis, and that will cost $19 per aligner. Or you can send the STL file to your in-house 3d printer, in which case you’re paying $2.50 per export. Or you can do a combination of both actually, so maybe you do like the first few stages in-house so the patient gets their aligners right away and then have uLab manufacturer the rest. And the kicker here is that the maximum you ever pay per case is $950. So in most cases it’s a cheaper option than Align.

And this seems to be getting traction. They launched the software in 2018 and they passed 250,000 cases recently. My best guess is maybe they do, I don’t know, 150,000 or 200,000 cases over the next year? To put that in perspective, Align did around 1.6 million over the last 12 months. So it’s still small compared to that, but yeah it’s interesting. The downside to uLab is that it’s still slower for comprehensive cases. And the reason for that is with Invisalign, the doctor is basically outsourcing the treatment planning to an Align technician, whereas with uLab, the orthodontist – or more likely the assistants – are doing the treatment planning work themselves. But uLab software I’m sure will get better at handling these more comprehensive, comprehensive cases over time. So manufacturing these aligners on your own 3D printers is still kind of a fringe practice, but I can definitely see it catching on as the software gets better and the 3d printers get cheaper and faster.

And then the other downside to uLab is that orthodontists don’t get the Invisalign brand. And my take on this is that I think brand mattered a lot when clear aligners were a nascent technology, but everyone knows about these things now. And I’ve heard orthodontists say that patients will often just go with whatever treatment they recommend, even if [the patient asks] for Invisalign at the start. So sometimes a patient will ask for Invisalign because they just don’t know what else to call it. It’s kind of the same way you might ask for Kleenex when what you really want is tissue paper…you don’t really care about the brand per se.

Here’s another thing. Another pushback you might give to uLab is that Align has all this case volume data that uLab doesn’t have and this data advantage is something that Align’s management brings up a lot. So they’ve done something like 9 million cases over their life, and the idea is that they can use data from these cases to accurately predict how teeth are gonna move in a way that takes into account all the different biomechanical knock-on effects. But yeah, I don’t know, this claim has always seemed somewhat overstated, because it’s not like Align is getting a complete scan of the patient’s dentition at every stage of the treatment process. Like the doctor isn’t taking another scan at month three, and then month six and month nine, and then sending those to Align, right? So all Align really sees is that initial scan, so they don’t really have insight into how each case is progressing over time. Now, the initial scan is important for segmentation. So, segmentation is the step where you’re identifying each tooth in the software. The software is told “here’s the canine, here’s the first molar, here’s the central incisor” but it’s not so much that you need like tons and tons of data [to do this].

I was talking to a former Align employee who worked in R&D about this and even in that initial segmentation process, there’s likely a plateau to how much of that data helps….like having 9 million cases probably doesn’t help you that much more relative to having only 3 million cases or maybe even 1 million cases. Now having said that, where I think case volumes could be helpful beyond segmentation is that while you’re not getting longitudinal data for each patient, you might still get a sense for how teeth develop, like the speed in which they move in teenagers or how big each tooth eventually gets, just by looking at patients across different age groups. And plus, there are some cases that may not go according to plan, and the doctor has to take a second scan and send that scan over to align. And so with more case volumes, you might see more of those edge cases, but yeah, I don’t know, it’s not like there’s this awesome data network effect flywheel, whatever in place here. So yeah, just wanted to calibrate this claim about the importance of data.

So anyway, the second major competitive threat I think is direct to consumer and that brings us to Smile Direct Club. Smile Direct, as well as a growing number of direct to consumer aligner companies, are bypassing the traditional orthodontist channel by selling directly to consumers, obviously. So under the Smile Direct model, there’s basically two ways that you can get treated. The first way is that they’ll mail you the PVS goop that you put over your teeth. And then you send that back to an SDC lab and SDC converts that mold into a 3D image.

The second way is that you show up at one of the Smile Direct stores. So Smile Direct, they run their own freestanding stores as well as stores inside of Walgreens and CVS. So you show up to the store, get your teeth scanned there. So before COVID the vast majority of their business, like 80% or 90% was coming through these stores. But whichever path you take, a dentist or an orthodontist that is part of the Smile Direct network is going to review the scan in SmileCheck – and SmileCheck is just Smile Direct’s software platform – so they’re gonna review it and then create a treatment plan. And then the consumer accepts the plan and uploads photos of their teeth every few months for the doctor to review. So the company it’s sort of like a tele dentistry platform bolted onto a DTC business model, you might think of it that way. But the main idea is that orthodontists are no longer the gatekeeper. So with Align, Align owns the brand that consumers ask for, but the orthodontists still keep the customer relationship, whereas in this DTC model, Smile Direct owns the customer relationship while orthodontists are kind of shoved to the back, where they’re just reviewing the cases.

This is kind of like the next phase of counter positioning. So in part one Align, counter position against the traditional wire and bracket incumbents by creating a consumer brand around this new aligner technology. And then now here’s Smile Direct and all these other guys counter positioning against Align by selling direct to consumers. This is something that Align will find very hard to copy because of channel conflicts. So Align has struggled with channel conflicts in the past. When they first launched, Align just targeted orthodontists but they were sued by dentists who thought it was unfair that only orthodontists got the product and they thought they should be able to have it too.

Align then figured if they’re going to sell to GPs anyway, they may as well proactively do so. And I’m just speculating here, but it could be that that was one of the reasons why Orthoclear stole so much share from Align back in the day. Align’s second misadventure with channel conflicts came a few years ago. They bought a 19% equity stake in Smile Direct and then agreed to supply Smile Direct with aligners. And soon after they did that, Align opened these freestanding showrooms where they could provide consultations to consumers. And what they told orthodontists was that this would be good for them because Align would funnel traffic their way. Nobody bought this. Everyone like saw through the ruse. This was clearly an attempt to go DTC.

Doctors were furious, SmileDirect sued them and Align was forced to retreat. So anyway, the direct to consumer model proved very popular with clear aligners and heading into COVID, Smile Direct was growing like a weed. They did close to $700 million in aligner revenue in 2019 and they were really only around for five years up to that point. To put that in perspective, it took Align 16 years to approach that level. So Align basically created this clear aligner category and then Smile Direct found a way to piggyback on that with a different distribution model at a much lower price point. Align will run a consumer somewhere between $4,000 to $8,000 whereas a Smile Direct case will go for 1,800 or 1,900 bucks or 2,300 bucks if you use financing. So it’s a massive, massive cost savings.

So I talked about all the things that Align vertically integrates…the CAD, the scanners, the manufacturing. Well Smile Direct also does manufacturing and it has its own proprietary software, but it takes things to the next level in that it leases the stores, it handles the customer service and it provides installment loans to customers to pay for the product. Basically the cost that an orthodontist would typically bear to run a practice, Smile Direct is putting on its own income statement, right? So they’re doubling down on vertical integration in the hopes that by doing so they can offer a better customer experience and then get the volumes to realize scale economies.

You can start with counter positioning but eventually you’ve got to work your way up to scale economies.

I’m not saying anything new here, but these DTC businesses, they’re easy to start but hard to scale. And so right now, this vertically integrated approach means that Smile Direct is burning lots of cash. So in 2019, before COVID, they generated negative $440 million of free cashflow on revenue of $750 million. And it just seems like this process of getting to scale is like getting harder over time. Like a decade ago when Dollar Shave Club and Warby Parker were coming up, maybe you could just throw money at Facebook and Instagram to acquire customers at attractive ROIs, but then that gradually got competed away. And these DTC brands had to find other ways to boost conversion by pulling levers in other parts of the funnel. In many cases that that meant going as far as opening stores.

So now we’ve moved into this next stage of DTC where the conventional wisdom has become “rent is the new CAC”, right, where you complement your online presence with stores. So that’s part of the playbook now. And I feel like Smile Direct has had to emphasize brick and mortar especially because it faces some unique challenges with clear aligners. Because in the online delivery model, they have to ship you the PVS stuff, and it’s up to the consumers to take their own impressions and this just isn’t a great experience. And in fact, one of the key reasons why they opened stores in the first place was so that customers could get the digital scans instead.

So you think about all the steps here: you need to ship the PVS to the consumer’s house; the consumer has to feel confident enough to like take their own impression – that’s something that’s usually done by a dental assistant – and then they have to mail that back; and then an orthodontist has to see if you’re a candidate and then Smile Direct has to come up with a treatment plan. So, I mean, there’s a lot of friction there and a lot of places where a potential customer can fall through the cracks. They opened the stores in part to keep prospects in the funnel, but I think maybe Smile Direct went too far with this. They had around 400 units and those stores were like 25% utilized heading into the pandemic. They’ve had to dramatically pare back their footprint. I think they originally thought the stores would serve as a customer acquisition vehicle but what they discovered pretty soon was that for the most part, the stores were just being used as fulfillment.

Fortunately for them, 40% of their stores were through CVS and Walgreens where they’re basically on a revenue share agreement and they’re not paying the fixed cost of rent. And then also most of their leases were month to month. So they’ve let those leases roll off and I think the plan is to just walk away from the stores. Now they’re thinking that patients will be willing to drive a little bit further to get to a Smile Shop. The other thing they’re doing is partnering with dentists. So this is a partnership model where dentists take the scan and then share the revenue. They have like a thousand dental practices now participating in this network. So it seems like they’re emphasizing the traditional channels for customer acquisition. In some ways, it kind of validates this idea that online direct to consumer is really just a starting point. It’s not the end all and certainly not a moat. It’s just a way to find customers and get initial traction.

I think these are the right moves because realistically I’m not sure that having consumers like take their own impressions is a model that works long-term. During COVID, Smile Direct shut down their stores and what we saw then was that like the online channel just couldn’t pick up the slack. So if you look at aligner shipments in the last nine months of 2020 for Smile Direct, those were down like 27%, whereas for Align the case shipments were actually up 9%. So short of sending everyone digital scanners, I’m not really sure how you solve for that problem.

Smile Direct has the added challenge of regulatory capture. So you have dental and orthodontic trade associations arguing against tele-dentistry for orthodontics saying that Smile Direct is shirking the standard of care by not having doctors perform patient exams. And the dental boards in Alabama and Georgia have passed rules that said a doctor needs to be on premises when a 3D scan is being taken. But this is increasingly a moot point because Smile Direct is partnering with dental service organizations and they’re covered in network by more and more insurance carriers. So it feels like they’re being validated by important parts of the value chain and more generally, I just think fighting against teledentistry or like tele-anything is just a losing battle because COVID has normalized it.

And I think that sentiment and regulations around telehealth are definitely changing for the better. So, yeah, this feels sort of like one of those Uber versus cab drivers or Airbnb versus hotels cases where like if the product is so much more convenient and affordable and consumers are really asking for it, the ecosystem will adapt and the regulations will eventually accommodate. That’s kinda my opinion. But that’s not to say that Smile Direct, isn’t playing with fire a little bit here. I think Smile Direct is fine for simple cases, but you probably don’t want to be stepping too far outside of your technical capabilities because, like moving molars can change the bite and that can have long lasting impacts. It honestly wouldn’t surprise me if Smile Direct we’re we’re biting more that more than they could chew here.

But that needs to be offset by like all the good they’re doing by making orthodontia affordable to so many people. I mean, the way things are today, whether you have a complicated case or an easy case, it really doesn’t make that much of a difference in terms of like what an orthodontists will charge. It’ll still be like 4,000 to 6,000 bucks. So here’s smile direct coming in at less than $2,000….all things considered, I think that’s probably a net positive for consumers, even when you take into account the possibility that they may be doing cases outside their technical capabilities.

But I’m not really sure what would lead me to say that Smile Direct is the one to bet on versus all the other DTC aligner companies, maybe other than the fact that it has a lead on its competitors when it comes to vertically integrating the manufacturing.

And I alluded to this earlier, but there’s really nothing special about the online channel per se from a competitive advantage standpoint and asking like how an online DTC company succeeds is really not that much different from asking how any retailer or any brand succeeds….like the answer is not going to be found in a generic channel strategy. Casper likes to say it’s their data science and marketing skills and they like to pitch this narrative of not being a mattress company but rather a sleep experience company, meaning we don’t just sell mattresses but also pillows and pajamas. And then Smile Direct seems pretty good at this stuff too. It’s like, we’re about better smiles, meaning we don’t just sell clear liners, but tooth whitening and power flossers.

So yea, there’s something to say about consistent messaging and branding, but also realistically these companies have to define their value prop more broadly to make like their economics work. So I think at one point Casper claimed that historically they were able to bring in $3 of revenue for every dollar of marketing spend, but you know, their gross margins are like 50%. So $1.50 on a dollar of marketing, that’s not great, especially when you consider customer support and other costs. So yeah, they probably need to attach more and more products in order for the unit economics to make sense. And maybe the same is true of Smile Direct, although Smile Direct has much better gross margin.

I don’t know. What I will say though is it’s a lot easier to imagine how scale economies develop than it is to call the specific winners in advance. Align was also burning tons of cash as they tried to gain adoption and it took them nearly 10 years after they launched to start consistently generating profits. And then obviously they spooled up the scale economies over time. And the bull case here is that Smile Direct could pull off a similar result. Because look, first they have pretty good brand awareness now and second, it’s a really compelling value proposition for consumers. Like the treatments are so much cheaper than Invisalign.

And here’s the other thing: consumers don’t actually know the difference between a good enough smile and a perfect smile, and they may not actually care in most cases. Smile Direct may not meet an orthodontist’s exacting needs for these comprehensive cases, but it might be good enough for the vast majority. And in fact, Smile Direct says up front, the goal is not to produce a perfect smile but just to make your smile better. So you can imagine a scenario where the low price point attracts volumes, they scale the manufacturing, they bring down their unit costs, which allows them to reinvest more aggressively than peers in customer acquisition, which brings in more consumers, which brings in more doctors to their network reviewing the cases, which means faster turnaround times, which in turn creates a better experience and draws more customers, more opportunities to cross sell toothpaste and night guards. So there are like these reflexive properties to scale. The second ingredient to this – and this isn’t specific to Smile Direct necessarily and it’s maybe a little bit more speculative – but I think there’s like this feedback between like capital and success, where to pull this off, you need a vertically integrated model, which means you need to raise more capital to absorb your burn until you get to scale.

And that money will flow to whoever capital providers think should win and will win in the category. There’s this self-fulfilling prophecy in a way where the people with the money are not just like finding the winners, but also anointing them. And they do so based on like who’s already winning because success breeds success given the scale economies and it feels like right now that player in DTC is Smile Direct. So they have pretty dominant share in that channel I think. And for now I think they’re the only ones vertically integrating the manufacturing. But I’m sure others will follow suit and yeah, the markets have just been super accommodating, so like Smile Direct’s cash burn really just hasn’t mattered from like a survival perspective. They secured a $500 million credit facility. They did a $650 million convert and that $650 million was upsized from $350 million. And this was like zero coupon, 40% out of the money. So, I mean, it’s kind of incredible the terms on which some of these companies are raising capital.

So switching back to Align, as far as I can tell most of the competitive impact – whether that be from do it yourself 3D printers or from direct to consumer – has been limited to the low end of the market. And whether competition is having an impact on Align’s numbers today, it’s sort of ambiguous. Like their ASP’s have been trending down for years….that could be pricing, but it could also be a mix issue because the less complex cases have also been growing. Or it could be like doctors getting volume discounts for ordering more cases. There’s also an accounting dynamic to take into account because part of the revenue is deferred if you use extra aligners and that can lead to a case where you’re selling these lower priced cases but those could show up as higher ASP just because you’re recognizing revenue faster.

Same thing with gross margin. Gross margins for the Aligner segment have been trending down for years, but even here, that could be pricing and competition but it could also be manufacturing costs being front loaded or volume discounts. I don’t think that management has really explained what’s going on there very well. But if the orthodontists are forced to take their prices down to match Smile Direct, the scenarios I think play out here are either: one, the orthodontist eats the lower prices, even as they continue paying Align what they did before; two, Align takes the margin hit. So Align charges lower prices to the doctor so that the doctor can maintain their unit profits; or three, Align has to find other ways to save the doctor money by helping them to do these cases more and more efficiently.

And I think probably all three of these factors are at play to varying degrees. But yeah, so on that third point what you’ve seen over the last year as Align is trying to help doctors save time. So they’ve rolled out a tele-dentistry platform where patients can make virtual appointments. They’re embedding more AI into this platform for virtual case follow-ups. And they’re rolling out this business consulting service to help GPs and orthodontists digitize and streamline their workflows. And they’ve had to accelerate this because of COVID, but I think more generally they’re launching these time-saving tools so that doctors can handle more cases and then preserve profitability that way.

But Align is in this position where they can handle more cases than anyone else today, but there may be a disruptive process going on where these competitors get better and better until like they’re functionally good enough and while Align is definitely the low cost producer of these aligners that’s not to say that their margins can’t be competed down from 25% to 15% or wherever. And yeah, I just see the competitive environment is getting more intense, not less intense, and this competition is coming from places that Align isn’t really set up to compete effectively against for like all the reasons I talked about. And that’s not to say that Align doesn’t have a lot of great things going for them, but you just have to be pretty confident in the growth opportunity and the moat when paying 80 times pre-COVID EBITDA for a $40 billion company.

So all right. That’s all I got to say about this. Thanks everyone for listening and for all your support and encouragement. It definitely means a lot and I greatly appreciate it. Okay, have a great week.

interview with @LibertyRPF

Posted By scuttleblurb On In Business updates,SAMPLE POSTS | No Comments

I recently did an interview with my friend @LibertyRPF [1], who publishes an insightful newsletter [2] covering tech, science, investing, and various other topics. It is one of my morning staples. You can access the original interview here [3].

Q: Hey David! It’s been a little over a year since we last did this [see 𝕊𝕡𝕖𝕔𝕚𝕒𝕝 𝔼𝕕𝕚𝕥𝕚𝕠𝕟 #𝟙 for our first interview [4] -Lib], I’m sure a lot has happened in the interim, but first, how are you? How are Zoe and Riley [5], the newest members of the ’blurb family?

Hey Liberty, the twins and I are doing great!  Thanks for asking.

Q: A lot of people have joined the newsletter game in recent times.  What I’m curious about is, as one of the Granddaddies of the genre, at least when it comes to the financial deep-dive sub-genre, what are you noticing when it comes to having longevity in this game? 

What stuff are you finding out in year three and four that you wouldn’t have easily guessed early on? What are you doing differently now, or want to change going forward?

For the first few years, I was just trying to get on the radar.  I didn’t know about Twitter so, like a savage, I sent personalized emails and handwritten letters with sample posts to money managers who I thought would like my work.  You, @BluegrassCap, and several others tweeted my blog and pulled me into modern times.  Scuttleblurb spread through word of mouth among the much-larger-than-I-imagined subset of fintwit that cares about fundamental research, which set the conditions for huge growth in 2019 and 2020.  But last year, I stopped engaging and focused near-exclusively on my work.  What little podcasting and Twittering I did in prior years ceased almost entirely.  Reclusive behavior, combined with the explosion of competing newsletters, had a predictably stultifying effect on growth. My subscriber base flatlined for most of last year. I’m frankly surprised (and relieved) that it didn’t shrink.

I guess the super obvious takeaway here is that if you want to grow it’s important to stay top of mind through regular, substantive Tweets and podcast appearances (voice tightens the bond). Ideally, you want your newsletter to be part of a subscriber’s daily routine, something they peruse while sipping morning coffee. I know Ben Thompson’s Stratechery occupies that privileged slot for many of us. But that’s not a realistic aspiration for a deep dive writer like me who only publishes once or twice a month and doesn’t offer takes on the biggest, most topical news stories of the day.

The explosion of content has changed the way readers engage with it. Most people, including me, will flip through one essay after the next like nothing, oblivious to all the hard work and creativity that went into it. Some will cancel their subscription if they have to waste even 5 seconds logging in to read a 5,000 word post.  “Too much friction”.  We are spoiled with great content.  I personally subscribe to over a dozen newsletters.  Most sit in my inbox unread. Sometimes my auto-renewal receipts remind readers to cancel as they realize they haven’t gotten around to reading my posts. This has been happening to me with greater frequency.

“Fluff” is also friction, avoid fluff, of which there are two kinds (I’m guilty of both at times). There’s the stylistic kind where you overwhelm the reader with jargon and needless sentences. And then there’s the more insidious content-specific kind where you don’t make a meaningful point. A nice trick here is to ask yourself if any reasonable person would agree with the inverse of your claim. If not, then is your claim worth making in the first place? “We strongly believe that the best companies have durable competitive advantages, innovative cultures, and are managed by aligned founders who strive for non-zero sum outcomes”. That’s motherhood and apple pie. I have yet to come across an investor who argues for narrow moat enterprises with torpid cultures led by rapacious hired guns.  

Q: There seem to be very strong forces that pull many writers out of the field.  By that I mean that a successful newsletter is a great resumé, and many of the writers I know have gotten very appetizing job offers. 

I feel like there’s probably only a relatively small subset of newsletter writers who truly want to write as an end goal — writing is thinking, and thinking is hard — and many others who are doing it to build towards something else.  So over time they leave and it may be possible for the few that just keep on going to kind of be the last people standing through sheer longevity.  I guess I’m just curious if you have any thoughts on this dynamic..?

I think you’re right – the industries where folks will pay good money for informed newsletters are also those in which writers are least committed to newslettering as a profession.  Lots of folks go into finance/investing for money and prestige, and compared to managing capital or working at a hedge fund, writing a newsletter can seem like a big downgrade on both dimensions. I think this is less true than it used to be.  Ben Thompson legitimized newsletter writing as a profession in so far as he showed you could earn a nice living by offering thoughtful analysis, without pumping stocks.  But when I launched scuttleblurb in late 2016, more than a few well-meaning folks felt my career was moving backwards. And it’s not like my newsletter motives were “pure” either. My fund didn’t start with anywhere near the AUM to earn a sustainable living. Scuttleblurb was an attempt to generate steady income in a manner that was synergistic with managing money.   

There are many more finance-interested people who want to work at or start funds than who want to write for a living….but I think those in the former camp increasingly realize the complementary value of publishing a Substack or Revue.  For those trying to land an analyst job, there is no better resume than a record of your investment writing.  A blog is a canvas to showcase creativity, analytical skill, passion and intellectual honesty.  For emerging managers, writing is an excellent way to attract and screen for the right partners.  An allocator who has read your work over the course of a year will have a clear sense of what you’re about before they reach out.  It saves time on both sides.

Every so often on Twitter I’ll see someone say “if newsletter writers were any good they’d be managing money” and I always think “great, when can I expect your wire?”….as if raising capital is the easiest thing in the world. At least for me, finding aligned partners has been a long process. Getting to scale took over 5 years, it came all at once, and there are a million scenarios where I make the same moves and things don’t work out. Just because someone isn’t managing money doesn’t mean they aren’t capable of doing so. Plus, some analysts just don’t want the stress of managing outside capital. Why diminish those who take an alternative path or don’t share your life choices and goals? Isn’t it better to have thoughtful analysts out there publishing their work than not? 

Q: What do you love most about this job? What part of it are you most excited about, or do you feel is most rewarding?

Definitely the money.  This work feeds my family.  The inspirational stuff around community, intellectual challenge, non-zero sum knowledge sharing, etc. applies of course.  But this project didn’t start with high-minded aims.  It started with me stressing out over how I was going to earn a living as I burned through my limited savings and struggled to launch my fund.  It started with me publishing into a void and thinking I was not gonna make it.  So to now have ~1,500 readers expressing support with their hard-earned cash is insanely rewarding.

Q: What do you dislike most about it? If someone told you they want to do what you do, all starry-eyed and optimistic, what warnings would you give them to make sure they know what they’re really facing out there?

There are so many newsletters competing for attention.  For every successful newsletter writer, I’m sure there are hundreds more who never gained traction, not because they weren’t talented but because it’s just really hard to break through all the other terrific free and paywalled stuff out there.

If you’re thinking about starting a newsletter anyway, I would fantasize less about success and ruminate more on whether you will actually enjoy the day to day experience. Writing for a living has a certain romantic appeal, but it is a solitary endeavor that can feel like a slog for someone who does not intrinsically enjoy reading, thinking, and writing for hours on end, day after day. This job suits my personality. I crank Zeppelin and lose myself in the work. But it’s not for everyone. Some people don’t like Zeppelin. (a little dad humor for you Liberty 😉 [Ha! You know me so well! 🤓 -Lib]

Q: Last year in our interview, you wrote about your research process. I’m guessing it’s not something that changes a lot, but I’m curious if you’ve learned new tricks or changed anything since?

No, not really.  

Q: Or if you’ve changed your views on anything important when it comes to your investing? Any companies or industries that you know little about, but feel like are holes in your knowledge, and you’re looking forward to digging into in 2022?

I think young fund managers, and I’ve been guilty of this too, have a tendency to over-intellectualize and complicate investing. Some of this is theater.  To stand out and appear deep, one quotes Marcus Aurelius and draws facile analogies between physics and investing.  By comparison, wisdom from experienced veterans can often appear trite and simplistic. But I’ve come to believe that that’s often because they’re done trying to impress.  They recognize that investing is not about complex theories, superficially applied but rather basic insights, deeply absorbed.  It’s that classic Charlie Munger line: “take a simple idea and take it seriously”. This is an old lesson I’m relearning. It didn’t stick the first time.

Great companies really feel this in their guts. Old Dominion Freight Lines, Sherwin-Williams (long), Fastenal, and Charles Schwab (long) are organizations that build around simple drivers of value creation. For instance, while the LTL industry embraced “asset lite” dogma, Old Dominion invested in the service centers and trucks required to offer reliable on-time service at a fair price (not the cheapest price). The profits it realized from winning share and scaling its fixed cost base were reinvested into still more service-enhancing capital investments, driving still more profitable share gains.  

Twilio obsesses over developers. CEO Jeff Lawson’s 300-page manifesto testifies to this. The company is made up of Amazon-inspired multi-disciplinary “two-pizza” teams who can respond to customer needs with the agility of a startup. As they grow past 10 members, those teams split into smaller ones, with the code base divided at each mitotic [Good vocabulary! -Lib] phase so that technical debt is paid down as the company grows. All employees are required to spend time supporting customers and building software with Twilio’s APIs.  

This isn’t always feel-good stakeholder capitalism stuff and there is sometimes more than one viable vector of attack. Airbnb and Booking (long) are, to borrow a phrase from William Finnegan [6] (Barbarian Days), the “oversold thesis and understated antithesis”. Booking quietly games the mechanics of performance marketing and conversion through maniacal experimentation. They’ve systemized the process more than any other OTA, with a team dedicated to maintaining the tools and scaffolding that allow anyone in the company, including new employees – who are, by the way, trained on statistics and hypothesis formation when hired – to launch experiments without permission. To pull this off, you need a culture that runs flat and encourages frequent (but small) failures.  

Airbnb is equally ambitious but crunchier. They built the most resonant brand in this space by taking community, connection, and product seriously. That Airbnb commands ~the same enterprise value as Booking on ~half the gross bookings and none of the profits is at least partly a function of vibes and storytelling: it’s easier to dream big with Airbnb than with Booking because CAC can be framed as intangible asset investment that should scale better than a recurring Google toll, and the company’s granular inventory molds better to all sorts of use cases and economic environments…though whether one is justified buying into this vision has yet to be seen.  Back when Booking was at Airbnb’s 2019 level of gross bookings, it grew faster and delivered +37% EBITDA margins vs. -7% for Airbnb.  Anyways, I guess the point is I tend to emphasize strategy when sometimes what really matters is that a company knows, like really knows deep in its marrow, what it’s all about and does uniquely well, top to bottom, things that are consistent with that identity. 

Besides “culture”, something else folks talk about is incorporating base rates into the investment process.  This sounds like good hygiene, but I find it hard to apply and even easy to misapply in practice.  I once listened to a podcast interview, this was maybe 5 years ago, where the guest chided a sell-side analyst for modeling Amazon’s annual revenue growth at 15% for the 10 year period from 2015 to 2025, retorting (and I’m paraphrasing somewhat): “If you look at the top 1,000 US companies since 1950 that started with $100bn in revenue, not a single one grew 15%+ per year over the subsequent 10 years.”

I’m reminded of that classic Monte Hall game [7], where a prize lies in one of 3 boxes.  You pick Box A.  The host, who knows which box contains the prize and is tasked with opening a prize-less one, opens Box C.  Do you switch from Box A to Box B?  Yea, sure, because in picking Box C, the host conveys information that suggests it is more likely that the prize is in Box B.  That’s just Bayesian updating.  But now imagine the same setup except this time the host randomly opens Box C.  Here there is no advantage to switching. In both scenarios, the observation is exactly the same: the host opens Box C; there is no prize inside.  But whether you, the contestant, are better off switching hinges on whether the host knew which box held the prize and opened an empty one. To paraphrase Judea Pearl, the process by which an observation is produced is as important as the observation itself.  

That “no $100bn companies since 1950 have grown revenue by 15% over a decade” may be an empirical fact, but it doesn’t take into account the process by which Amazon (long) got to where it is.  The speed and intensity with which online businesses scale is unlike anything we’ve seen in the Age of Oil, Automobile, and Mass Production (h/t Carlota Perez) and it seems misguided to anchor to pre-internet statistical artifacts. It’s proper to start with the “outside” view and adjust according to local information about a company’s competitive positioning, addressable market, unit economics, etc.  Too many investors get swept up in company-specific narratives and ignore broader context, that’s true. But I’ve also found that those who tsk-tsk with “no company has ever…” finger-wagging often frame against the wrong context and tend to downplay updating or don’t possess the company-specific knowledge to understand how significant that updating should be.  

If you’re walking through the woods and happen across a lizard reciting the alphabet and your friend asks whether it can vocalize words, you don’t reply “the base rates don’t look good; no reptile in existence has ever uttered words”. No, first you wonder about the mushrooms you picked earlier, but then you say “holy shit, this lizard knows its ABC’s!” Not a great analogy, but you get my drift. [🦎 -Lib] That Amazon, like no other private enterprise, got to $100bn of revenue in 20 short years and was still growing close to 30%/year off that huge base is an indication that there may be something special going on here, that perhaps the idiosyncratic merits of this situation demand major updating of base rate priors.  The same could also have been said of Google, also a member of the ~$100bn club, growing 20%+. Rather than cling too firmly to historical base rates, it seems more useful to ask what’s different about Amazon and Google, and to then consider the consequences of that answer. Statistics aren’t explanations.  Data doesn’t speak for itself.  Without a qualitative understanding of how a company creates and captures value, you don’t know why the numbers are what they are or what might cause them to break down or inflect. 

Q: I know it’s hard to judge one’s own work, but I’m curious if — looking back on Scuttleblurb since the very beginning — you could share what you think were some of the high-points and low-points when it comes to your analysis.  Any standouts where you think, “this really aged well, I got it right there” or “oops, I think I screwed up there for reason XYZ”..?

Like 2 or 3 years ago I wrote a few posts about how private permissioned blockchains might have some interesting business use cases… for instance, in simplifying the process of transferring land titles, counting proxy votes, and recording share ownership, tasks that are today are processed through byzantine methods subject to uncertainty, delays, and costly errors.  I saw blockchain as being more about efficiency than revolution, a way to handle pedestrian record keeping tasks more transparently, at lower cost and greater accuracy.  I acknowledged that there were major institutional barriers to adoption, but nevertheless thought we would be talking more about corporate blockchain today.  

But enthusiasm around this stuff has waned.  Today crypto ideas are more philosophical, more self-referential, less obviously and immediately useful. Remember when, to sound smart, people used to say “I’m skeptical of crypto but blockchain is interesting”?  They don’t say that anymore.  The party around crypto assets has drowned out staid corporate conversations around blockchain as a record keeping technology.  The talk these days is more around leveraging crypto incentives to organize people for…blah…whatever, yacht parties, climate change.  I pine for the days of Long Island Iced Tea Blockchain.  It’s not clear to me if it is decentralization or the hype around decentralization that is doing the heavy lifting here or if it even matters.  I offer no opinion on how much of this is good or bad, and have less than zero desire to defend any side of this holy war.  I only mean to say that things have played out much differently than I thought they would…but of coursethey did.

I was much too enthusiastic about Twitter (long) and overestimated the pace and impact of some of their product initiatives.  At first, it was almost endearing to see Twitter stand and fall (“c’mon Twitter buddy, you can do it!”) while Facebook won its nth Gold medal.  But after so many years of missteps, now we’re all worried about degenerative bone disease.  They’ll likely miss DAU guidance.  Expenses are off kilter.  Creator products were slow to launch and remain janky. Investor sentiment is terrible. Twitter’s enterprise value is about where it was in 2018/2019.

But – and here’s the part where I get booed offstage – the company is in a much better place today than it was back then.  They are experimenting with new products and acting with way more urgency than they have in prior years.  They’ve made it easier to onboard, proposing to users a growing selection of Topics rather than requiring them to build interest graphs by piecemeal following individual accounts.  Recent and pending product launches – Spaces, Private Spaces, Revue, Super Follows, tipping, etc. – have the potential to better engage and retain users.  

It’s hard to exaggerate how bad things were on the ad side. Twitter was an interest-based graph that didn’t track your interests. It would show ads based on who you followed and the ads you engaged with in the past. Hobbled by a dilapidated tech stack, Twitter would take months to roll out new ad units. But having just devoted the last 2-3 years splitting its ad server functions into separate sandboxes, the company is now developing and launching new ad formats at an accelerated pace. 

Twitter won’t ever rival the “always-on” direct response dominance of Facebook – they have relatively limited data and the text-centric nature of its platform may not lend itself as well to certain visual categories.  And compared to Facebook, Twitter doesn’t have near the expertise to deftly maneuver around ATT constraints. But it can certainly be a much stronger complement than it is today. The idea is that with user-side initiatives like Topics and Communities [8] producing sharper signals, Twitter will bring a more targeted ad product to the episodic brand advertising – creating buzz around products launches, drafting off cultural moments – for which it is uniquely well-suited, as well as crystalize durable interest clusters for the long tail of smaller advertisers to DR-advertise against.  

In short, Twitter is tying users to interests, which generates more targeted data for advertisers, who now also have access to a more user-friendly back-end from which to launch better converting ad formats. This is one of the most socially consequential information networks on the planet and the business is improving off a very low performance base. But man, enough already, right?  This year, Twitter needs to demonstrate that its simultaneous user and ad-side efforts are bearing fruit.  C’mon Twitter buddy, you can do it!

In my Zillow post, I took for granted the basic operational and blocking/tackling aspects of iBuying.  When looking at the world through a strategy prism, you can sometimes lose sight of obvious ground level realities.  I thought Zillow’s brand and traffic gave it an advantage in acquiring and turning over inventory, and that it could monetize rejected iOffers as highly qualified seller leads.  But obviously, none of that matters if you’re recklessly buying market share at any cost and betting on home price appreciation to bail you out!

It’s not clear to me that iBuying is an inherently broken model.  Opendoor seems to be doing fine, reporting strong unit margins even as they continue to expand the buy box. Zillow discarded underwriting discipline in a rush to grow. It may even be that Zillow’s existing assets and revenue streams – brand, mortgages, escrow, title, agent network – were in fact liabilities in so far as iBuying conflicted with agent lead gen or the company thought it could be a bit sloppy on iBuying because they could make up for it in other ways.  Opendoor, on the other hand, had to be much more assiduous about forecasting home prices, monitoring repair costs, and otherwise managing risk because there was nothing else to fall back on. Getting the basics wrong would have had world-ending consequences for them.

But if iBuying is a viable model – “if”, because this model hasn’t been tested by a bear market and it’s unclear how much extra rake can be pushed through or how many ancillary services can be cross-sold to offset negative HPA – well, that puts Zillow in a tough spot since one of the reasons they got into iBuying in the first place was because they saw it as an existential threat to their core lead gen business. For that reason, and given Rich Barton’s propensity for shaking things up, I suspect there’s probably another BHAG in the hopper, maybe on the institutional side of things. Zillow has this amazing top-of-funnel asset that you’d think they’d be able to monetize in a big way, though I guess people have been saying that about TripAdvisor (and Twitter!) forever too.

Anyway, I could go on and on.  Every one of my posts has these kinds of blind spots and shortcomings.  But on the whole, I’m happy with my work.

Q: Normally I’d ask you about how Scuttleburb has been doing in the past year as a business, but you’ve published a business update at the end of December, so I’m just going to link it here:

First, while I detect a melancholy tone, I gotta say that I find what you’ve built with only your words extremely impressive, with revenue going up 15x since 2017 (and in this business, revenue and profits are fairly close if you’re a one-person-orchestra).

It’s interesting how the psychology of momentum works, and how our brains tend to extrapolate whatever has been happening recently forward.  If your subscriber graph had been going up in a straight line from 2017 to 2021, it would probably feel really good. But because it’s been plateauing lately, it doesn’t feel nearly as good (even if the next phase eventually turns out to be more growth — time will tell).  I think it’s important to zoom out. You’re a guy sitting at home in pyjamas, typing stuff into the computer, and you’ve materialized through sheer persistence and intelligence a community of customers that would fill a decent-sized concert hall. Kudos!

I guess this isn’t really a question, but I am curious what you think about the ups & downs of being a solo creator, and how the psychology of it plays out.

Thanks for that.  I didn’t mean for the letter to come across as melancholy or pessimistic.  When I say “subscriber trends look weak” and that I’m “fading somewhat amid the scrum of new talent”, well, those are just the plain realities.  Acknowledging the realities doesn’t imply that I am sad or frustrated by them or hope for something better.  If my subscriber count stayed flat from here on out, that would be a fantastic outcome.  I just don’t want to shrink to unsustainable levels.  In 2020, my annual churn was 14%; in 2021, it jumped to 26%.  I think I’m still in the safe zone, but the trend isn’t great and I can’t be having like more than half my subscribers leave every year.  At some point I’ll have cycled through the addressable fintwit TAM. But beyond the income threshold required to sustain my modest lifestyle, send the girls to college, and save for retirement, I don’t really care about growth. I care a great deal about doing quality work though. I think it was Ira Glass who said that at some point you get good enough at your craft to know what great looks like and it can be disappointing not to live up to that standard. I feel that sometimes.

Q: Were any of your posts from the past year particularly difficult to research, or that you learned a lot from..? Maybe things that unexpectedly went pear-shaped, like Everbridge, and how you analyzed and scuttlebutted the situation to figure out the odds on what was going on?

Hm, I don’t really have pivotal moments where everything locks into place. For me, synthesis is a gradual process. TV shows and movies emphasize silver bullet events – Bobby Axelrod lays down a big hero bet after finagling a key piece of information. 

Reality is far less exciting.  What really happens is you build muscle memory about a company and its ecosystem over years and calibrate conviction along the way. That’s why I would caution against buying after a first deep dive. Research should be exploratory, not confirmatory.  The idea is you don’t know if the stock you’re researching is as good as you think it is at the start, but it’s very easy to convince yourself that it is just because you’ve devoted so many of your waking hours to it this month. There is a Dunning-Kruger effect at play where because you don’t know how little you know, you deceive yourself into thinking you understand more than you do….until the stock sells off by 30%. Then your hands turn to paper.

Q: Anything else you’d like to share? What did I forget to ask about?

No, except that nothing I’ve said in this interview is investment advice and I can buy or sell any of the securities mentioned at any time.  Thanks for the thoughtful questions!

Q but not a Q: Thanks man!

Interview with Mirakle

Posted By scuttleblurb On In Business updates,SAMPLE POSTS | 1 Comment

A few weeks ago, I did an interview with Mirakle, a Korean language business newsletter (link [10])

Below is the English version:

Thank you so much for the opportunity – My first language is not English and although I have learned English for 6 years in regular school system in South Korea, my written English may not sound clear to understand

No worries. I promise my Korean is far worse than your English

I learned how you started newsletter writing (at here link [11]) and how you were picked up by Twit community – That is quite amazing story – The idea that researching and writing only can make your living would quite resound to my audiences – How do you appreciate your current position now? How satisfied are you and your family on what you are doing?

In 2008 Kevin Kelly wrote this essay, 1,000 True Fans [12], that basically talked about how, contrary to the prevailing belief that grabbing the attention of millions was required to earn a living online, an independent creator need only find a relatively small number of “true fans” who were willing to pay for their work. This was nice in theory at the time – the internet made it possible for any normie to broadcast their creativity to the world – but tough to realize in practice because how does one find those fans? Social media supplied part of the answer. A blog dedicated to an arbitrarily niche interest can resonate with a likeminded group on Twitter. That group can be far larger than what narrow personal day-to-day experience might lead you to expect as there are more than 200 million people engaging with that platform every day, and even a thin sliver of that population can translate into a meaningful audience for a single creator. I set an aspirational goal of 200 subscribers when I started. That close to 1,500 readers would pay ~$210 a year to read a blog written by an unknown analyst would have seemed far-fetched at the time, yet here we are.

You no longer need to be affiliated with an established media outfit. New independent writers are making good money covering niche topics with far greater depth and insight than traditional media (I’ll take my work, or that of Mostly Borrowed Ideas [13]TSOH [14], and Yet Another Value Blog [15] – other terrific independent writers in my genre – over the cursory stock pitches published in Barron’s any day). There are even trusted independent curators, like The Browser [16] and Liberty’s Highlights [2], to help sift through the sea of content. This is not to diminish the ground level reporting and assiduous fact checking that large publications put into major news stories of broad public interest. That is important and noble work. But the explosion of independent newsletters is great for those who enjoy long form analysis on niche topics.

Of course, working for yourself on things you find interesting has widespread appeal, and with Substack and Twitter eliminating what few entry barriers there were in launching a paid newsletter, the competition for readers has exploded. My particular domain – analyzing competitive advantages and business models – seems to get more saturated by the month. After a certain point, growing a subscriber base requires more than just good content. You need to get out there and actively engage through Twitter threads, Spaces, podcasts, etc. But I don’t think of scuttleblurb as a business and have never been interested in growth for its own sake. I’m not trying to build the largest possible audience. So long as this blog brings in enough to provide for my family, I’m satisfied.

If I were in your position, I would be bombarded with the inner-mind tension between writing something that I only found out to broader people and investing something that I only thought would increase its value for broader people – writing and investing for others – what does interest you more? I learned that you have dipped your feet into both choices and assumed that you might give us more insights.

Frankly, I didn’t set out to be a writer. Scuttleblurb was a means to an end. I needed a way to cover expenses while I scaled my investment business, so I figured I’d post my research online and see if anyone would pay to read it.

Writing, for me, is a selfish act. Besides putting food on the table, it makes me a better investor. It puts structure to thoughts and stops me from fooling myself (a good way to test whether you really understand a concept is to explain it to others). I also find that the very act of writing can open creative outlets and trigger new avenues of exploration. My coverage isn’t influenced by what I think my subscribers want to read. I just write about companies that interest me and hope others come along for the ride.

Most of people who do investing in remote companies from countries like South Korea often feel it to be difficult to know more about the stocks that they want to invest. For them I think your ways to approach companies could have interesting implication – as you are individual researcher who might not have ample chances to participate fancy IR events that companies are holding. Can you share your routes to corporate information and if you have any advice, can you please share?

You might be surprised how far you can get with just an internet connection. Publicly traded companies in the US post their annual and quarterly reports, earnings calls, and investor presentations on their websites. Their Investor Relations departments will often speak to individual investors. You can reach out to former employees and competitors on LinkedIn or to industry folks who publish or are quoted in trade publications. The hit rate is low, so you need to be scrappy and persistent, but it’s certainly doable. Just don’t waste people’s time. Put in enough work to ask substantive questions and be willing to share what you’ve learned as well.

Keep in mind that sound investing has as much to do with judgment and synthesis as it does information gathering. Do enough of these calls and you’ll realize that everyone is blindfolded and touching a different part of the elephant. Part of an analyst’s job is to weigh to different perspectives and roll them up into as accurate an understanding of the company as you can. Saying you’ve spent countless hours doing this many calls is a quantifiable measure of progress. By contrast, synthesis, dispassionate analysis, and resource management are somewhat abstract skills, not something you can really brag to allocators about. But the lens through which you interpret information and how you balance your time across different opportunities are so important.

I once heard an investor say that they take research on a company to the point of diminishing returns…and then push even further. But there are some downsides to this impressive-sounding rigor. The world is an unpredictable place. No matter how well you know a company, there will always be something that takes you by surprise. Deep diligence can lead to unjustified conviction or lull you into a false sense of security. Reluctant to admit to wasted effort, you may dismiss counterarguments and rationalize negative developments. And the time spent taking your knowledge from 99.01 to 99.02 on company A might have been better spent going from 0 to 10 on companies B and C…so even if you have the mental flexibility to change your mind and exit an insanely well researched position, you may find yourself lacking replacement candidates as you literally don’t know what you’re missing. The balance between exploration and exploitation is unique to each person. As for me, I want to be in maybe the 80th to 90th percentile of knowledge on each of the companies I own. But finding myself in the 99th percentile may be a sign that I’m not optimally allocating my scare time.

As an ant returns to its nest after finding a food source, it will leave a pheromone trail for other ants to follow. Those ants, upon finding food at the end of the trail, will leave more pheromones on their way back, further reinforcing the path for other ants. As a food path becomes less promising, fewer ants follow it and the pheromone scent dissipates. So ants explore many possible routes simultaneously and devote ever more resources to the promising ones (what Douglas Hofstadter calls a “parallel terraced scan”…you can read more about this in Melanie Mitchell’s book Complexity). That seems like a good basic model for thinking about how to spend your limited resources. You don’t know what’s worth spending time on at the start, so you extend tentacles every which way. As you gather more knowledge about each, you prune some branches and intensify pursuit of others, and then extend this approach down to avenues of inquiry within each company.

I felt that there are full of interesting angles approaching the companies in the Scuttleblurb posts – and I also felt people love your style of writing factual walkthroughs on the history of the companies without telling them BUY/SELL/HOLD. So basically I thought that you are opening them the door for new possible interpretation of the world but leave the door open for the audiences to close. That is quite different from other analyst or researchers, I guess. What do you like most about your style of work? and what makes you keep it that way?

In investing, writing is very often a tool of persuasion. An analyst does their research, determines the stock is a BUY, and crafts a narrative consistent with that rating, which often leads them to diminish contrary views. I write to understand, not to persuade. Scuttleblurb is a research journal. It’s a place for me to think out loud and figure things out. My thoughts should be structured coherently but they need not coalesce into an airtight consistent thesis that argues why you should buy or sell a particular stock.

This approach doesn’t sell nearly as well as sensationalized long or short reports, especially on certain battleground stocks (Burford [17] in 2019 comes to mind). It may seem that reading two lopsided but opposing takes might get you to something resembling the full picture. But that’s sort of like saying the average of Fox News and MSNBC converges to the truth. Are you really hearing “both sides of an argument” (as if there can only be 2 sides) or just two distorted and motivated points of view? I would much rather get one intellectually honest assessment of things than dogmatic takes on opposite sides of an issue.

At the other interview, you mentioned that writing is part of your process of investing – How writing is adding value to the right investment decision? And what initiates your writing? do you write companies that you want to buy at first? and how do you select the topics of your writing?

I don’t know if I want to buy a company before I write about it but nor do I dive into things totally blind. On the surface, there are glimmers of scale, network effects and other sources of competitive advantage, and I write to flesh out whether and to what degree they apply. These companies come to my attention somewhat serendipitously – in the process of researching one name, I’ll think of another that shares similar characteristics or I’ll stumble upon another company in the same ecosystem that seems interesting.

For instance, Moody’s and S&P are a standards-based duopoly. Their ratings serve as benchmarks that market participants use to peg the credit worthiness of one bond versus another over time. To issue bonds at the lowest possible coupon or have those bonds included in major indices, an issuer must pay Moody’s and S&P for a rating, and each issuer that does so further entrenches Moody’s and S&P as the standard. Researching those companies led me to FICO, which enjoys a similar moat in consumer credit, with its FICO Score ubiquitously adopted by US lenders to assess the creditworthiness of borrowers. And looking into FICO led me to the big 3 national credit bureaus – Equifax, Experian, and TransUnion – who supply the data that goes into FICO’s algorithm and whose data and software are woven into the workflows and business systems of banks. Those business systems include purchase core/issuer processors from Fiserv and Fidelity, who tie into a complex Payments ecosystem that includes card duopolists Visa and Mastercard, merchant acquirers like First Data and Adyen, payment facilitators like Stripe, etc. etc.

For me, I think writing should affect people’s investment decision as they read again what they wrote before, so over time, I believe that writing would help a great deal to make quality feedback on their own decisions. So I am more curious about your experience – Do you have stocks that you initially dig into but ended up not wanting to buy after a while of study?

I don’t buy the vast majority of stocks I write about. That’s the way it should be. For me, writing is a learning expedition. It would be one hell of a coincidence if each one led to “buy” decision. If that were the case, it’d be a sign that I either have insanely good intuition or I am lying to myself (far more likely the latter).

Your research must take quite an amount of time as it doesn’t fail to take deep dive into the wide range of coverage everytime – but for me (based on my own experience), I often felt strong impulse of writing as soon as I come up with an idea (plus we have audiences who waits for me to write), so I could not really focus on the longer-term research. How do you balance research timing and writing?

I do both at the same time. If I just sit back and passively consume content, nothing will stick. So rather than write only after I’ve spent several weeks researching, I will summarize what I’m learning in my own words and come up with questions and theories in real time, organizing paragraphs and sentences along the way. As I do more research, I’ll go back and revise the stuff that is wrong or incomplete.

I believe that the definition of corporate value itself or the way to gauge corporate value have not been changed by the technological advances, but sometimes I throw doubts on that beliefs, too – especially when I am looking at the balance sheets of the companies of big techs, I often ask questions myself such as ‘where’s the IPs of Apple?’ ‘where’s the most valuable assets of Google – their tech engineers!’ ‘where’s the culture of Amazon?’ ‘where’s Elon Musk’s COVID19 health condition in Tesla’s balance sheet?’ How value investors have to adopt the new changes? and how are you evolving?

Even for industries that are heavy in tangible assets, value creation is often tied to intangibles. Value resides less so in things but in how creatively and efficiently those things are arranged and used.

Take the low-cost European airline Ryanair for example. The key to operating a consistently profitable airline is to command the lowest unit costs, which is a function of cost discipline and having full planes in the air for as long as possible. Ryanair enforced single-class seating to speed onboarding; did away with in-flight meals to minimize clean-up time; and standardized on a single aircraft model to reduce crew training and maintenance costs. They targeted uncongested secondary airports, where planes could take-off and land faster and which were willing to agree to lower landing fees. Cost savings from the above actions were invested in lower ticket prices, which attracted more passengers, giving Ryanair the leverage to bargain for lower landing fees at airports and secure aircraft volume discounts from Boeing, which cost savings were partly recycled into still lower fares. Leading up to the COVID-19 pandemic, Ryanair was profitable every year since at least 2000, averaging close to 20% operating margins. That’s unheard of for an airline. Clearly, Ryanair is more than just the value of the planes on its balance sheet. Anyone with a few billion dollars can own jets; what’s hard is replicating all the activities that give rise to the feedback effects of scale. A number of incumbent airlines have tried and failed.

Or consider Amazon’s e-commerce business, which has around $105 billion of PP&E assigned to it. The link between those considerable tangible assets and business value is the intangibles that surround it: an organizational setup comprised of small agile teams who can innovate and launch new products without much incremental bureaucracy; the famous flywheel dynamic, where order volumes leverage fixed costs and attract suppliers, resulting in more product selection and lower unit costs that are passed on to consumers, both of which draws more order volumes; a subscription program, Prime, that promotes customer loyalty and accelerates flywheel spin. Riding on top of all that is $40 billion of revenue from digital ads. While it didn’t generate any meaningful revenue until maybe 5 years ago, the digital ads business was really almost 30 years in the making: without Amazon’s logistics base and the aggregation of consumer demand, the ads business doesn’t exist.

Fixed assets are a double-edged sword. The resulting operating leverage can wreck a company. But when paired with intangibles – culture, org structure, software, online distribution, and other stuff you won’t see on a balance sheet – that optimize their use, they can create an insurmountable moat.

Now, a unique property of companies that directly monetize intangibles is the degree to which they can scale. It doesn’t matter how much scale and cost discipline Ryanair has, there are only so many people that can ride its planes in a given year. The same constraints don’t apply to an online business like Google. Before Google, search engines determined relevance by matching site content with user queries, an approach that taxed computing resources by more than it improved search quality as more and more pages were indexed. Google’s algorithm, on the other hand, works like a voting system, where pages are ranked based on the quality and volume of inbound links from other sites. It gets stronger as the web grows. And as more users choose Google for its superior search results, the more data Google has to deliver even better results, attracting still more users.

Google enjoys winner-take-most outcomes. There are feedback effects to scale and, because its service is equally accessible to everyone, there is no reason for users to opt for the second-best search engine. There are practically no marginal costs or constraints to delivering search results (and the corresponding ads) to almost anyone in the world, so Google can grow its revenue to an extent that an airline or car manufacturer cannot. Last year, Google did over $209 billion of ad revenue, up from $135 billion in 2019. That kind of growth on such a huge base is without precedent in the pre-internet age and we should think twice about applying base rates from that era to digital businesses today (I touched on this in my interview with LibertyRPF [18] earlier this year).

If you feel comfortable, can you tell us your relationship with Korea? (I just assume that you have something in Korea as your last name is KIM)

I was born and raised in the states, but my mom is from Busan and my dad is from Daegu. I have lots of family in Seoul and try to make it back there every few years.