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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.

[ELLI – Ellie Mae] Market Opportunity, Competitive Threats, and Profitability

Posted By scuttleblurb On In SAMPLE POSTS,[ELLI] Ellie Mae | 1 Comment

Ellie Mae is one of the few SMID-cap SaaS vendors I track whose stock has lost value over the last year, its growth narrative clouded by waning growth in mortgage originations. During the first half of 2018, a common view espoused by housing-related companies was that refinancing volumes had pretty much nowhere left to go but up and purchase volumes – far less sensitive to rates and fueled by a secular tailwind of millennial demand(1) – would continue growing by mid/high-single digits for the foreseeable future despite tight inventory conditions.  But things have been weaker than imagined, with First American and Fidelity National experiencing decelerating purchase title orders and refinancing volumes continuing to plummet.  Ellie Mae’s management was caught off guard and after tempering full year revenue guidance in mid-2017, was forced to do so again, several times, in 2018.

Rather than charge its customers a fixed monthly fee, Ellie Mae engages in “success-based” pricing, where lenders pay a base fee up to a certain number of loans plus an additional amount for every closed loan above that threshold (regardless of the actual funded amount or whether the loan is part of a purchase or refi transaction).  The revenue model puts Ellie Mae in partnership with its customers (since they both prosper from growing loan volumes), but exposes it to cyclicality that most SaaS vendors avoid.  Weakness in closed loan fees and revenue from other volume sensitive services, which account for 35% of Ellie Mae’s total revenue, dampened Ellie Mae’s overall growth rate in 2017. [closed loan fees, over 20% of total revenue in 2016, plummeted by 27% even as contracted base fees have compounded by >35%/yr over the last few years.  Contracted revenue (~70% of total), which includes aforementioned base fees plus services and subscription revenue on various ancillary products, has expanded by 65% since 2016 while non-contracted revenue, success-based fees and fees from transactions on the Ellie Mae Network, has contracted by 12%.]

Anyway, let’s set the macro backdrop aside and get into why Ellie Mae even matters.  Underwriting a mortgage is a complicated process buffeted by regulations and inefficiencies, as described in my last ELLI post:

“From the potential home buyer first reaching out to a loan officer; to the loan officer pulling a credit report and discussing pries and terms with the borrower, and ordering an appraisal, title insurance, and other services from third parties; to the underwriting department assessing compliance with regs and underwriting guidelines; to the closing department preparing the bundle of signature papers; and multiple departments reviewing all the docs for fraud and compliance and accuracy along the way before the loan is finally sold to an investor, over a thousand pages – application, credit, flood, title, borrower financials, property appraisal, fraud, compliance, insurance – are spawned by a dozen or more service providers operating across silo’ed databases and systems”.

To address escalating regulatory demands, lenders have, for the most part, simply ratcheted up their hiring.  Two-thirds of the $8k spent in taking a loan from application to close is concentrated in personnel…that is, paying lenders and back office employees to verify and reconcile information; procure services; and wait around for someone upstream in the production chain to complete his part of the paper work.

The mortgage production process has several phases, with a dozen to-dos falling under each phase.  The green boxes in the below exhibit represent tasks that can be automated.

Source: Ellie Mae

Ellie Mae’s flagship product, Encompass, mostly addresses the 44 days that pass from when the mortgage application is received to when it is funded.  As the loan makes its way through this pipeline, it is scanned for defects at various points so that it emerges from the funnel in such pristine condition that the investor who buys it won’t have to kick it back to the originating lender because of some overlooked defect(2).  Between the core SaaS product that automates these processes and stores all related records in a single system, and the Encompass Network through which Encompass users transact with third parties who verify income and employment, conduct property appraisals, and underwrite mortgage, flood, and title insurance, Ellie Mae thinks it can cut a process that typically takes over 70 days to something closer to 15.  In doing so, the lender conserves value otherwise absorbed by personnel costs, and reduces both the interest costs of carrying a mortgage on a warehouse line and the opportunity cost of mortgages that can’t be underwritten in the meantime.  Once a system like this gets set-up, with lenders and back office employees relying on Encompass as the operating system of their mortgage manufacturing process, it is very difficult to dislodge.  Ellie’s customer retention rates are 95%+.

At the center of everything is the Encompass Lending Platform, a set of tools and APIs that Ellie Mae uses to build proprietary software, including the core Encompass SaaS product that makes up 60% of its revenue(3).  These APIs are also exposed to customers (who use them to build Encompass customizations) and to third party service providers (who use them to access lenders on Encompass’ platform)(4)While network effects are ostensibly apparent in the bidirectional pull between service providers and Encompass customers, the whole digital mortgage space is replete with non-rivalrous integrations – service providers basically see Ellie Mae, Black Knight, Roostify, etc. as distribution channels; plugging into multiple platforms is nbd  – and everyone seems to offer their own networks or exchanges.  I mostly see the Ellie Mae Network as table stakes, rather than a differentiating advantage.  That said, with ~40% of mortgages processed on its platform, Ellie Mae is certainly a required integration for service providers and mortgage investors (that’s why they, and not the lenders, pay the transaction fees).  However, I don’t think the dependence is mutual.  For a lender, does an network with 100 appraisers really offer much more value than one with just 20?

There are a few different ways to think about the addressable market and Ellie Mae’s share of it: the company supports ~2,400 lenders vs. ~6,000 lenders nationwide, including 3 of the top 10 and 10 of the top 30; hosts 200k+ active users against a a nationwide pool of ~850k lending officers and immediate support personnel; and processes 2.5mn loans against ~9mn mortgages originated [19] in the US over the last 12 months.  But the more effectively Encompass does its job, the more automated the origination process becomes, and the fewer the number of loan officers required per loan.  And as mentioned earlier, Ellie Mae’s revenue is in part tied to loan volumes.

Thus, management has been encouraging investors to frame the company’s market share in terms of mortgage volume and its monetization potential in terms of revenue per mortgage.  Ellie Mae extracts around $180 per originated loan against a potential ceiling of close to $400 based on the services that are presently available on its platform (base fees + per loan closing fee = ~$100; Ellie Mae Network (flood reports, income verification, etc.): $130; other software: ~$140).  Ushering a loan through the origination funnel might cost $8,000+, while the potential cost savings of adopting the Encompass platform – namely, lower personnel costs as the time to originate compresses from over 40 days to ~10 to 15 – are substantial at $2,600, 20%-30% of which might eventually be shared with Ellie (per management).  The cost-benefit gap is probably wide enough to accommodate several points of annual price hikes.

Here’s the bull case.  Multiplying $2,600 by ~9mn funded mortgage loans yields around $20bn-$25bn in industry-wide cost savings.  Assuming 30% of that is shared with software companies like Ellie Mae who enable those savings gets us to a total addressable market of ~$7bn(5).  Ellie Mae’s ~$460mn of revenue accounts for ~7% of that. 

So, assuming that Ellie Mae can grow its revenue per loan by ~10%/year and walks its market share up to 50% of originations, we would be looking at $1.6bn in revenue, which drops down to ~$450mn in EBITDA (including stock comp expense) assuming 28% margins (vs. 17% margins today and Black Knight’s margins of 46%).  Blow out the shares by ~5%/year and I can pencil out ~$4.30/share of cash earnings (which deducts capex and capitalized software).  Slap a 25 multiple on that, tack on the accumulated cash, and there’s your ~12% return.

But there are a few competitive entanglements to consider.  Recently, Ellie Mae has been expanding its presence at the front end of the value chain, with tools that automate marketing campaigns (Encompass CRM) and automatically assign leads to the right loan officer (Velocify; acquired in October 2017 for $128mn).  With Consumer Connect, Ellie Mae white-labels a web-based application through which mortgage borrowers can research loan options, upload documents, obtain status updates, access loan officers, and upload documents that then flow automatically into Encompass.  Ellie Mae offers Consumer Connect for free to its customers in the hopes that doing so will drive more mortgage volumes into Encompass.

This adjacent move is a reaction to the rising prominence of various upstarts in the digital mortgage application space, namely Roostify and Blend.  Whereas Ellie Mae began by directly targeting the hidden belly of the mortgage origination process before now forward integrating functions that are closer to the consumer, Roostify and Blend, founded in 2014 and 2012 respectively(6), began by interfacing with borrowers before extending into the nuts of bolts of origination.  Both have now secured major banks like Chase and Wells Fargo as customers, and are weaving up- and downstream integrations with other relevant players in lead generation and mortgage servicing.

These front-end competitors are becoming a critical point of integration, pulling ever more utility into earlier stages of the value chain, away from Ellie Mae’s ecosystem.  Roostify integrates into LendingTree so that a LendingTree lead who selects Bank A for a mortgage loan will immediately hop into a Roostify application that is white labeled and branded by Bank A.  Roostify (and Blend) also both integrate into Encompass, so if Bank A happens to rely on Encompass to streamline mortgage originations, all the relevant data from Roostify’s application is delivered into Encompass.  But Roostify and Blend touch the borrower earlier than Ellie Mae and it strikes me that many of those green boxes in the earlier exhibit either currently are or could just as easily be handled by them, including income/asset/identity/employment verification.  Much of the inefficiency in the traditional underwriting process is exorcised by synchronously matching the delivery and receipt of information and storing it all in a single place so there isn’t a back and forth shuffle of pdf’s. A digital mortgage application already supplies these functions, either natively or through integrations with third various partners like Yodlee, Equifax, docutech, Salesforce.  And so, Roostify and Blend are predictably positioning themselves as “hubs” through which all underwriting constituents – consumers, lenders, service providers – can converge to coordinate tasks and get real time status updates on the loan’s procession through the pipeline.

Black Knight (BKI), a mortgage servicing platform spun off of title insurer Fidelity National last September(1), is another competitor to consider. [Mortgage servicing involves collecting and recording mortgage, tax, and insurance payments on a mortgage, and comes after the origination phase.  Servicing can be done by the underwriting bank or by a third party like Ocwen].  Black Knight is a giant in the realm of software/data/analytics for the mortgage niche: it supports $8.5bn of enterprise value on $1bn of revenue and claims 20 to the top 25 mortgage servicers as customers.  Around 70% of outstanding US mortgages are serviced on its platform.  But in addition to mortgage servicing, Black Knight offers mortgage origination software through its Empower! brand(7). Empower! is only ~40% of Ellie Mae’s size and at less than 20% of Black Knight’s total revenue, plays second fiddle to the company’s servicing business.  But management seems to have taken a renewed interest in reviving this franchise, as evidenced by recent product enhancements and new financial disclosure that separately discloses its revenue.  Moreover, last year the company launched a mid-tier version of Empower! (Empower Now!), extending its reach to regional and mid-market lenders where Ellie Mae operates.  Ellie Mae, meanwhile, is migrating upmarket, where Black Knight is more firmly entrenched, possibly setting the two companies on a collision course.

But in its attempts to leverage its dominant position in servicing to an expanded presence in originations, Black Knight faces several obstacles.  First, origination and servicing are distinct processes with little overlap, steered by distinct sets of employees.  There doesn’t seem to be any functional logic to buying a bundled product that includes servicing and origination software.  In terms of bundling, it seems Roostify and Blend have a more compelling vector of attack: the loan officer responsible for managing leads and reviewing digital applications also takes point in walking that mortgage through to funding.  But his responsibilities certainly don’t extend to collecting payments.  Second, Black Knight is not really offering a modern SaaS product – with real time updates, rapid product improvement rollouts, and a common set of capabilities available to all customers – so much as it is standing up an expensive, customized (and some might say, outdated) system that can take up to a year to implement.  Unlike Ellie Mae, you will not hear Black Knight talk about migrating infrastructure to AWS or building off a modular service oriented architecture or harping on APIs that customers and ISVs can use to extend the core product. 

A bespoke solution loaded with professional services may be appropriate for large banks with $100bn+ balance sheets – and indeed, Ellie Mae is losing to competition among the few hundred lending organizations that make up the high end of the market – but a lighter weight version of this arrangement may have a harder time gaining traction for smaller banks than a streamlined SaaS product.  Also, the cost structure required to support a high end solution are not amenable to a lower priced instantiation, and even Black Knight is limiting its purview for Empower Now! to the top 200 lenders (out of a universe of 5,000+).  It is generally easier to get organizational buy-in to gradually nudge a “good enough” product upmarket than push a natively enterprise solution downmarket.

Show me the money

Here are the components of Ellie Mae’s revenue growth:

Average active users and rev/active user have decelerated meaningfully over the last few years.  Even so, 20% ytd revenue growth in contracting origination market ain’t bad!

At least one sell-side analyst has praised the company for protecting margins in these trying times.  But, whether the company deserves praise in this regard depends on your definition of profits.

So do you look at:

(a) EBITDA ex. stock comp? ($mn)

(b) EBITDA less stock comp?

(c) EBITDA less stock comp less “acquisition of internal use software” (capitalized software)?

(d) EBITDA less stock comp less “acquisition of internal use software” less capex?

You know my thoughts on stock based comp.  I think it’s okay to back it out of profits so long as you blow out the shares and evaluate things on a per share basis.  In other words, the cost of issuing stock must be reckoned with somewhere.  The problem is that Ellie Mae’s adjusted EBITDA and adjusted EBITDA margins account for it nowhere.  As measures of profitability, they are wrong, full stop.    

But (c) seems like a reasonable measure of “real” pre-tax cash profits, since capitalized software is functionally equivalent to either R&D or infrastructure support costs.  And the trend here is ugly.  Ellie Mae’s revenue has increased by $375mn since 2012; profits have declined by $14mn during that time.  There’s been no leverage on any part of the cost structure over the last 6 years (except maybe a little bit on G&A):

But on the other hand, I don’t know why we should expect otherwise.  In pursuit of a lucrative market, Ellie Mae has, since 2013, been investing aggressively in sales, customer support, product development, and technology infrastructure(8), and isn’t that what it should be doing?  On the other, other hand, maybe the competitive environment has intensified to such an extent that the recurring table stakes investments required to stay relevant is trending higher and higher.  I suspect both explanations are true.


(1) The largest part of the millennial population, those between the ages of 26 and 27, are just a few years away from the age at which they start buying homes.

(2) Ellie continuously keeps up with all the regulatory minutiae at the national and local level.

(3) The other 40% comes from a/ fees that Ellie Mae earns on transactions that take place on the Ellie Mae Network, b/ professional services, and c/ various other software and data solutions (closing, CRM, loan compliance, access to an online database of Fannie/Freddie lending guidelines and forms, etc.)

(4) As I’ve written before, monolithic software applications are being disaggregated into a set of specialized functions that communicate through APIs, enabling speedier, more scalable, more flexible product development

(5) You could make the case that this figure, which only takes into account the saved personnel costs, understate the actual TAM.  If you include the $670 that is spent on technology for every loan origination, the real opportunity might be closer to $13bn.

(6) Blend has raised $160mn in venture funding over its short life and is now valued at ~$500mn.

(7) Empower! has been around since at least 2008, back when Black Knight was known as Lender Processing Services.

(8) While the company is leveraging AWS for newer products, including private data lakes, Ellie Mae, for the most part, operates and maintains data centers that host software delivered on-demand to its customers. 

Disclaimer: As of the time this report was posted, accounts managed by Compound Insight held shares of ELLI.  This may have changed at any time since.   

[CMPR – Cimpress NV] Scale Economies and Hard Realities, Pt. 3

Posted By scuttleblurb On In SAMPLE POSTS,[CMPR] Cimpress NV | Comments Disabled

Cimpress is a fine business that has been in search of strategic direction for the last 6-7 years, groping for the right balance between value-added customization and low-cost production.  These two sources of differentiation are often at odds because the scale economies required to claim a cost advantage depend on running lots and lots of volume across significant fixed costs, a process that is best suited for homogeneous products that share a common manufacturing base and process.  You can imagine casting a single widget SKU over and over again.  There are no incremental set-up costs from line changeovers.  The assembly line just keeps humming as long as it can, spewing a stream of identical widgets onto a continuously flowing conveyor belt, the upfront cost of heavy equipment diffused over more and more manufactured units.  At the other extreme, a stylist’s average cost per haircut stays roughly the same, whether he does 20 haircuts a day or 30. Of course, most jobs fall somewhere between these two poles.  Cimpress (originally known as VistaPrint), which makes a variety of customized physical marketing materials – business cards, signage, apparel, gifts – for mostly micro business with fewer than 10 employees, claims that it can capture the benefits of both differentiation and low-cost (“mass customization”):

Source: Cimpress Business cards are a perfect use case for mass customization because from the customer’s perspective, a set of business cards, tatooed with a unique logo and font, is unique; but from Vistapint’s perspective, the core manufacturing process and materials required to produce them is essentially the same across all customers.  And after its founding in 1995, Cimpress spent the first dozen or so years of its existence focused on paper-based products…business cards (where it remains dominant) postcards, brochures, presentation folders, data sheets, and the like, predominantly in North America. Volume brought scale, scale compressed average unit costs, profits from cost advantages funded VistaPrint’s strategy, which was to litter inboxes with cheesy marketing campaigns offering something like business cards or return address labels for free and drawing customers to the website, where they could then be cross-sold other products and bamboozled with exorbitant shipping costs on the check out page (after they’d already spent the time designing their items and were psychologically committed to the purchase). 

Today, Vistaprint prints 6bn business cards a year, one for nearly every person on the planet.  It can produce a pack of business cards in less than 10 seconds and fulfill the order in less than 2 minutes.  No one else comes anywhere close to extracting the scale economies enabled by that kind of volume. Although paper-based marketing, including business cards, is in decline, the company’s Vistaprint segment is still showing high-single/low double digit organic growth as it continues to steal share from the tens of thousands of small manual operations that still account for most of the putative $30bn market opportunity [per management; computed as 60mn small businesses with fewer than 10 employees across North America, Europe, Australia, and New Zealand multiplied by $500 in annual marketing spend], leaving Cimpress, with just $2.4bn of total revenue, plenty of runway ahead.

But sometime in 2011, with revenue growth decelerating, management embarked on an aggressive M&A strategy.  Since fy11 (fiscal year ends June), on top of ~$590mn in capex and capitalized software development, management has spent around $900mn buying 15 companies – ranging from a DIY website building (Webs.com) to a host of European print and design companies catering to graphics professionals (consolidated as the “Upload and Print” operating segment) – tangentially related to the core Vistaprint business by dint of their marketing orientation but otherwise diffuse in terms of product SKUs and addressable markets.  And for this ~$1.5bn investment, Cimpress’ EBITDA (after stock comp) has grown by just $106mn, a 7% pre-tax return compared to management’s 10% hurdle rate for predictable organic investments in developed countries and 25% bogey for riskier investments in emerging markets. Now, one might argue that the cost structure is larded with growth opex that will eventually subside.  But, we’ve also heard this line from management before, as it has fumbled its way from one strategy to the next. 

The first course correction came in fy11, when management recognized that deep discounting, aggressive cross-selling, and cheap checkout tricks were compromising repeat purchase rates, diluting lifetime customer values, and attracting low quality customers looking for an easy deal…basically, a leaky bucket that required constant infusions of customer acquisition spend that management did not think was sustainable. And so, Cimpress made significant investments in packaging, product quality, and user experience on the site.  It dramatically reduced what it charged customers for shipping, which at the time apparently made up a “very material portion of revenues”, and introduced less jarring discounts on more transparent list prices.  These actions were meant to chase away the cheapskates who only cared about price, leaving the company with a more loyal and satisfied core more apt to repeat purchase.  Didn’t really work.  Despite some operational improvements – quality complaints, production throughput times, late deliveries all improved –  organic revenue growth slowed from 22% in fy11 to 20%, then 12%, then 4% over the subsequent 3 years.  Gross margins declined a bit, EBITDA margins declined a lot.  Buyer repeat rates actually declined from 30% to 26%.  Management’s initial expectations for $5 EPS (representing 20% annual growth over 5 years) and $2bn in revenue by fy16, would clearly not come to pass. That brings us to Act II. 

Sometime in fy13, the company embarked on an effort to disaggregate its tech platform into a set of software microservices appropriately named the Mass Customization Platform (MCP) as part of a broader effort to centralize all sorts kinds of functions – product management, order routing, fulfillment, commodities procurement – across its 20+ brands:

“…our vision for MCP is to be a constellation of modular, reusable and independently functioning software components and related services which is analogous to a well-organized set of interchangeable Lego blocks. This platform will sort millions of heterogeneous incoming orders into homogeneous specialized production streams which, thanks to the automated workflow and the regular repetitive production steps we can enable, will embody the principles of mass customization. Yet, the overall platform needs to remain reconfigurable and modular to ensure the relevance to a wide variety of applications….what we are doing is we are frankly trying to break the businesses which we bought, not just Vistaprint, but each of the individual companies we bought, into the component parts of the merchant, the customer-facing business unit with the brand and the fulfiller, and then to reconfigure all the IT systems so that those can…act as a routing layer between those.” – Robert Keane, Chairman and CEO (Cimpress Investor Day, 8/10/2016)

Management’s big idea was to create a matchmaking service that would pair the unique, specialized, and often small-sized manufacturing and fulfillment needs of its sprawling internal businesses (“merchants”) – some selling business cards to micro-businesses in the US, others serving graphic design pros in Europe who in turn serve micro-businesses – to its most cost effective option among a network of in-house and third party production plants and shipping/logistics providers.  As the number of fulfillment partners joining the platform expanded, so too would the number of SKUs the company could offer, which in turn would attract still more fulfillment partners seeking production volumes to run through their specialized plants.  Two-sided engagement would lift volumes flowing through Cimpress’ network, bringing procurement leverage to bear against service providers, equipment vendors, and commodities suppliers.

But just 5 months after promulgating this lofty vision during 2016 Investor Day, management conceded that this centralized model, which was intended to increase speed to market and production flexibility, had instead bogged down the company with complexity and bureaucracy.  It announced plans to retreat back to a more decentralized organizational setup wherein production, fulfillment, and product management would be siloed once again by brand, though non-core corporate functions (finance, legal, major capital allocation), procurement, and the modularized technology platform would remain as shared services across banners.  Now the thinking is that decentralization will unleash “entrepreneurial energy”, ensure accountability for results, and improve customer satisfaction.  And that’s where we are today. Mistakes have been made, that much is clear.  The company’s acquisition of DIY website builder Webs.com, one of it’s largest, seems particularly ill-conceived.  Website building is a high gross margin business that pure-plays struggle to monetize because lofty customer acquisition costs eat up all the profits.  But Cimpress believed it could do away with much of these advertising costs by cross-selling web services into its existing customer base, because in management’s own words “…a website is the same as a brochure, but it’s a digital version of that.” 

But of course, a website is more than just another marketing tool that you toss into the shopping cart as you purchase signs and business cards; it’s increasingly the entire digital storefront and a critical system of record.  The companies that do well in website building either own critical on-ramps like domain registration (Godaddy) or offer kick-ass functionality further up the stack, with sophisticated, friction alleviating technology and/or 3rd-party app integrations (Wix and Shopify).  And there’s a reason why website builders don’t bundle business cards…not only are these offerings not a natural point of integration, but doing well in either area involves entirely different processes. I’m not rehashing Cimpress’ somewhat ignomonious capital allocation and strategy choices with snark (or I at least hope it doesn’t come across that way).  On the contrary, I think it’s admirable that this management team at least attempts to take an earnest look at its shortcomings, fesses up to them, and experiments with new ideas.  I bring this up just to frame the difficulty of growing through a continuous product introductions and simultaneously extracting scale economies. 

At one extreme, the company could have just stuck to business cards and closely related paper-based products, gaining a little more production leverage every year and steadily improving its gross margins…but growth would have inevitably slowed and then reversed as the market for business cards is in decline and Cimpress’ business card revenue growth has decelerated significantly over the last decade. But then, proliferating product categories to boost volume growth makes scale economies harder to come by.  Through the acquisitions that now comprise its Upload and Print segment, Cimpress multiplied its SKU count by 300x, and the number continues to grow at a rapid pace.  The scale benefits attending homogeneous manufacturing and fulfillment processes attenuate as you start offering different substrates and formats, and especially as you expand into banners, apparel, pens, magnets, and other trinkets made of entirely different materials, manufactured through a different process with different equipment in different countries.  I think the company recognized this long ago, hence its emphasis on higher quality products to customers with better lifetime values; but I also think it’s fair to say that management underestimated how difficult it would be to reap the benefits of mass production over so many diverse product categories. Check out their margins over time…

The nosedive in gross margins can be mostly explained by investment in design services and a mix shift towards Upload and Print, which has been growing faster than Vistaprint and is more dependent on outsourced production.   But, this segment also has lower sales and marketing costs per order than Vistaprint and all else equal, the two segments should have comparable EBITDA margins…but those have declined considerably as well over the last decade, even as Cimpress has shown some sales & marketing and G&A leverage over time.  I think this can be at least partly explained by shipping, which runs through gross profit.  The company is loath and perhaps embarrassed(?) to reveal how much money it was making on shipping, but assuming average shipping price charged to the customer of $10 and an average order value (back when management still revealed this figure) of around $35, it was clearly significant. 

I don’t imagine its own shipping costs have changed by nearly as much, and so providing relief to its own customers likely translates to a mostly direct gross profit hit.  Also, losses from the “all other business units” segment, which houses speculative investments, emerging markets, partnerships,  continue to grow, from -$9mn in fy16 to -$36mn LTM.  Finally, digital products and services (Webs.com I assume?) has witnessed significant revenue declines. Except for maybe losses in emerging markets, which are still small and sub-scale, none of the above mentioned causes of margin compression will reverse, so the high-teens EBITDA margins of the mid/late 2000s are likely a thing of the past.  Management does not deny this and, in the face of persistently declining margins, now directs investors to think instead about dollar profits, retention rates, and lifetime customer values, tacitly acknowledging that ever more of the scale benefits are shifting from production leverage to value-add per customer. Cimpress’ last 10-K (year ending June 2017) reveals 17mn customers served by Vistaprint, which means the number of unique customers hasn’t budged since fy14.  However, Vistaprint’s revenue has grown by over 25% over that time, implying that revenue per customer has gone from $65 to around $80.  Management does not break out gross profit or opex by business segment in its financials, but we do have this useful exhibit from the last Investor Day:

The buyer repeat rate, at between 30%-35%, is so low that one wonders whether the lifetime value of customers is really the right metric for management to focus on, but let’s just go with it.  So if revenue per Vistaprint customer is $80, then it looks like gross profit per sub is close to $50.  Assuming a 10% discount rate and that 35% of buyers make repeat purchases [I’m assuming it’s higher than the 31% rate the company disclosed for fy17] implies an LTV per customer of $73.   Before the company went on its acquisition spree and it was just basically Vistaprint, the cost of customer acquisition was around $24, suggesting an LTV:CAC of ~3x.  Once you factor in higher recurring costs of supporting today’s relatively higher quality customers, the ratio is probably closer to 2.5x(?), right at the cusp of acceptability.  To put that in perspective, Trupanion is at ~4.5x, Godaddy is over 5x. [Founder and CEO Robert Keane writes the kind of letters that value investors just eat up, chock full as they are of Buffett-esque straight talk and verbiage.  But I’ve actually found disclosure to be frustratingly inconsistent.  For instance, up until fy14, the company provided metrics on average order values (AOV), order volumes, repeat customers, bookings per repeat customer, and other good stuff.  They stopped regularly disclosing most of this in fy15, defending the move by maintaining that a metric like $AOV doesn’t provide much insight because there are so many businesses besides Vistaprint.  Like, huh?  Vistaprint still represents 65% of revenue, 80% of segment profits, and the majority of organic investments.  And even if that weren’t the case, why stop disclosing the very data required to estimate lifetime value at precisely the time in the company’s history when it is explicitly targeting this metric?]

As mentioned earlier, Cimpress’ acquisitions and organic investments over the last 5-6 years appear to have impaired value, with returns on incremental capital falling short of capital costs, and over time, we see that the company’s returns have deteriorated rather markedly in even the last few years.  And they are way below the the 30%+ returns the company was realizing before its spree.  Meanwhile, over the last 5 years, organic growth has been cut nearly in half, from 20% in fy12 to ~10%/11% LTM.

[“adjusted” because the numerator excludes restructuring charges; acquisition related earn-outs, amortization, and depreciation; and impairments] But that hasn’t stopped valuation multiples from doubling over that period.

But perhaps I am throwing excessive shade.  While I think Cimpress is a worse company than it was 5-10 years ago and its mass customization platform is maybe not quite what was promised, it’s still hard to imagine a competitor rivaling Cimpress’ scale advantages, and I think the company will continue taking enough share to deliver high-single/low double-digit organic revenue growth for the foreseeable future.  Founder and CEO Robert Keane, who owns 10.5% of the company and owns the same number of shares as he did 7 years ago, has significant skin in the game.  The company has retired nearly 30% of its shares over the last 7.5 years in the low-$40s. Using the high-end of management’s estimate of investments required to grow free cash flow by at least inflation, LTM mFCFE per share is around $8/share [1], so the stock trades at ~20x, which doesn’t seem too demanding a valuation given the company’s competitive positioning and growth opportunities.  Cimpress recently reported an outstanding quarter across all reported segments, suggesting budding traction with its decentralization initiative.  But I frankly have no idea if this inflection is sustainable. 

Given the pronounced deceleration in core legacy business cards, where the engine of mass customization was applied beautifully for the first 15 years of the company’s life, diversifying into far flung SKUs may have seemed sensible at the time….they were squeezing less juice from scale economies but could compensate for that by moving upmarket, offering a value-added bundle proposition with a heavier service component.  But in retrospect, shareholders would probably have been better off if management just maximized the hell out of lower organic growth and plowed excess capital – capital that could not be reinvested into core Vistaprint – into share buybacks rather than acquisitions. [1] Estimating relief under the new US tax law is tricky because the company already reallocates income across a sprawl of geographies to minimize its tax payments.  Cimpress derives just 40% of its revenue from the US and over the past year paid just $40mn in cash taxes on $180mn in pre-tax cash profit, so I’m not so sure the new rule will meaningfully benefit the company.

[TripAdvisor, Trivago, OTAs] Thoughts on the Carnage

Posted By scuttleblurb On In SAMPLE POSTS,[TRIP] Tripadvisor,[TRVG] Trivago | 1 Comment

Trivago’s “relevance assessment dimension”, implemented in late 2016, is an algorithmic adjustment that compels hotel advertisers to improve their landing sites and booking engines if they want to rank higher in trivago’s search results.  The idea is that while the user experience starts with a room search on trivago, it extends to when she clicks off to actually book the room on the advertiser’s site…so if the advertiser screws up that last step (according to trivago), it will have to pay more for each referral.  One consequence of this change was that trivago penalized OTAs whose links sent users to yet another page of search results on OTA.com rather than directly to the property that the OTA listed on trivago.

While trivago technically has 200+ advertisers competing for placement in its marketplace, two of them, Expedia and Priceline, respectively comprise 36% and 43% of the company’s revenue. [Expedia acquired 63% of trivago from early investors in 2013 and continues to own 60% of the company post its December 2016 IPO].  It’s usually not a good idea to behave like a powerful aggregator towards two dominant customers who actually are powerful aggregators when you, actually, are not…but that’s essentially what trivago did, tasking its algorithm to extract the most value from advertisers in zero-sum fashion while providing CRM, bidding, and booking tools for smaller hotels – including “express booking” where trivago actually hosts the booking site on behalf of the advertiser – to compete more effectively against the OTA giants with the aim of stoking greater bid density and pushing the agencies, in trivago’s own words, towards “the pain points of their profitability targets.”

In the first several quarters after implementing relevance assessment, trivago saw qualified referrals ~+60% y/y and revenue per qualified referral (RPQR) growth of +4%-4.5%.  The company admonished that RPQR would be lower (or, euphemistically, “normalized”) in the second half of 2017 since as advertisers adapted their sites to trivago’s relevance assessment standards, they would be not be required to bid as much for traffic.  No big deal.  But then things took a turn for the worse.  On 9/6/17, trivago announced that revenue growth for the full year would be more like 40% instead of 50% and EBITDA would be lower than guided too, as the RPQR hit turned out to be worse than expected.

The charitable interpretation to this bleak outcome, the line that management continuously parrots to investors, is that by optimizing the user experience, trivago is nobly sacrificing near-term profits for the sake of long-term gain.  Management understands that having loyal users is the key to spinning up a platform that gives you license to marginalize suppliers (advertisers, in this case), and so trivago is splurging on TV advertising [over 90% of the company’s revenue is dedicated to sales and marketing], assiduously monitoring the results, and iteratively tweaking campaigns towards the aim of building brand value.  At the same time, by adjusting its bidding algorithm and forcing suppliers to play ball, it is ensuring that users have the most seamless search and booking experiences possible.

But it’s not clear to me why Trivago feels uniquely positioned to accomplish the task of creating memorable ads or whatever it is that they think drives persistent site visits.  Because unlike, say, a SaaS model, where the journey from site visits to free trials to paid subscriptions sucks the user into ever deeper states of captivity that can, in theory, generate sticky, layered recurring revenue streams, what is the lock-in mechanism here?  At least TripAdvisor can claim authentic and current user-generated reviews.  Google began with a superior mousetrap and didn’t need to spend gobs on advertising to attract users (plus, because general search is so frequently used, it is habit-forming in a way that travel-specific search is not).  Trivago’s vertical search has, well…what exactly…to keep users continuously coming back once they have clicked off the site?  And furthermore, what can’t be replicated?  Expedia offers its own version of relevance assessment, its Accelerator program encouraging hotel properties to graduate up the Expedia listings page by paying extra commissions or by improving quality scores.

Growth in qualified referrals and referral revenue have decelerated in dramatic fashion.  No bueno:

[Definition of qualified referrals from the F-1: “We define a qualified referral as a unique visitor per day that generates at least one referral. For example, if a single visitor clicks on multiple hotel offers in our search results in a given day, they count as multiple referrals, but as only one qualified referral. While we charge advertisers for every referral, we believe that the qualified referral metric is a helpful proxy for the number of unique visitors to our site with booking intent, which is the type of visitor our advertisers are interested in and which we believe supports bidding levels in our marketplace.”]

And with that, the potency of trivago’s brand advertising also appears to have waned, as the company experienced significant y/y de-leverage on sales and marketing in the latest quarter and declining returns on ad spend over the last 2 quarters:

ROAS weakness also happens to coincide with TripAdvisor’s renewed commitment to brand advertising this year, so on top of volume weakness, perhaps TRVG is also witnessing pricing pressure on ad units? [After spending $51mn on TV advertising in 2015, TripAdvisor reallocated marketing dollars to online search and spent nothing at all on TV in 2016.  They’re committing $70mn-$80mn this year as part of a multi-year brand ad campaign]. 

If online travel were fragmented up and down the value chain, then being the first to spend aggressively on brand advertising for the sake of creating a liquid marketplace that then itself becomes the value proposition, might just work.  The numbers are tempting.  Global online hotel bookings of ~$145bn comprise around 1/3 of the total offline + online hotel bookings and are taking share from the offline channel.  At a 15% take rate, that’s a $22bn addressable market growing low double-digits annually.  On its current revenue base of $1bn, claiming even a small share of that could drastically move the dial.  But the question of course is, can you grab share at compelling economics?  I don’t understand the fundamental value proposition offered by trivago that cannot be offered equally well by many other top-of-funnel peers or even further down-funnel for that matter.

This is why I find I Trivago’s competitive positioning so precarious: it doesn’t possess the bargaining power to procure traffic at advantaged cost nor an irreplicable process to transform that traffic into value so compelling and unique that even their powerful customers will cede economic ground.  Online travel is increasingly dominated by aggregators further downstream who have myriad acquisition channels – including Facebook, Google, and direct brand advertising – through which to lure travelers.  And as in any highly competitive market, attempting to generate sustainable value off brand advertising is an unwinnable game unless there is a differentiating resource at the core.

At the Citi Tech Conference last month, when asked about competitors recently copying trivago’s strategy, the company could offer only the following effete non-statement:

“I think the only sustainable competitive advantage that you can have is to continue to be ahead of your competition. And so, the competitive response is to continue to innovate in marketing and in product and make sure that there is always a gap between yourself and competitors that are copying what has worked very well for you. I think that sounds generic, but I think that’s the only thing you can do.”

TRVG’s management maintains that its can sustain 25% EBITDA margins at some point (better than Expedia’s high-teens EBITDA margins).  I doubt it.

TripAdvisor is the Twitter of online travel: a unique, hard-to-replicate asset that eludes monetization but has significant strategic value.  There’s clearly a double marginalization problem to be solved via vertical acquisition, which TRIP Chairman Greg Maffei seems open to.  And that might really be the primary reason to hold on to the stock.  Well, that, plus the non-hotel side of the business (attractions + restaurants) is killing it, growing revenue by 25%-30% over the last year and solidly profitability.  That business is probably worth ~$1.5bn (4.5x revenue), leaving $2.4bn in enterprise value for a hotel business, one facing revenue and cost pressures, doing around $200mn in EBITDA (after stock comp).  By comparison, trivago’s enterprise value is $1.8bn, and they’re doing only $13mn in EBITDA.  The value disparity makes little sense.

[Re: “hard-to-replicate”, as I previous wrote:

“Over 360mn people visit the company’s site every month to plan their trips because they trust its deep fount of nearly 500mn authentic and current user-generated reviews and 90mn photos on 7mn hotels, attractions, and restaurants.  Those travelers, upon completing their trips, post their own reviews, contributing to a burgeoning body of shared knowledge that drives traffic through better search engine rankings and compels still more potential travelers to visit Tripadvisor at the start of their research process.  The company further stokes participation by offering badges and other marks of distinction to particularly helpful and active reviewers.  Hoteliers, well aware of Tripadvisor’s critical top-of-funnel role, make a special effort to respond to consumer reviews.  If you’ve stayed at a hotel boutique, you will have no doubt been encouraged at some point to leave a review on Tripadvisor by the hotel manager, who often proudly plasters the property’s Tripadvisor rating on the front window as a point of differentiation.  It would be monstrously difficult to recreate the breadth and depth of TRIP’s reviews.”]

[“Monstrously difficult”?  A bit hyperbolic on my part.  In theory, I guess I don’t really see why the Priceline, which already has over 135mn hotel reviews, couldn’t expand its share as it garners more direct traffic through brand advertising]

In prior quarters, the y/y decline in TRIP’s revenue per hotel shopper was largely attributed to a mix shift from desktop to mobile, a concern alleviated by the hope that mobile monetization improvement would eventually overcome such dilution.  But now, bid-downs by Priceline, which is shifting ad dollars to brand advertising after years of diminishing ROI on performance marketing, have whacked monetization on the desktop side and confounded several quarters of positively inflecting trends.

After a two-year hiatus, TripAdvisor also recently began splurging on TV advertising…so, on top of getting hosed by its largest customer on the revenue side, TripAdvisor is now competing with Priceline for TV ad spots as both pursue a common goal of driving more direct traffic to their own sites.  It’s hard not to be cynical about TripAdvisor’s standalone role in the value chain.

So, with trivago implicitly raising bid prices and both trivago and TripAdvisor trying (and, in the latter case, failing) to encroach directly upon bookings, it appears that Priceline is finally saying “nuh-uh” and using bid downs as part of a bargaining tactic to keep suppliers in check.  Whether the shift from performance to branded advertising is structural seems inconclusive.  Recent comments from Priceline CEO Glenn Fogel:

“I think one of the things very important to recognize is the dynamic nature of how the performance marketing works. So while we can make change in terms of how much money we want to spend and we where we want to spend it, our partners are also making changes all the time, and other people and auctions are making changes. So, this is dynamic and interactive, so it’s difficult to project long term what’s going to happen.”

Still, Priceline has been talking about pressure on performance ad returns for some time and even as Expedia professes loyalty towards trivago as an acquisition channel, it admits that meta search generates lower “repeat propensity” than search engine marketing.  In any case, what seems abundantly clear is that TripAdvisor and trivago, who derive 46% and 79% of revenue, respectively, from Priceline and Expedia, are really in no place to dictate terms.  Generating extra-normal profits as standalone entities, like the kind implied by the obligatory “small x% of big $TAM” exhibit that these guys all like to use, requires TRIP and TRVG either claiming a fair share of extraordinary surplus or an unfair share of modest surplus.  The absence of a uniquely compelling value proposition impedes the former; industry structure constrains the latter.

Implicit in my TRVG/TRIP bashing, however, is that value in the this industry accrues a level below and in that spirit, Expedia could be interesting.  EXPE sold off last week as the company noted that its cost structure would be larded with investments related to accelerated hotel on-boarding [3 years ago, EXPE was adding 25k-30k hotels / year, this year it’ll be 80k, and will “step change” in future years], cloud computing [a 2-3 year transition.  $100mn this year, much greater than management’s guidance a year ago, growing by over 50% next year], and marketing [as management turns its attention to deepening local marketplace liquidity after years of broad-based acquisition].

Expedia isn’t the cleanest company with the strongest moat – the core OTA is dependent on Google for traffic and faces competition from a consolidating supplier base, HomeAway is up against AirBnB, tech stack integration across a slew of acquisitions appears to have been sloppy – but as the second largest OTA by bookable properties next to Priceline, the company has certainly crossed the threshold of critical scale and fostered a sustainably profitable two-sided marketplace.  Disintermediation concerns stemming from an increasingly consolidated supplier base and worries about Google/Facebook aggressively moving into the space, have plagued OTAs for years…but Priceline and Expedia have done just fine as continuous investment in technology, marketing, hotel relationships, and vigorous A/B testing have congealed into a hard-to-replicate value proposition for suppliers looking to offload inherently perishable inventory and travel shoppers looking to dependably source the broadest, most relevant selection at the lowest price, with increasing participation on each side of the platform begetting buy-in from the other.

[Re: A/B testing, as one Twitter friend put it…

HomeAway, acquired for what seemed like a pricey $3.9bn in December 2015, has been growing rapidly (+40%-50% y/y) and profitably in the face of competition from AirBnB and Priceline, and now seems like a pretty smart buy.  And Expedia is still in the process of making all ~100k vacation rentals available exclusively online (some bookings are currently arranged offline between guest and host) [20], and has not yet really begun to pursue international markets or fuse Homeaway listings with inventory from its core OTA sites in cities.

When I strip out trivago and stock comp (see below), it looks like Expedia is trading for around 11x EBITDA and 17x FCFE, which seems reasonable to me even if we grant that EBITDA growth will slow to the bottom end of the +10%-20% range (or even somewhat below) for the next few years on accelerated spending…and it looks quite cheap if we think that by weaning itself off acquisitions, dedicating itself to organically deepening engagement, broadening the platform through aggressive on-boarding, and boosting overall productivity by partly shifting its tech infrastructure to the cloud, Expedia can drive accelerated bookings growth and margin expansion 3 years out.  At the very least, I think we can be far more confident that Expedia’s investments offer a reasonable return than that trivago’s continuous spending on TV commercials will ignite sustainable platform activity.

($ millions except per share data)

EXPE TEV ex. TRVG cash           19,159
TRVG stock price $            7.17
x # TRVG shares owned by EXPE                 209
=             1,499
Adj. EXPE TEV           17,661
EBITDA ex. TRVG             1,589
FCFE ex. TRVG             1,249
Stock comp ex. TRVG                 135
EXPE FCFE ex. TRVG ex. stock comp             1,114
/share $           7.06

You can also own Expedia through Liberty Expedia (LEXEA), which owns 15.5% of Expedia’s common stock representing a 51.9% voting interest in Expedia…but, I don’t think there’s a compelling “arb” here.  LEXEA split off from Liberty Ventures a year ago for the purpose of Expedia eventually purchasing LEXEA’s EXPE shares.  Liberty Expedia also owns an internet retailer of health and dietary supplements called Vitalize (formerly known as Bodybuilding.com), which, based on declining revenue and profits, isn’t doing so hot, and has deteriorated to such an extent that it is small enough to be unceremoniously lumped into “corporate and other”.  It does around $316mn in trailing revenue with negligible OIBDA.

You are getting 0.41 shares of EXPE for every 1 share of LEXEA that you own.  LEXEA also has around $5.40 in net debt / share.  So the NAV breaks down like this…

 Expedia $          50.43
 Net debt $          (5.36)
 Vitalize ???
 Total $          45.07

…vs. LEXEA’s current share price of $46.  The delta between NAV and the LEXEA share price values Vitalize at around 0.2x trailing revenue.  Seems fair.  Whatever.

Priceline’s stock also sold off post-earnings on decelerating bookings (from ~mid-20s y/y ex. fx growth over the last 4 quarters to 16% in the latest quarter).  While size constraints may translate into slower growth relative to the past, there’s plenty of runway ahead.  Its largest online property, Booking.com, has an insurmountable moat in a fragmented European market [in Europe, independent lodging comprises 67% of total rooms vs. 30% in the US] where I estimate it claims around 40% of European online accommodation bookings, or about 20% of total European bookings.  Globally, Priceline’s ~$80bn of total gross bookings is just 20% of online hotel bookings, or about 6%-7% of total online + offline.  Room nights +19%, the number of bookable properties +41% (including vacation rentals +58%) during the most recent quarter, and the meta properties, Kayak and (more recently) Momondo, are growing and profitable.  OpenTable, on which the company took a huge impairment charge last year, has sucked, but I think we’re past that.  I don’t see any meaningful impediments to Priceline continuing to grow its cash earnings per share by mid-teens+ for the foreseeable future.

So yea, setting aside the takeout aspect for TripAdvisor and just evaluating these companies on their standalone long-term value creation potential, I would  rather own Priceline (17x EBITDA backing out long-term investments, including Ctrip) or Expedia (11x), respectively, than either Trivago (NM) or TripAdvisor (17x).


Posted By scuttleblurb On In SAMPLE POSTS,[IAC] IAC,[MGM] MGM | 3 Comments

There was a time, not too long ago, when an investor could treat IAC as a collection of binary early stage bets anchored by a few more mature and profitable entities. To most, IAC’s 12% passive minority stake in MGM, acquired near the COVID lows, was a weird one-off opportunistic gambit that could be marked to market. The real diligence was saved for Angi’s, DotDash, and Vimeo. I don’t think many felt compelled to deep dive into casinos because like, whatever, the $1bn MGM investment comprised just ~9% of IAC’s market cap at the time and it felt like most of the upside was going to come from IAC’s digital assets, not a passive minority stake in a mature brick-and-mortar casino operator. Psych!! Now Angi’s is melting away as its fixed price offering, launched to great fanfare 2-3 years ago, struggles to find product-market fit. DotDash no longer expects to hit its $450mn EBITDA target next year given the weakness in brand advertising. Vimeo has lost ~90% of its market cap since being spun off last May, as losses have widened, growth has dramatically decelerated off tough COVID comps, and investors have soured on unprofitable growth concepts. Meanwhile, MGM shares have nearly doubled from the ~$17 price at which IAC first accumulated shares in 2q and 3q 2020. IAC has since added to its MGM stake, first at $45 and more recently in the low-$30s. With valuations in digital growth assets wrecked and its own stock price sliced in half, IAC could have opportunistically acquired another digital lottery ticket or more aggressively repurchased (more of) their own shares. But no. They increased exposure to MGM instead. Today, the $2.1bn MGM position accounts for 35% of IAC’s market cap, making it the second most valuable asset in the IAC complex after DotDash.

MGM is a set of cash flowing retail casino properties plus a call option on a nascent but potentially massive online sports betting and iGaming opportunity through its 50% ownership of BetMGM. Through its Las Vegas Strip (LVS) segment, MGM operates 9 casino resorts, with Aria1 [21], Bellagio, MGM Grand, Mandalay Bay, and The Cosmopolitan the most notable and profitable among them. The Regional segment consists of 8 casinos, with The Borgata (Atlantic City, NJ), MGM Grand Detroit (Detroit, MI), and MGM National Harbor (Prince George’s County, MD) contributing more than 60% of Regional’s pre-COVID segment EBITDA.

Las Vegas has come a long way from the mob-run cesspool portrayed in the 1995 classic Casino. In his concluding monologue, Sam Rothstein, head of the (fictitious) Tangiers casino, laments:

The town will never be the same. After the Tangiers, the big corporations took it all over. Today it looks like Disneyland….After the Teamsters got knocked out of the box, the corporations tore down practically every one of the old casinos. And where did the money come from to rebuild the pyramids? Junk bonds.

Today’s Las Vegas is an entertainment destination, host to an NFL team, dozens of industry trade shows, megastar concerts, and Michelin Star Restaurants. Profits have migrated away from low and mid-tier casinos like Circus Circus and Westward Ho, toward properties that resemble luxury cities, with high end retail spaces, restaurants, and other posh amenities enveloping conference attendees, high rollers, and Asian tourists, a favorable development for MGM and Wynn, whose Vegas portfolios tilt fancy.

Regional properties are more for the dead-eyed locals. Atlantic City and certain high-end 100k+ square foot casinos like MGM’s Borgata and National Harbor have a regional “destination” feel to them I suppose, but there are hundreds of others – like the Ameristar and Hollywood branded locations run by Penn Entertainment or the Isle of Capri and Harrah’s casinos run by El Dorado (now Caesar’s) – that attract middle-income gambling-oriented clientele in a ~100 mile radius.

So while MGM’s LV segment gets nearly 3/4 of revenue from non-gaming sources – hotel rooms, food, beverage, entertainment, and retail – close to 80% of Regional revenue comes from gaming.

You’ll notice a similar disparity at Wynn and, to a lesser degree, at Caesar’s, which latter operates shabbier Vegas properties like Flamingo (will probably be sold soon), Bally’s, and Paris that don’t attract as much food and retail traffic.

The gaming industry has consolidated over time, with acquirers binding disparate casino properties together through loyalty programs, keep players engaged in an ecosystem. Through the MGM Rewards – the second largest gaming rewards program after Caesar’s, with ~35mn members – regional casinos can feed traffic to destination resorts, as the rewards earned by gambling at Beau Rivage can be redeemed for concerts or room discounts at the Bellagio or Aria.

Here’s a pre-COVID summary of the top casino operators in the US:

Source: Caesar’s/El Dorado merger presentation

MGM is in the middle of the pack in terms of property count, but generates the most EBITDAR per property with 3 of the 5 most profitable Vegas assets, and commands leading ~50% share of the Vegas gaming market, which is in a much better state today than it was heading into the last recession. Back then, Vegas was flooded with supply, with MGM, in partnership with Dubai World, breaking ground on City Center, an 18mn square foot hotel-casino-retail-residential colossus2 [22] whose development costs exploded from $4bn to $9bn just as the economy tipped into recession. Exacerbating matters, another luxury casino resort, The Cosmopolitan, opened its doors just a year later in 2010. Since then, with the exception of Resorts World last year, there haven’t been any notable capacity additions and by most accounts there won’t be for at least the next 5 to 10 years. The returns just aren’t as compelling as they used to be. The Bellagio, the most profitable casino in Vegas, generated ~$500mn of EBITDAR at its pre-COVID peak on a development base of just over $2bn. If Resorts World is any guide, a comparable property would cost more than twice as much to develop today.

Following a brief COVID blip in 2020, Vegas is booming again. MGM’s LVS EBITDAR margins, at 38%, are 7-8 points above their pre-COVID peak on record revenue, even with cross-border travel restrictions deterring high-spending Asian gamblers and traffic from convention attendees, who are among the most profitable customers, ~1/3 below pre-COVID levels.

Source: Las Vegas Convention and Visitors Authority (link [23])

MGM isn’t alone. Caesar’s and Wynn have also reported record Vegas profits. Some of the margin gains are due to sustainable cost cutting and efficiency gains – things like self-service check-ins and the cessation of daytime entertainment and buffets and whatnot. But I think most of it can probably be attributed to temporary COVID spasms. Operators haven’t had to invest as much in promotions and marketing to lure pent-up demand and Average Daily Room rates are 36% above 2019 levels.

The Regional properties are also enjoying record margins but facing tough comps as locals apparently dumped their stimulus checks on slots and blackjack last year. But if the last recession was any guide, gaming revenue at regional properties tend to be relatively resilient.

Source: PENN Entertainment presentation (8/2/22)

In addition to its US properties, MGM also owns a 56% stake in MGM China, which operates two casinos in Macau that derives ~80% of revenue from gaming. The Macau gaming market, once the world’s largest, has been decimated by draconian COVID restrictions that include occupancy limitations, temperature checks, quarantines for mainland Chinese residents. The Chinese and Hong Kong governments suspended group tour travel and ferry service. The consequences have been predictable. MGM China did -$66mn of EBITDAR over the last 12 months, down from $735mn in 2019. The Hong Kong listed stock has lost ~80% of its value since the start of 2018. With Macau and China lifting some restrictions in recent months, I’m inclined to think the worst has past. But even if I’m wrong MGM still looks pretty dang cheap:

And I guess MGM’s management thinks so too as they’ve raised capital through a series of transactions (see below), including the sale of the operations of The Mirage and Gold Strike for 17x and 11x EBITDA, respectively, to retire 31% of its shares since early 2021 at ~5.5x EBITDA.

(the most significant source of cash has come from the sale of MGM’s operating partnership units of MGM Growth Properties (MGP) – an umbrella partnership REIT [24] that owned 7 of MGM’s LVS properties – to VICI Properties, another REIT formed in 2017 as part of Caesar’s bankruptcy restructuring, who is leasing back the properties to MGM. The real estate of MGM’s other 2 properties, Aria and Bellagio, is owned by Blackstone. Today, all of MGM’s domestic properties are owned by either VICI or Blackstone-affiliated entities. Sale-leasebacks have become a common way for casino operators to raise cash. El Dorado funded part of its $17bn merger with Caesar’s by selling casino real estate to VICI).

MGM’s profit margins are probably somewhat inflated and who knows if convention traffic ever reverts to pre-COVID levels. Compressing MGM’s property margins by 5 points and assuming no MGM China appreciation results in a valuation of 7.6x US EBITDA / 20x mFCF, which still seems reasonable for a collection of high-end casino resorts, bound together by a huge loyalty program, that gush cash as part of a consolidated industry structure. Admittedly, the US retail gaming industry is saturated, with few avenues for organic growth. But MGM has a few aces up its sleeve ;).

First, 15 years after it first actively explored development in Japan, MGM, together with its local JV partner ORIX, was finally selected by Osaka to build one of the country’s first integrated resorts. Several other US operators have tried to crack the Japanese market over the last 20 years, to no avail. Las Vegas Sands withdrew its bid in Osaka [25] to pursue development in Tokyo or Yokohama before pulling out of those cities as well in May 2020. Wynn also dropped out of Osaka in 2019 after a decade of “working on Japan quietly behind the scenes”3 [26]. They claimed to be pursuing something in the Tokyo region, but haven’t followed up on this for years. Caesars withdrew from Japan following its merger with Eldorado, with Eldorado CEO Thomas Reeg cautioning analysts that they had “not made firm decisions on the international front”. But then soon after MGM won over Osaka, the company announced it was back in the game [27], working with Clairvest, former Las Vegas Sands executives, and a consortium of developers to build something in Wakayama.

Should the MGM-ORIX bid be approved by Japan’s central government sometime in the next few months, the consortium expects to break ground in late 2023 and open in 2029. This is a big deal. At an expected cost of $10bn, Osaka will quite possibly be the most expensive casino ever built. The project will likely be funded 50/50 between MGM and ORIX (or 40/40/20, with the 20% stub funded claimed by a yet-to-be-determined group of Japanese companies). Assuming its 50% share is 55% debt-funded, MGM will contribute around $2.25bn. I think the most expensive casino resort built so far in Asia is Wynn’s Marina Bay Sands (Singapore), which opened in 2010 at a cost of $5.8bn and did $1.7bn peak EBITDA on a $3bn revenue base. At 30% of gross gaming revenue (or “GGR”, amounts wagered minus amounts won by gamblers), Japan’s gaming tax rate is considerably higher than Singapore’s, which ranges between 8% and 22% [28]. So maybe on a $10bn investment, the Osaka mega-resort delivers something like ~$6bn of revenue and ~$2bn of EBITDA. At 8x EBITDA, MGM’s 50% stake is worth $8bn, the equity portion ~$5bn, translating into ~$1.2bn of incremental equity value when discounted back 8 years at 12% (compared to MGM’s present ex. MGM China market cap of $12bn).

Possibly more significant is the latent value in MGM’s 50% ownership of BetMGM, an iGaming (online casino) and online sports betting joint venture with UK-based online gaming operator Entain4 [29]. Since the Professional and Amateur Sports Protection Act (PASPA) of 1992, which prohibited online gaming activity in most states, was overturned by the Supreme Court in May 2018, online sports betting has been legalized in 25 states. To the degree that Daily Fantasy Sports, which is regulated in 43 states, is a leading indicator for OSB we may see more states follow suit.

Source: actionnetwork.com [30], as of 8/1/22

Online sports betting is now accessible to ~44% of the US population. Should Proposition 27 pass in California this November – which seems probable given that 58% of Californians supported the ballot measure, as reported by BetMGM management in May – penetration will ratchet to ~56%. This should be particularly good for BetMGM as Vegas traffic and MGM Reward’s membership over-indexes to California.

Without the cultural entrenchment of sports, iGaming acceptance has been harder to come by, legalized in just 7 states5 [31].

Wynn tried to offload its OSB/iGaming division last year to a SPAC run by Bill Foley (of Fidelity National fame), but the deal was called off months later. At the moment, Wynn Interactive is run-rating at just $80mn in revenue (compared to $1.6bn of LTM revenue at DraftKings and $1.3bn of expected 2022 revenue at BetMGM) and isn’t losing nearly enough money to make me believe management is taking things all that seriously. Caesars claims around low-teens share of national sports betting measured by handle (the $ amount of wagers placed) but MGM has some exhibits that suggest Caesars’ share is much lower by GGR. PENN Entertainment, with $547mn of LTM digital revenue and its insistence on responsible growth, hasn’t engaged in promotional land grabs to nearly the same degree as peers, generating -$17mn of cumulative EBITDA on $889mn of revenue since the start of 2019 compared to -$2.9bn of EBITDA on $3.1bn of revenue at DraftKings. There are a dozen others getting after it but by most accounts FanDuel, DraftKings, and BetMGM are so far the primary contenders, with ~75%-80% combined GGR share in OSB and 70%+ share across OSB and iGaming.

Here is Online Sports Betting GGR share by state:

Source: DraftKings Investor Day (March 2022)

Just 4 years since PASPA was overturned, the $32bn addressable US market is fueling vertiginous growth for the leading participants. BetMGM is on pace to deliver $1.3bn of revenue this year, up from less than $200mn in 2020. FanDuel and Draftkings have likewise produced explosive triple digit annual growth.

Source: BetMGM

(DraftKings estimates $26bn of US TAM by applying the OSB and iGaming gross revenue per adult in New Jersey, the most mature online gaming market, to the US adult population and adjusting for differences in per capita GDP).

The growth is not without controversy. The primary bear case is that in their rush to grab share, online operators are spending exorbitant sums on marketing and promotions that can’t be justified by the lifetime value of acquired gamblers. This past January, my friend Andrew Walker called attention to the frenzy of promotions in the newly authorized New York market, observing in his article What the fudge is happening with NY sports betting promos [32]?

Seriously, the betting promos are absolutely bonkers. The headline craziness is Caesar’s / William Hill, [33] which is giving away $300 in a free bet plus a deposit match up to $3k for a total of $3.3k in “free” money. FanDuel will give you $50 free plus a risk free $1,000 bet [34]DraftKings is doing a 20% deposit match plus a free bet that varies in size. [35]

But I don’t understand how businesses can create positive value from the amount of free money that’s being given away. Consider Caesar’s, since they’re the outlier in terms of over quality. They’re givign away free bets; if you assume those bets are ~50/50, they’re effectively giving away $1.65k for a $3k deposit. Now, it’s not quite that bad, since you do need to do some betting to unlock all of that money, so Caesar’s will pick a little bit back in spread fees and everything…. but I just having trouble believing that the average customer Caesar’s is grabbing has a life time value of more than $1.65k.

With sales and marketing expenses more than double its gross profits, DraftKings has been burning cash hand over fist:

(check out the stock-based compensation running at 44% of revenue!)

These financials are a horror show.

DraftKings will retort that 83% of acquired customers retain after 1 year, 70% after 3; that a given cohort, including churned customers, generates 122% of year 1 revenue in the second year, 143% in the third. That doesn’t resolve the lifetime value question since those retention and gross revenue figures may be sustained by ongoing promotions. Also, that BetMGM sees most of its acquired customers churn off in the first 4 months before leveling off – a progression that seems more realistic to me – makes me skeptical of Draftkings’ claims (or at least its presentation of those claims).

BetMGM sometimes trots out this exhibit to demonstrate their strong competitive position across OSB and iGaming:

But what’s more interesting to me is how wildly market share shifts from month to month based on the relative promotional cadence of each participant. To be fair, a bunch of states have legalized gaming over the past year on a low starting base, so a player who gets the jump in a handful of new jurisdictions by bombing new gamblers with promotional offers can quickly find themselves taking meaningful national GGR share even if their competitors do a good job retaining existing customers. Even at a state level, a similar low base effect may be at play. In New York, Caesar’s Digital debuted this year with absurdly generous promotions (see Andrew’s post) to win 41% of GGR, only to see its share fall to 15%-20% as soon as it cut back on marketing. But given how nascent the New York OSB market is, Caesar’s may still find itself losing share even as it retains GGR from existing customers if most of the incremental GGR is picked off by competitors who continue carpet bombing the market with promos. Like let’s say in the first few months of launch, state GGR grows to $10 against an addressable potential GGR of $100, with Caesar’s claiming $4. Caesars can retain all $4 of GGR after it pulls back on marketing and still see its market share reduced to 20% if DraftKings and FanDuel promo their way to winning 80% of the next $13 of state GGR. In short, share volatility may be less indicative of an unhealthy market than an early one.

It’s worth noting that if customer retention sucks, GGR may be a misleading measure of sustainable share because it doesn’t subtract promotions, which latter can be so high that they comprise the bulk of GGR – for instance, in 1q22, Caesars Digital reported negative $53mn of net revenue (as Caesar’s admitted, ”we were more aggressive than we needed to be out of the box”). PENN Entertainment, who has excoriated its spendthrift peers, likes to point out that it has grown share on a Net Gaming Revenue (NGR) basis with a far more abstemious marketing diet.

Source: PENN Entertainment

But this is misleading in the opposite way because PENN’s NGR share will naturally grow in the short-term if everyone else is busy depleting their own NGRs with big upfront promos. And if acquired customers really do retain (and gamble) at high rates without much incremental marketing, then PENN will lose NGR share as state markets saturate and DraftKings, etc. taper off their splashy promos. Notably, since it dramatically curtailed CAC, pulling hundreds of millions that it planned to spend on marketing, Caesars claims that its national handle share has remained steady at around 15%, so maybe it’s had some success leveraging its loyalty program and physical properties to build loyalty with online gamblers.

To me, the most compelling sign that all this promotional spending may earn a return after all is that DraftKings is consistently seeing positive contribution profits (gross profits minus advertising expenses) in states 2 to 3 years after entry, suggesting that promotional costs do indeed taper off as as the number of remaining customers left to acquire shrinks…which of course would only be possible if existing customers didn’t need to be re-engaged at the same cost over and over again. In 2018, its first year in New Jersey, DraftKings reported $10mn of contribution losses on $21mn in revenue; in 2021, they generated $68mn of contribution profits on $239mn of revenue (28% margins). Between 2018 and 2019, DraftKing launched in 5 states. 4 of them were profitable by 2021 and the 5th is expected to be by the end of this year. The 2-3 year ramp to profitability has been observed by BetMGM and Caesar’s as well, with the former realizing contribution profits in just 6 months in Michigan.

So the idea is that digital operators have reported horrendous consolidated losses over the past year because the upfront losses from seeding new, legalized markets are overwhelming the contribution profits from the few, early launch markets of 2018 and 2019. With online gaming now available to most of the addressable US population, the profitability picture is poised to flip around this year and next as the contribution profits from current legalized states more than offsets promotional launch costs in the relatively few remaining states who haven’t yet authorized online gaming but will. BetMGM expects to be EBITDA profitable by the end this year; DraftKings and Fanduel towards the end of 2023 (though with SBC such a huge cost add-back for DraftKings, does it really count?). The precise path of margin improvement is confounded by the timing of new state launches – for instance, marketing and promotional costs from a California launch will absorb profits that would otherwise have been realized from existing states. But at maturity, digital operators expect to generate margins that are comparable to retail casinos.

For this to materialize, Tier 1 operators need to somehow acquire and engage customers in a cost advantaged way. As is true of any consumer facing app, engagement means having a responsive app with compelling content. Some operators might start by renting third-party gaming platform from Kambi or GAN. But to enable differentiated experiences, like variations of in-play betting and personalized gaming, all the majors have or are on their way to fully integrating their tech, with DraftKings acquiring SBTech, PENN Entertainment acquiring theScore as they transition off Kambi, FanDuel leveraging the tech platform of their parent company, Flutter, and BetMGM doing the same with their 50% owner, Entain. Everyone licenses content from IGT, Scientific Games, and Evolution through revenue share agreements but they also seem intent on pushing exclusive first-party games. As of April 2021, 5 of BetMGM’s top 10 titles were created in-house by Entain and Entain content accounted for 25% of BetMGM’s YTD GGR. PENN’s Barstool Casino gets 20% of its handle from in-house games, which it expects to grow to 50%. BetMGM estimates that in-house technology alone provides a 7% to 12% margin advantage over those who rely on third-party platforms.

The Tier 1s can also acquire gamblers at lower cost by piggy backing on existing assets. DraftKings and Fanduel converted their dominant share in daily fantasy sports into dominant share in online sports betting. PENN Entertainment hopes to lure the 20 to 40 year old audiences of popular sports media properties, spending more than $2bn for Barstool Sports and theScore. MGM and Caesars, with rewards programs that boast 35mn and 65mn members, respectively, can cross-promote across online and offline properties. BetMGM players enrolled in MGM Rewards and redeem points from their online play for discounted room rates or concert tickets or whatever at MGM’s regional or Vegas casinos. MGM reports that BetMGM is the largest source of new MGM Rewards enrollees, with over 43% of Rewards sign-ups now coming from BetMGM compared to 33% a year ago. Once ensnared in the MGM ecosystem, sports betters can be cross-sold iGaming and vice-versa. Where iGaming and OSB are allowed, MGM reported in 1q that 44% of online bettors engaged in both. Omni-channel players are acquired at just 30% of MGM’s average CPA and are predicted to be nearly twice as valuable as single-channel players. Finally, in states where they run physical casinos, MGM and Ceasars aren’t burdened with fees6 [36] that pure online operators like DraftKings and Fanduel must pay to land-based operators in order to gain market access. BetMGM believes this provides a 6 to 7 point margin advantage.

Of course, none of these advantages prevent a newcomer from nuking the market with sloppy promos and destroying everyone’s unit economics for a while, though whether they can do so profitably without the scale of current Tier 1s is another matter. There is no reason for a gambler to download apps from no-name Tier 2 operators with no offline complements and inferior content and gameplay experiences, except to take advantage of one-time promos that are unlikely to prove sustainable. ESPN, rumored to be breaking into OSB, has the brand and audience to leapfrog into Tier 1 contention, but they will be starting years behind incumbents who have the tech, mindshare and, at least for MGM and Caesars, an irreplicable physical presence and rewards program. Plus, Disney is already burning billions on their DTC efforts. Do they want to burn billions more scaling OSB at a time when shareholders are whinging about cash flows?

Anyways, given the scale requirements this seems like the kind of market that will eventually consolidate around ~2-4 players. Whether they operate as a disciplined oligopoly is TBD, but at least for now, everyone is swearing off shock-and-awe marketing and committing to adjusted EBITDA profitability by next next year. Caesars is scaling back its cumulative digital EBITDA losses from $1.5bn to ~$1bn. For a while, DraftKings and Fanduel were granted permission to spend profligately while MGM and Caesars, whose shareholders were accustomed to free cash flow, were somewhat more constrained. But now even investors in hyper-growers are punishing growth at any cost (which comes with the silver lining that no new entrant will have the leeway that today’s iGaming incumbents have enjoyed the last 4 years).

Coincidently, DraftKings has guided to the same 30%-35% long-term EBITDA margin guidance that BetMGM has put out there, which doesn’t make much sense. Setting aside that DraftKing’s margin target is totally meaningless as it surely excludes massive stock-based comp, BetMGM has more efficient marketing thanks to its rewards program and doesn’t pay access fees in states where it operates physical casinos. And while DraftKings is already enjoying 28% contribution margins in New Jersey, the 13% gaming tax rate in that state [37] is well below the average 19% sports-betting tax rate in the US [38]. In New York, OSB operators are required to pay 51% of GGR for the first 10 years! DraftKings is also far more tilted to sports betting, whose mid-single digit percent of handle is well below the take rate on slots and table games, though tax rates on iGaming are higher than OSB and iGamers, according to MGM management, are also more expensive to acquire, so maybe it’s ultimately a wash.

Could OSB and iGaming cannibalize retail handle? Well so far, there’s no signs of this happening. Gaming revenue across regional and Las Vegas casinos is at or near record highs. In New Jersey, where iGaming was legalized in 2013, physical casino revenue has steadily grown and actually accelerated in 2019, the first full year of online sports betting.

Source: PENN Entertainment

Even if cannibalization eventually manifests, I think destination casinos like the kind MGM over-indexes to should be relatively more immune than mid-tier properties run by Caesars and PENN. We’ll see.

So look, I’m far from sold. But if the cohort contribution margins of the last 4 years are indicative of how market profitability evolves then iGaming/OSB looks like a call option that is getting more in the money with every passing quarter and, in my opinion, omni-channel operators like MGM and Caesars, with their rewards programs and offline complements, are best positioned to capture the spoils. BetMGM thinks that “long-term” (let’s call it 5 years) it can acquire 20%-25% the US market (conservatively pegged at 38% of the adult population as it excludes California and Florida), at EBITDA margins of over 30%. DraftKings thinks it can do $2.1bn of adjusted EBITDA on net revenue of ~$7bn (assuming 64% population penetration for OSB and iGaming in Canada and 65% and 30% penetration in US OSB and iGaming, respectively, compared to 46% and 13% today). MGM’s share and margin estimates get you to around the same place. So $2bn EBITDA at 10x, discounted back 5 years at 12% would mean that MGM’s 50% stake in BetMGM is worth around $5.7bn today, or about half of MGM’s US market cap. Or the whole thing could be shut down as the economics prove unsustainable. With MGM shares priced at 11x maintenance free cash flow, I don’t think the call option is priced in.

Stepping back, a conservative IAC sum-of-the-parts looks something like this:

MGM is cheap for all the reasons discussed. BetMGM and the Japanese venture, should they pan out, adds another ~$1bn of value to IAC in present value terms. MGM China is operating at trough profitability due to draconian zero COVID measures that will be eventually be relaxed.

Angi’s has been a big disappointment so far. I got this one wrong. The plain speaking optimism that I once found refreshing has now gotten annoying as it fails to be backed up by the financials. “It’s still early days”, but 2-3 years into the fixed price BHAG, we should at least be getting disclosures on the unit economics of the most mature service categories. Instead, the only profitability guidance we’ve gotten, besides vague and inconsistent qualitative color on contribution profits, is that gross margins across Angi Services are between 15% and 35%, a range so wide as to be meaningless. If product snugly fit market, I feel like Services would be growing at least 50% y/y organically at this early stage. Instead, the business is now growing low-teens, more like ~30%+ when you back out roofing, where they “just got ahead of ourselves in aggressiveness on price and some other operational challenges”.

I fear Angi’s challenges aren’t just temporary. The combination of Handy, a growth oriented “tech” company run by 20-30 year-olds in New York and HomeAdvisor, a more old-fashioned smile-and-dial outfit based in Denver, has resolved into cultural tensions. Feedback from contractors, who often don’t understand or appreciate the ROI math of Angi leads, ranges from “meh” to “bleh”. I have yet to encounter a contractor who thinks of Angi’s as a critical, must-have lead gen channel. Angi’s employees seem to have a short-term, mercenary bent, with a former Handy Sr. Director of Operations and Strategy commenting (h/t Stream Mosaic [39]):

the attrition rate is very high, because of that, you need to bring in a lot of people. Like my example earlier, if you hire 100 people, you might be lucky if five of them make an entire year. I was in a training class of around 30 people, and by month four or month five or maybe month six, I was the only person in my training class left. Because it’s such a high attrition rate, you’ve got to really fill the top of your funnel of employees. You’ve got to fill it to the maximum. It’s very easy to get hired once you apply. There is not a lot of requirements, they’re not very stringent.

While Angi’s might provide reliable service in a dense city like New York (Handy’s HQ), at least here in Portland, OR, I literally it easier to find contractors on Google than I do on Angi’s. In short, I just don’t get the sense that people love working for Angi’s or that the service is particularly compelling to either service providers or consumers.

DotDash is no longer expected to hit $450mn of EBITDA next year due to a “rapid pullback” in ad spend from Retail, CPG, and Food verticals, but I’m still constructive on the long-term story. You’ll recall that last December, DotDash acquired the publishing division of Meredith with the idea of applying its expertise running fast, clean websites to Meredith’s storied brands, which include Southern Living, Better Homes & Gardens, and Martha Stewart Living (consider that Better Homes & Gardens is searched 11x more frequently than DotDash’s analogous home-focused property, The Spruce, yet gets just half as much online traffic). In 1q, Health.com [40] was the first Meredith property to migrate to DotDash’s platform. With 30% fewer ads and 5x the site speed, click through rates increased by 60%, programmatic ad rates by 50%. Since then, 6 more properties have transitioned, with similar site speed gains. I am valuing DD/Meredith at 11x this year’s EBITDA, arguably too conservative for an asset growing revenue 15%-20% with minimal capex requirements and 50%-60% incremental margins.

Most of the remaining IAC is a collection of unprofitable, binary VC-type bets that nobody wants in today’s cash flow sensitive market environment. But IAC’s valuation is so bombed out that you can mark it all zero. MGM, DotDash, and Angi’s alone more than cover the enterprise value after subtracting the value of corporate overhead. Or you can put a zero on ANGI, as the sum of the remaining parts, marked conservatively, also cover IAC’s valuation.

Disclosure: At the time this report was posted, accounts managed by Compound Insight LLC owned shares of IAC. This may have changed at any time since. [Update: as of 2/21/23, accounts managed by Compound Insight LLC no longer owned IAC shares]

some thoughts on Charles Schwab

Posted By scuttleblurb On In SAMPLE POSTS,[SCHW] Charles Schwab | 9 Comments

I have a post on APi Group and Amphenol coming toward the end of the month but before then I wanted to offer some thoughts on Charles Schwab. Nothing here is investment advice.

Last week I was joking with my friends LibertyRPF [41] and MBI [13] that Twitter felt like a time machine taking me back to 2008-2009, when as a young associate at Fidelity I was tasked with scrutinizing in gruesome detail the balance sheets of insurers and words like “held-to-maturity (HTM)” and “available-for-sale (AFS)” became fixtures in my daily vocabulary. I never expected HTM and AFS to come back into vogue, but here we are. Everyone reading this likely knows by now what these terms mean, but just in case here’s the definition from the SEC [42]:

HTM securities, which management has the intent and ability to hold until maturity, are carried at amortized cost. AFS securities are carried at fair value and unrealized gains and losses are reported as net increases or decreases to accumulated other comprehensive income (“AOCI”).

So what Schwab does is it deposits the cash balances from client accounts into its bank and mostly invests those deposits in US government-backed securities which, while rock-solid from a credit perspective, are still underwater thanks to rising rates. “AOCI”, which you can find in the shareholders’ equity part of Schwab’s balance sheet, primarily reflects after-tax unrealized losses on Schwab’s AFS securities, plus the after-tax unrealized losses on AFS securities that Schwab transferred to the HTM bucket last year to avoid having to include further unrealized losses in AOCI (this will become relevant later).

The “gotcha” hot take goes something like this: did you know that AOCI doesn’t include unrealized losses on HTM securities at year-end and that taking those losses into account would wipe out nearly all of Schwab’s tangible equity? Did you know??….the implication being that Schwab’s bank is technically close to insolvency.

But of course there is a difference, often a huge one, between tangible GAAP equity and regulatorily capital. In banking, there are several capital ratios that need to be maintained above a certain threshold. For Schwab, the most restrictive one is the Tier 1 Leverage Ratio, which divides Tier 1 Capital into assets and certain off-balance sheet exposures. For all but the largest banks1 [43], you can basically think of Tier 1 capital as tangible common equity plus preferred equity minus unrealized gains and losses. What this means is that the unrealized losses on Schwab’s securities don’t impair T1 capital until those losses are realized, either through credit impairment or sale. Because the vast majority of Schwab’s investment portfolio is parked in super safe government-backed securities, its Risk Weighted Assets (the sumproduct of interest-earning assets multiplied by a risk weight proportional to each asset’s credit risk) are very low and its Common Equity Tier 1 Ratio (CET1 – tangible common equity minus unrealized gains/loss divided by risk weighted assets) is a whopping 22%, way above the 7% minimum. So Tier 1 Leverage the far more restrictive ratio and unlike the CET1 ratio, which only counts common equity as capital, any capital holes can be plugged with preferred stock from Uncle Warren.

Since 85% of Schwab’s securities are backed by the US government, we don’t really have to worry about credit quality. But we do need worry about Schwab being forced to liquidate those securities (thus converting unrealized losses to realized losses that hit T1) to meet deposit withdrawals from clients who want to take advantage of higher rates, a dynamic known as “cash sorting”.

At year-end, Schwab reported $40bn of Tier 1 Capital against $567bn of assets, for a Tier 1 Leverage Ratio of 7.2%. The minimum capital requirement is 5% so we’re starting with a $12bn capital buffer that organically expands as the balance sheet shrinks (more on this later).

So a critical question here is: will there be so much cash sorting that Schwab is forced to sell investment securities at a loss, thus dragging the Tier 1 Leverage Ratio below the 7% threshold and forcing a capital raise that potentially death spirals into abysmal dilution. The 22% decline in Schwab’s stock over the last 2 days suggests the market is assigning a non-trivial probability to this scenario.

Here are what I believe to be the sources of funding at the end of 2022, with numbers pulled from Schwab’s 10-K:

Cash: $40bn (excludes $43bn of “Cash and investments segregated and on deposit for regulatory purposes”)

Available FHLB secured credit facilities: $69bn (the Federal Home Loan Banks, FHLB, provides loan advances against a range of collateral to help member banks meet short and long-term liquidity needs. The haircut on government-backed collateral is small [44], 1%-2%, reflecting their liquidity and minimal credit risk. Subsequent to Dec. 31, 2022, Schwab drew down an additional $13bn of FHLB advances. Since we don’t know the intra-quarter sources and uses of funds, let’s ignore this for now. Doing so doesn’t materially impact the analysis)

US Agency and Treasury AFS securities that mature in < 1 year: $22bn (these could be sold without realizing material losses)

Federal Reserve discount window: $8bn

Unsecured commercial paper: $5bn

Uncommitted, unsecured lines of credit: $2bn

AFS securities at fair value minus the short-duration US Agency and Treasury securities listed above: $123bn

(in addition to all this, Schwab has another $173bn of HTM securities, which I treat as untouchable given the impact that realizing losses here would have on statutory capital)

There are a few important caveats.

First, in order to access FHLB funding, banks need to maintain positive tangible capital, the definition of which is set by the Federal Housing Finance Agency who, for reasons that defy logic, includes unrealized losses and gains on AFS securities. So you can see now why Schwab moved $173bn of AFS securities to HTM last year. Had they not done so, any further unrealized losses on those transferred securities would have hit their GAAP tangible equity and possibly compromised their ability to access FHLB funding.

However, even under this more onerous definition of tangible capital, I still think Schwab’s access to FHLB advances is secure. They reported GAAP tangible equity of $16bn at year-end and are generating ~$8bn of run-rate after-tax earnings. Their AFS securities were fair valued at $148bn, which includes $12bn of unrealized losses, $25bn of which rolls off in less than a year. So for Schwab to blow through its $16bn of tangible equity (even setting aside the considerable earnings build and the <1 year maturities) unrealized losses on AFS securities, 85% of which are backed by the US government-backed, would have to more than double from year-end levels. Eye-balling the maturity buckets of Schwab’s AFS securities, this might require a nearly 150-200 bps upward shift across the Treasury curve.

Second, the $69bn of available FHLB advances would be collateralized by a roughly equal portion of Schwab’s $307bn of securities ($148bn AFS + $159bn HTM), but I don’t know much of that collateral would be coming from AFS vs. HTM, so including the entire pool of AFS securities as a source of funds, in addition to $69bn FHLB advance, is double counting to some extent. $69bn of borrowing availability is about 22% of Schwab’s AFS and HTM securities. Multiplying that percentage by $148bn of AFS translates to about $33bn of AFS securities that are pledged as collateral to the FHLB and unavailable for liquidation, leaving us with $90bn of unrestricted AFS.

Third, is there actually $69bn of FHLB funding available? At least one Twitter person [45] thinks no, arguing that “FHLB system isn’t built for these behemoths that are…larger than the FHLB”. While this anon provides no additional context, I don’t think this risk should be outright dismissed. Silicon Valley Bank was unable to tap its full FHLB borrowing capacity for reasons I don’t fully understand. Given the relentless outflows at SVB, maybe the FHLB concluded that lending to them was a lost cause.

To be on the safe side let’s assume that, contrary to Schwab’s disclosures, none of the remaining $69bn of FHLB advances are available and that this year the company is met with a gargantuan $100bn of outflows, nearly 30% of their year-end deposit base. After eating through $40bn of cash and $22bn of short-dated govies, Schwab would need to sell ~$40bn of AFS securities with 1+ year maturities to meet remaining redemptions. The unrealized losses on the full $123bn of >1-year AFS securities was about $12bn at year-end, but let’s say those mark-to-market losses have since widened to like $15bn, or ~$11bn after-tax. In this scenario, Schwab would realize about ~$4bn of a/t losses on its $40bn AFS liquidation. With $100bn of deposits and assets now off the balance sheet, Schwab’s Tier 1 Leverage ratio improves from 7.2% to 8.6%, leaving about $17bn of capital cushion, enough to absorb the ~$4bn of realized losses from the AFS sales, even without taking into account the, say, ~$6bn-ish of pro-forma earnings that would flow into retained earnings throughout the year.

But what amount of outflows can we reasonably expect? Schwab has $17bn of outstanding loan balances that come due after June and, more importantly, X% of $367bn of bank deposits that will cash sort out of the bank and into higher yielding alternatives, either out of fear or greed. What is X?

Well, since cash sorting responds to changes in the Fed Funds rate, it should not come as too big a surprise that Schwab’s bank deposits declined by $77bn ($444bn → $367bn) from 2021 to 2022, as the Fed took rates from 0 to 4%+, the fastest pace of hikes in 40 years.

Source: Winter 2023 Presentation [46]

What Schwab has observed throughout its history, though, is that cash sorting settles down as rate hikes cease. Clients want to maintain some minimum amount of transactional cash in their accounts. Whether starting with high levels of cash or low levels of cash, they all converge toward an “equilibrium” level.

Source: Winter 2023 Presentation [46]

According to Schwab, the above analysis was done “across 30 different wealth tiers, across 5 different client segments and the pattern is exactly the same”. On their Jan. 27 earnings call, management claimed they were in the “later innings” of the cash sorting cycle and that the cash they were getting from new accounts was offsetting “any lingering sorting activity” from existing accounts. All this is just to say that if Fed Funds goes from ~4.5% to, let’s say ~5%-5.5% this year, it would be quite surprising to see the same ~$77bn of cash sorting deposit outflows that Schwab experienced in 2022, when rates exploded from 0% to over 4%….and needless to say, the Fed is almost certainly re-evaluating its hawkish posture in light of SVB’s failure and the ensuing anxiety.

So if this were just about run-of-the-mill cash sorting, I think Schwab could cover deposit outflows under any reasonable bear case scenario. But with Silicon Valley Bank now defunct, things have changed. From a liquidity standpoint, I think Schwab is in a much stronger position than SVB or even First Republic for that matter. Whereas uninsured deposits – that is, deposits exceeding the FDIC insurance threshold and therefore most likely to flee in a panic – comprised an estimated 94%(!) and 67% of SVB and FRC’s total deposits, respectively, at year end, they made up just 21% of Schwab’s. Plus, cash and readily salable AFS securities cover the near entirely of Schwab’s uninsured deposits. The same cannot be said of SVB and FRC.

*estimate from the Federal Financial Institutions Examination Council [47]

But anxiety is contagious. You can imagine: someone reads about the SVB collapse, sees that Schwab’s stock is down a lot, assumes something must be seriously wrong there too, and pulls their cash from Schwab bank into T-Bills, forcing more liquidity pressures that push the stock lower, etc. in a reflexive doom loop. In 2022, cash sorting was provoked by rate hikes so rapid that even as bank deposits declined by 17%, net interest income still grew 33%. This year though, if cash sorting is motivated by fear rather than greed, a similar level of outflows would not be accompanied by higher rates. Moreover, FHLB advances are expensive. At year-end, Schwab was paying 4.9% on outstanding balances. If $50bn of ~0% deposits are replaced with 5% FHLB advances (assuming that’s even possible), we’re talking about an incremental ~$2bn hit to after-tax earnings per year on a current run-rate base of $8bn. In short, even if a mass outflow of deposits doesn’t impair capital it may drive earnings lower until people calm down, at which point fear-driven cash sorting is reversed and fresh deposits can be put to work at today’s higher rates. If liquidity concerns prove to be a hiccup and things go back to pre-SVB days in short order, I think there’s a credible path to $6-$7 of per share owners’ earnings (that is, earnings after the incremental capital has been posted to support asset growth) in 5 years. At 20x + accumulated dividends, you’re looking at ~18%-20% returns off the current price ($59).

I admit to being wary about publishing this post, as the reputational damage of being wrong on something like this far exceeds the benefit of being right. If Charles Schwab’s bank teeters into receivership, it will be one of the biggest financial events in years and anyone who suggested that failure was unlikely will be dog-piled with told-ya-so’s. If it turns out that Schwab is fine and the stock recovers to ~$75+, people will shrug and move on with their day.

Let me be clear. While I think it would take a colossal outflow of deposits – something well north of $100bn – to take Schwab down, it would be foolish to deem this scenario impossible given the stench of panic pervading the air. It’s human nature to extrapolate what’s happening today further into the future than is warranted and sometimes this tendency can be profitably faded. But this approach can fail horribly when public confidence itself is an input to intrinsic value, as it is with banks.

A public service announcement is warranted here. My memories of the GFC are all too vivid. I remember bank CDS, quoted in single digit basis points just a year ago, being traded for points up front. I remember puzzling over how to dimension liquidity needs, how big a capital crater subprime CDO exposures might leave, and how much, if any, government support would be available. I remember reasonable-sounding write-ups (like this one!) invalidated within days. I remember an otherwise stolid co-worker pushed to tears by the emotional strain of an especially harrowing week. I wish this on no one. If you think this could be you, maybe just $CSU and chill (not investment advice!).

On Twitter, comparisons between the GFC and what’s happening today have been rightly poo-poohed. Back then, major banks were holding toxic assets on razor thin capital bases. Valid solvency concerns fed into liquidity strains. The term “other-than-temporary-impairments (OTTI)”, where impairment charges are taken on securities whose fair value is not expected to recover to par, was on the tip of everyone’s tongue in 2008. Nobody is using it today because credit quality is not a core issue. But what both periods have in common is fear, and fear doesn’t dispassionately ask whether your securities are par paper, nor does it wait for earnings to leisurely bleed into capital. It punches you in face as it darts for the exit.

(special thanks to @willis_cap [48], who went back and forth with me on Schwab throughout the weekend while he was on vacation in Hawaii and offered helpful suggestions to this write-up)

Disclosure: At the time this report was posted, accounts managed by Compound Insight LLC owned shares of SCHW. This may have changed at any time since.