*** Note: For entertainment and informational purposes only. Not investment advice. Please do your own research. ***

Hims went public via SPAC in Q4 2020. At the time, it was easy to dismiss them as yet another money-losing subscription box company with cheeky suggestive advertising that had successfully raised and burned enough venture funding to skyrocket to $100M+ in revenue.

This 2017 Fast Company article opened as follows: The first time I saw the website for Hims, a new men’s wellness startup, I thought it was elaborate satire.

With ads like this for erectile dysfunction, it was easy to conclude the same.

The below projections were what was promised at the time, with guidance for 30% revenue growth over the next few years. They expected 2022 to have $233M in revenue and line of sight toward adjusted EBITDA profitability.

Source: Hims Investor Presentation (Oct 2020)

Since the IPO, it’s been eight straight quarters of remarkable beat-and-raise execution. I went back and tracked what management had originally promised, how their guidance evolved with each passing quarter, and what they actually delivered.

The business outperformance has simply been stunning. That 2022E $233M revenue projection from late 2020 was revised to $372M revenue by the start of 2022. They will likely end the year in excess of $500M revenue while crossing into profitability. Those figures do include acquisitions of Apostrophe and Honest Health from 2021, but even so, the company has far exceeded their targets and continue to raise them.

That revenue possesses a high margin with strong potential for operating leverage. Gross margins have been trending toward 80%, and opex has been gradually trending down, dropping from ~56% of revenue in Q1’21 to ~33% in the latest quarter. Note I’ve excluded stock-based comp to minimize the distortion around the IPO.

Marketing expense remains in the low 50%, but much of it is for new customer acquisition. Management has indicated targeting a payback period of under 1 year, with 85% retention thereafter.

It turns out that strategically targeting chronic health issues combined with a path to effective treatment options through generic medication and telehealth delivery might actually be a decent prescription for a compelling business with recurring revenue and high margin.

Here’s the playbook:

• Pick chronic health categories that have natural recurring usage dynamics. Better yet if these conditions have a social stigma attachment or are perceived as less urgent conditions, which means patients are overly refraining from seeking care and which may be less regulatory burdensome for a company to operate.

• Favor those conditions with wide generic availability for high margin potential

• Differentiate on user experience and ease and convenience, and prioritize online delivery of treatment - either telehealth consultations or e-commerce

• Acquire customers when their younger and healthier, then cross-sell into multiple health lines as they grow older to improve stickiness

• Stay disciplined on customer acquisition spend

• Expand internationally

From the starting points of hair loss and erectile dysfunction, there are actually many health conditions that fit that profile.

Which indicates a pretty long runway for the company to grow along with its customers, and the likelihood of improved customer retention as additional options are selected.

It’s an impressive opportunity set, and one that the company is executing against effectively while staying pretty lean with under ~500 employees. They are crossing into profitability and still have ~$200M in cash available.

So now the bear case.

Ultimately, these are commoditized products with a bit of nifty marketing, slick packaging and a subscription pricing model, and the question is whether that elevated customer experience wrapper is enough to sustain the margin.

There will be much less expensive options available for those that care to look. I was a minoxidil purchaser from Costco for many years, but I’m a much more price sensitive shopper than most. The current economic climate may motivate others to take a similar approach. Perhaps those 1M subscription customers end up going elsewhere.

Perhaps a competitor like Amazon figures something out.

Perhaps something happens in their delivery operations. Someone gets violently ill from their products. Perhaps telemedicine is not robust enough from a care perspective.

Perhaps dilution goes off the rails as they throw stock at acquisitions and hiring.

Perhaps they overextend and overspend on marketing.

The CEO holds Class V shares with 175:1 voting rights. That’s egregious, but hard to argue with the job done so far.

The past year has been painful. I forgot my Substack password and stopped writing. For better or for worse, I’ve continued to hold. It’s been quite brutal out there.

I do seem to have a soft spot for seemingly deep value high growth plays, which often turn out to have been low priced for good reason.

There’s a lot to like with HIMS though. The business outperformance so far speaks for itself. The growth will eventually moderate, and they will certainly miss at some point. But with flipping to profitability, ample cash reserves, and a long growth runway, the current stock price at ~2 to 3x gross profit doesn’t seem too demanding for the potential upside.

I waded into a position over the past 2 years, buying a bit more with each successive earnings report. It helps that the price keeps coming down even in the face of improving business performance. In retrospect, this was a more appropriate way to build a position.

Source: Wish apps on Google Play

*** Note: For entertainment and informational purposes only. Not investment advice. Please do your own research. ***

The narrative in the numbers

If stories have shapes, then which narrative shape does Wish fall under?

Source: Avoid Boring People, A Story is a Lie and A Story is True.

At the time of last year’s IPO, it seemed to be the classic Rags to Riches story. A founder CEO, born in Soviet Poland, immigrating to the West, studying math and computer science, working as an engineer at Google and then founding a company dedicated to bringing affordable goods and services to the neglected and overlooked value-conscious consumer globally.

The narrative has shifted. Now it feels like something between an Icarus (rise-and-fall) and a downright Tragedy (fall).

The stock chart certainly maps pretty well. At under $5 per share, Wish is down 80% since the IPO at $24, and down 84% from the all time highs at $31.

Just about everybody is underwater at this point. It’s been a painful ride.

Sentiment has predictably soured. Wall Street is backing away and issuing downgrades across the board.

Source: MarketBeat

What marketplace businesses trade at ~1x gross profit?

At $4.93 and 628M shares outstanding, the current market cap is ~$3.1B. With $1.5B net cash, the enterprise value is $1.6B.

Trailing 12-months revenue is $2.8B and gross profit is $1.6B.

In other words, half the market cap is in cash, and the business trades at ~1x EV/gross profit.

It hasn’t always traded at such low multiples. What has collapsed is the sentiment in the business as reflected by the multiple, and not so much the fundamentals.

Note, there are still 70M options to be exercised and 39M RSUs outstanding. Even with this ~15% dilution overhang, the case that the company is egregiously undervalued still holds in my opinion.

What marketplace business trade at 1x gross profit? Only ones that Mr. Market believes are likely to go out of business.

Reddit reflexivity

I would have thought that Wish entering the Reddit meme stock conversation would have been a net positive. Not only does company’s mission appear to resonate with the Reddit ethos, the actual product mix would have seemed to fit squarely within the customer demographic. At worst, I would have thought it was free marketing for the company.

Now, I’m pretty sure it’s been a negative. Ugly stock performance fuels derisive public sentiment which stains the perception of the product. It’s an unfortunate negative feedback loop. Crappy products sold by a crappy company. No wonder the stock has performed so poorly.

I got caught up in that negative spiral, particularly following a disaster of a Q2.

But then I spent more time revisiting my earlier thesis, reviewing the product experience again, and thinking about where the company might go from here.

For better or for worse, I find myself having more conviction in the prospects of the business than ever before.

How bad is the cash burn really?

For the first half of 2021, the company burned ~$650M in operating cash, taking their cash balance from $2.2B to $1.6B. That looks really bad on the surface.

However, approximately $470M of this negative cash flow impact has been due to reductions in current liabilities (accounts payables, merchants payable, accrued refund liabilities). I’m not sure why they took down their current liabilities so dramatically - from $1.8B to $850M over the past few quarters. Perhaps this is a reversal of their extension of payables at the outset of the pandemic. Perhaps they are unwinding the accounts of low quality sellers. At any rate, the pace of liabilities reduction is unlikely to continue since you can’t cut liabilities past $0.

The actual burn impact from owner’s earnings (net income + D&A) has been closer to ~$200M for H1. It’s still unprofitable, but it’s at least much more palatable than the headline burn figure.

Historically, Wish has carried current liabilities of ~2x revenue, excluding the pop in Q2’20. That ratio has compressed in 2021. I suspect Wish will stabilize or even take current liabilities back up to historical levels relative to revenue, which could potentially have a positive impact on cash flows.

Source: Wish IR

The point is that the cash burn may not actually be as bad as it looks on the surface.

Was Wish just ahead of the curve?

Wish noted that their customer acquisition machine stopped working starting in mid May, and they subsequently cut all ad spend to figure things out. They pointed to the world reopening and Apple’s privacy changes as the primary culprits.

I was perplexed by this development since I had thought Wish’s data science was supposedly their crown jewel.

Since that report in August, many companies have reported absolutely brutal Q3 earnings. For example, Snap fell 25% as its ad business was disrupted by changes to Apple’s privacy terms.

Wish had talked about this effect in their Q2 earnings, noting that even though most of their users are on Android, Apple’s changes caused advertisers to shift their spend to Google and distort customer acquisition costs.

…as more advertisers shifted their spend from iOS to Android, they drove up bids for impressions, limited the quantity of impressions supplied and ultimately increased their advertising costs. These rising digital advertising costs contributed to lower marketing efficiency.

In retrospect, these comments were a harbinger of the incredible blowout earnings that Google reported in Q3.

Cutting marketing spend under such circumstances was the prescient and correct decision, as painful as it was.

There are signs that Wish may be making progress on addressing their marketing efficiency issues. It seems that they restarted paid traffic acquisition starting in September.

Source: Semrush

This is not a complete picture as it does not reflect their mobile app marketing activity, but I’m treating this as a positive indicator nevertheless.

The good news is that management has been in this position before.

In this interview from 2016, Peter talks about how they shut off marketing and ran cash flow positive for 10 months to prove that they could.

From there, they were running the business at cash flow positive leading up to their IPO.

The possibility that the business is in secular decline remains, but I like the odds that this is a temporary blip. We’ll see what they report in their earnings this coming week, but I suspect they may be one of the first ones to come out of this industry-wide setback.

Amateurs talk strategy. Professionals talk logistics.

I spent the past few weeks diving deeper into the user experience, and I came away extremely bullish.

In one case, I made 3 separate purchases - 2 kids hats and a charger - placing orders on Aug. 17 and 19. They arrived in one package on Sep. 3, within the expected delivery date of Sep. 9.

These were inexpensive items and I was satisfied by what I got for the price. I was impressed by the detail of the tracking and how Wish was able to combine the packages at their China facility.

For a separate purchase - a Halloween costume - I tried out the local pickup option at a beauty salon. It worked pretty smoothly, and the proprietor was very familiar with Wish pickups.

I can understand the appeal of the Wish Local program from a business owner’s perspective. It’s free to participate, and you get the benefits of driving customer foot traffic, upselling your own products and services to Wish customers, and earning commissions for every pickup.

There has been a noticeable uptick in locations over the past few months. The below is a map of the Bay Area.

From the buyer side, selecting pickup reduces the cost of shipping. For my order, it shaved the shipping cost from $8 to $4. This will likely become configurable eventually. I could see local businesses wanting to operate small dollar store depots and adjusting the shipping pricing or even offering free shipping to dial up foot traffic.

Delivery times have been reasonable at 2-3 weeks, although the app usually overestimates and guides for 3-4 weeks.

They are also experimenting with buy-now-pay-later options. The below is a capture of what is available today, and they also recently announced an expanded partnership with Klarna.

This is specifically for the U.S. Wish’s fintech opportunities seem tremendous given how much volume around the world they do, so I’d expect a lot more news on this front to come.

Wish has endured a reputation for questionable product quality and lengthy unreliable shipping for practically its entire existence. Perception is hard to change, but that might not be warranted anymore. The logistics and backend, tracing the package from the seller to the buyer, whether direct to the doorstep or via a local pickup option, seem quite solid to me.

Front-end optionality

What the company lacks is a decent front-end customer experience. The current Wish app experience feels cluttered, tacky and irrelevant to me, though I recognize I’m not necessarily their target customer. Though perhaps not, as I do appreciate a decent bargain, and I am guilty of paying down for quality.

However, my hunch is that when you have the backend logistics nailed down, the front end is much more straightforward to swap out.

Frankly, the Wish app and brand may have too much baggage at this point.

The company has actually been supporting a number of different vertical-focused apps for awhile. For example, they have the Geek app which is tailored to electronics items. It looks like Wish with a different color scheme and different merchandising.

They also have Home for home decor, Cute for fashion, and Mama for maternity and baby items.

1Sansome for social fashion shopping looks like it was only recently released given the low number of installs so far. It is a very different look.

For some reason, the app hardly has any traction (yet).

Turning to Reddit for clues:

Has anyone poked around the 1Sansome (Wish's newest offering) app and compared to Instagram app? They look/feel very streamlined and influencer info identical in many cases.

…

Agreed, it is cool; a properly integrated e-commerce and social media platform is sort of the holy grail of targeted marketing and creating a "fun" shopping experience. Thus far i don't think Facebook marketplace and Instagram shopping have done a great job executing. Perhaps with Wish's infrastructure and rapidly evolving global logistics (e.g. Wish local, Wish wholesale, the other targeted apps - 1S, Geek, Mama, Home etc...) such a partnership would make for a formidable global e-commerce play at truly competing with AMZN and BABA 🤔 Add in a fintech component and we are talking new world order.

Also agree, 1S having so few followers is weird... Frankly, the entire roll out of 1S is weird. It's been done very quietly; not even a press release on Wish's IR website. Even the popular influences with 250k+ followers on Insta, only have a handful of followers on 1S and the #wishfluencer tag is not used frequently anymore. It all kind of feels like a decently polished Beta environment... but why? The only thing I can think is that there is something very big in the works, and it is a self imposed quite period during testing OR there is some serious execution/communication failure on the company's part. Given the number of job posting on LinkedIn (188 at present), and other tea leaves, the former seems more likely.

The best answer is given by the questioner.

1Sansome is a ContextLogic trademark. 1Sansome on the Wish app looks like any other generic private label fashion brand. It may be that this is just one of many company experiments that doesn’t go anywhere. Or, it may be the beginning of a vertically integrated response to Shein (estimated private valuation of $30B), with more social and video elements and access to a broader local pickup network.

However this turns out, I like the experimentation.

The advantage of having a controlling founder CEO at the helm is that these calculated pivotal long-term bets can be made.

People

It is encouraging that there are now other seasoned executives to help carry out the vision.

This was the management team a year ago at the time of IPO. They effectively only had three C-level officers then.

This is their management team now.

They’ve added Jackie Reses at Exec Chair (May), Farhang Kassaei at CTO (July), Tarun Jain at CPO (August), and Vivian Liu at CFO (October), all of whom come with impressive backgrounds. They are probably still missing a CMO, COO and CRO, but it’s a much fuller and improved executive team now.

I was admittedly worried about the risk that some of these recent hires might quit after last quarter’s debacle. With years of tech experience under their belts from the likes of Square and Google, none of them needs to work. They could easily choose to back out if they didn’t want to be there. That <knock on wood> hasn’t been the case.

The only person to have checked out is Ari Emanuel, who resigned from the Board in September. That might be ok as he has a lot on his plate with Endeavor. Interestingly, Reses joined the Endeavor board in August.

I’m not quite sure what to make of Reses’ day-to-day role or how involved she actually is in the business. In her bio, she seems to define herself first as the CEO of Post House Capital position. Maybe her value is more to signal the company’s fintech aspirations rather than the actual operational blocking and tackling. As a well-connected billionaire, someone who introduced Bill Ackman to UMG as part of Pershing Square Tontine, why exactly is she choosing to spend so much time on a piddling $3B market cap e-commerce company anyway?

I suspect there is more value here than the market is giving them credit for.

Hopefully one or more of the new execs will join Peter on future earnings calls. It sounded kind of lonely up there during the Q2 call.

The company also continues to hire.

There are now 1,100 employees, up from 828 at IPO. There are close to 300 jobs on their careers page, with interesting indications of where the company is headed: video, payments, incentives/games, merchant ads platform, logistics as a service.

If the company is really on the decline and going out of business, they certainly do not seem to be acting that way.

Mr. Market throws a knuckleball

It’s been humbling and lonely to be a Wish bull lately.

This company has a ~$3B market cap, trades at 1x gross profit and 2x their $1.5B cash balance.

This was a company that grew revenue from $144M in 2015 to $2.5B in 2020 and did it at roughly breakeven.

I think the current price makes sense if the company were to collapse over the next 5 years as quickly as it grew in the prior 5 years. It’s not being run this way, but if it really came to it, I believe you could cut marketing and extract $1.5B+ in cash flows before the ice cube melted.

The market seems to be bracing for a dismal showing in Q3, a continuation of the 30-40% declines experienced in portions of the business in Q2.

If the company does anything better than that, then it seems the business is severely undervalued.

In fact, I really like the company’s prospects, and I suspect the seeds being planted will eventually yield tremendous fruit. The market is valuing the business like it’s going down the drain, while I think the company is just getting started.

I continue to think a stock buyback announcement (i.e., the board just authorizes a buyback) makes sense.

I would love to see some insider purchases if the stock price remains at these levels following earnings.

In baseball, knuckleballers typically befuddle hitters who can’t deal with their fluttering unpredictable pitches. Every once in awhile though, the knuckler throws a flat pitch, which typically ends up in the stands.

The current setup in Wish is about as fat a pitch as I’ve ever seen. The market is telling me that I’m an idiot though. Perhaps I am. But you can’t hit home runs if you’re afraid to strike out.

Which narrative shape does Wish fall under? I believe we’re watching a Cinderella story. I’m willing to wait to watch it unfold.

*** Note: For entertainment and informational purposes only. Not investment advice. Please do your own research. ***

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Source: Sotheby’s, Zeng Fanzhi & Jack Ma (2014), Paradise

*** Note: For entertainment and informational purposes only. Not investment advice. Please do your own research. ***

The world doesn’t need more underinformed commentary on China. Yet I find myself irresistibly drawn toward the topic, specifically Alibaba and Tencent. I’m like a moth to a falling flaming knife with predictable results.

There’s nothing new here that hasn’t already been written at length over the past year. I’m really just trying to justify to myself why I hold such significant exposure in these companies.

These companies tick off many boxes for me as businesses I would want to hold for the long-term:

• Dominant business with high cash flows

• Long runway

• Moats

• Owner operators

• Attractive valuations

There are two problems, however.

The first is that you don’t really “own” the company and you have to accept that the Chinese Communist Party (CCP) is in control and play by their rules.

The second problem is that the U.S. government may inflict collateral damage on these holdings as it prosecutes a trade war against China.

All of this has led to extraordinary negative sentiment in the markets right now when it comes to China.

The bear narrative goes something like this (credit George Soros):

China cannot be trusted. They steal intellectual property. Most of their companies are fraudulent. Their economic metrics and financial statements are likely bogus, and they know it. That’s why China is so committed to opacity, even when the U.S. threatens to cut off access to their capital markets. China has built up an unsustainable debt-fueled house of cards on the verge of collapse. Investors are just throwing money away. That’s what you get when you invest in and support an authoritarian regime that is consolidating control and destroying their most innovative industries and companies in the process. They are turning back the clock on capitalism. They are crushing any entrepreneur who poses a threat to their authority with draconian regulations. The country is slowly bleeding its people away. Your VIE shares are fake shares and everything is ultimately controlled by the Communists anyway. With Xi, this time it’s different. I told you so.

The bull narrative seems to go:

Chinese companies are massive and wonderful businesses. They are too cheap. They are way ahead of the West when it comes to the consumer Internet. The leading players have operations or investments in every relevant category. Their second, third, fourth, n’th tier cities have the populations of small nations on their own. Enormous waves of humanity are moving up the economic ladder and poised to increase their spend. The leading players are incredibly positioned to benefit from that predictable growth trend. The government isn’t so short sighted as to debilitate their leading companies in this way. Charlie Munger, along with other influential and influenced value investors, have invested and doubled down. This too shall pass. But…why take the career risk? Perhaps sit this out until the picture clarifies.

Howard Marks once laid out how the market cycle unfolds and how investor psychology changes.

Source: Howard Marks, Mastering the Market Cycle, via @RamBhupatiraju tweet

The following line marking “At the Bottom” resonates the most for me:

“No one wants to commit capital under these conditions, since prices reach bottom at just the time when people are most depressed and cautious.”

I certainly feel that way.

There’s a ton of opinion out there, and no one knows anything.

I’ve been following Dan Wang to understand the context. The press tends to lean negative when it comes to China. He points to structural considerations to explain why:

“News bureaus are highly concentrated in Beijing, due in part to natural corporate consolidation, but mostly because the government maintains a strict cap on foreign journalist visas. As a result, the bulk of journalists are based in the part of China that has the most politics and the least sense of growth. Everything here is doom and gloom, a fact well conveyed to the outside world. What’s missing are the facts of more pleasant life and higher growth in other cities.”

After considerable allocation of time and money, this is where I’m coming out:

1. Alibaba and Tencent are incredible businesses with unfair advantages that currently trade at an attractive price.

2. China regulatory actions on balance appear to be a net positive in the long term for these companies and their shareholders. The regulations are reasonably consistent with their stated goals, unlikely to alter China’s long-term aim to encourage foreign investment, and will probably benefit the incumbents in the long-term.

3. U.S. regulatory and trade war related actions, however, are a concern. While some of this may be political posturing, only the U.S. is explicitly calling for actions that could lead to outright trading bans.

4. Risks to Western companies appear to be underappreciated. It certainly should not be isolated to the China side. Western companies are just as susceptible to antimonopoly regulation and trade war crossfire.

The key question: Can I get the return without the control?

I believe the answer is yes.

Foreign investors cannot participate directly and fully in China’s upside, and that is unlikely to change. Getting comfortable with the reality of VIE the relative lack of control is the price of admission.

The lack of control may reflect a deterioration of standards, but that’s been the general trend and bargain to invest in tech companies over the past few decades with the emergence of dual share classes. Exposure comes with a distinct possibility of ruin, but the more painful risk may well be to not participate at all.

In my view, the CCP is acting as the ultimate activist and demanding their platform economies to share their scale benefits. Regulation leads to a healthier environment for sustainable growth. These actions erect barriers to entry in financing and business prospects that benefits the incumbents. It’s short term pain for longer term benefit for all stakeholders. Admittedly, the foreign investor does not rank high on that list, but there has not been explicit criticism or action against their interests.

Generally, I would prefer to pick great companies, sit back and trust in management, and be happy to be along for the ride. I don’t really have a choice as a lowly retail investor anyway.

I own Alibaba / Softbank as well as Tencent / Prosus. I hold the ADRs as well as the Hong Kong shares, though I’m somewhat indifferent as both represent VIE ownership. If the U.S. were to ban Chinese trading, then I’d have to unload the Hong Kong shares anyway. Softbank and Prosus come with relevant correlated exposure to Alibaba and Tencent for tax loss harvesting, avoids the U.S. regulatory risk, and also come with intriguing emerging market Internet venture portfolios.

This is just my opinion. China has become uninvestable for many investors, who have a China-At-No-Price attitude. That thinking has helped them avoid the recent carnage. I believe the downside risks are already reflected in the stock price.

Famous last words perhaps.

I am intrigued by the odds, so lots more words follow below.

1. Alibaba and Tencent are incredible businesses with unfair advantages that trade at an attractive price.

A lot has been written on these companies.

For Alibaba, Rob Vinall’s H1’21 letter has a good overview of the business and assessment of the regulatory impact. The starting point is their core marketplaces business, annual active consumers of 1.1B, GMV of $1.2T USD, and average spend per consumer of $1,400 USD:

“The investment case in Alibaba is straightforward. Its core marketplaces business is a wonderful business. It is highly profitable with an underlying operating margin of 75%. It can grow without committing much incremental capital. It is protected by numerous entry barriers including a massive installed customer base, network effects, and a thriving ecosystem. And it is likely to grow in the low to mid-teens for the foreseeable future driven by the growth in online consumption in China.”

Additionally, there are a number of nascent businesses. Within commerce, there is a growing offline retail footprint, the Cainiao logistics network, the global cross-border business in AliExpress (China to the world), the B2B business that provides the gateway for international brands to reach China’s consumers (the world to China), and ownership of leading e-commerce players Lazada (Southeast Asia), Trendyol (Turkey), and a 30% stake in Paytm (India).

That’s on top of a sizable media portfolio, the leading cloud infrastructure business, and a 30% stake in Ant Financial.

Source: Alibaba FY 2021 earnings presentation

The New Retail initiatives are progressing. Alibaba is investing in infrastructure to support commerce across online and offline and spanning the spectrum of fulfillment, from on-demand / local business level to hypermarket to traditional hub and spoke fulfillment.

Source: Alibaba FY 2021 earnings presentation

These Fresh Hippo stores will be really neat to check out one day.

Alibaba will have the widest integrated commerce offering spanning offline and online, plus cloud, plus payments. They’ll touch just about every Chinese consumer as well as every global brand interested in selling to those consumers. Some of these initiatives might be unprofitable or may not work out, but the overall direction seems inevitable. It’s a combination of Amazon and Google’s advantages in the U.S.

See more here: CEO 2021 letter, Alibaba - bull and bear, New Retail (Bain)

Tencent has two unfair advantages. The first is that they control distribution within entertainment (gaming). They either own the studios and properties outright, or they extract massive rents (up to 70%) from other publishers to distribute their games across China. The second is that their WeChat social media platform gives them the visibility and insights to cherry-pick the best emerging apps, take minority stakes in those companies, and then direct traffic to the anointed to supercharge their growth. This creates an incredibly powerful virtuous cycle: massive scale → data insights → informs strategic investments → traffic and engagement → more scale. This is as if Facebook and Apple were to collude to combine their data, traffic and distribution advantages to charge high take rates and build a venture portfolio. Where Alibaba controlled the choke point from a commerce perspective, Tencent controls the choke point from a content distribution and advertising perspective.

See more here: Compounder Fund thesis, Vineyard Holdings writeup, Tencent (Acquired podcast), Not Boring - Tencent and their investment portfolio

The below diagram showcases the immense ecosystems that Alibaba and Tencent have built, acquired or invested in. Emerging companies would need to choose, whether explicitly or implicitly, in which ecosystem to operate.

Source: Goldman Sachs, Is China Investable?

The CCP may have reasserted their monopoly on monopolies, but I think you can still have quite a valuable business on the back of a duopoly.

The market has been rattled though. China tech stocks have lost $1T in market cap so far this year and now trade at significant discounts to U.S. peers.

Source: Goldman Sachs, Is China Investable?

2. China regulatory actions on balance appear to be a net positive in the long term.

My take is yet another uninformed opinion.

To me, the regulations are reasonably consistent with their stated goals, unlikely to alter China’s long-term aim to encourage foreign investment, and will probably benefit the incumbents in the long-term.

A. The CCP is doing what they said they were going to do.

In the last national congress (held every 5 years) in 2017, President Xi Jinping issued a report that outlined the following themes:

Remain true to our original aspiration and keep our mission firmly in mind, hold high the banner of socialism with Chinese characteristics, secure a decisive victory in building a moderately prosperous society in all respects, strive for the great success of socialism with Chinese characteristics for a new era, and work tirelessly to realize the Chinese Dream of national rejuvenation.

Last year, Xi declared that 2021 would mark the beginning of a “new development phase,” one that would privilege national security, common prosperity, and social stability over unfettered growth.

The government’s sweeping crackdown on Big Tech (more specifically, on 平台经济 “platform economy” companies) is consistent with that vision.

Moreover, the Internet giants have increasingly become de facto infrastructure that operates beyond the government’s oversight and control.

As The Information’s Shai Oster puts it in this podcast:

"What Alibaba and Tencent have done is created national banking infrastructure. In China, national infrastructure is a national security. It's like highways, it's like power. And if huge amounts of your economy are being transacted behind closed doors effectively, through a private enterprise, that's not okay for the Chinese government."

For a government that prizes these attributes and above all control, after witnessing Internet platforms around the world grow their power, particularly in having outsized influences in election outcomes and the ability to expel sitting presidents from their platforms, it’s no wonder that they would act.

Octahedron Capital published A Few Things We Learned in 2Q’21 that summarizes the key goals and regulations that have been introduced (so far).

Given that backdrop, it probably was not entirely unexpected that the regulators would act. The speed and ferocity in which they acted, however, is another matter.

(and almost fanatical devotion to red uniforms and the CCP).

These two points capture China’s thinking:

She expands on this in a post regarding Huang Qifan, an influential central government policy advisor, regarding the main problems with consumer Internet companies. In summary,

“the lack of regulation and pure, simple greed has made it go awry, and so the costs are now outweighing the benefits, when you consider all stakeholders, not just shareholders.  The "reckless expansion of capital" … is really about how irrational investment and abusive practices have wiped out any efficiency gains from technology, and are instead hiding unviable business models that do not add anything long-term to the economy.” 

The actual regulations against the Internet platform companies have been aligned to these goals.

Source: Octahedron Capital, A Few Things We Learned in 2Q’21

As Rob Vinall wrote, the intended regulatory outcomes matter because:

“the apparent consensus in the West that the goal of regulation is to turn the clock back on capitalism. The intent is clearly to strengthen the market economy, not dismantle it. In the words of the Chinese government, the aim is stable, high-quality growth, not just fast growth.”

The regulations themselves may very well be a roadmap for what Western countries ought to consider, as the concerns that China has regarding the Internet platform companies are shared globally.

B. Dealing with the government is the normal course of business.

Chinese companies cooperate and comply and will adapt to the new environment. It’s an essential core competency and perhaps even a competitive advantage.

Shai Oster remarks how Tencent’s government relations team always seems to be a step ahead of the industry. They take prompt and decisive action, including the recent call to limit playing time by minors to 3 hours per week.

Government criticism regarding the ill effects of video games are hardly new. Tencent has been restricting playing time for minors for their games since 2017. In 2018, China froze license approvals for new titles for 9 months to combat games deemed illegal, immoral, low-quality, with negative social impact, and causing bad eyesight in children. 28,000 studios shut down in 2018 and 2019 due to these regulations, but then 22,000 new companies were opened in 2020.

That’s how it goes in China.

As an interesting aside, in 2014, the largest antitrust fines then levied by China had actually been against foreign firms, primarily in the auto space for price fixing. It has hardly made a dent in their appetite to participate in the China market. Keep pushing until you hit the boundaries, then stop.

Source: Synergistics Limited, China’s antitrust fines for foreign car companies fail to stall growth, Financial Times

Tencent president Martin Lau, on the Q2’21 earnings call from August 2021, addressed several questions related to the evolving regulatory landscape (transcript), highlighting four key points:

1. Internet regulation is a global trend. China is just leading the way.

2. Regulators are focused on identifying and rectifying industry misbehaviors and establishing regulations, with emphasis on compliance, social responsibility and fair and proper behavior.

3. Government wants to foster long-term sustainable development and healthy growth of the Internet. They recognize the economic and social importance of the Internet.

4. Tencent intends to embrace the new environment fully. They will be fully compliant. That has always been their attitude, and they believe they are well positioned to do it. They feel it is good for them and good for the industry in the long run.

Alibaba shared a similar position in their earnings call (transcript):

We believe all these new regulations aim to foster the healthy development of the Internet industry over the long run.

We will fulfill our responsibilities as a platform in accordance with the regulatory requirements and continue to carry out our commitments to be a good company that creates long-term value for the society in China and globally.

C. This is the new cost of doing business

It seems each passing week brings another set of penalties.

Other than the for-profit education industry, the penalties levied on the Internet platform companies so far have been manageable. The two most significant have been:

• Meituan (October 2021): $533M fine, or 3% of revenue

• Alibaba (April 2021): $2.8B fine, or 4% of revenue

Other examples were for price dumping related to community group buying (March 2021, ~$230k), for failure to disclose merger activity (March 2021, ~$75k), and for illegal monopolistic behavior related to M&A (July 2021, ~$75k), but these have been at a very minor scale. Hardly a punishment it seems. Fetch…the cushions!

More impactful to the bottom line will be the government ending preferential tax rebates. Alibaba, for example, forecasts an effective tax rate of 20% in Q3’21, up from 8% a year ago.

To end these rebates seems like a reasonable evolution given these companies are now fully grown and enjoy such a dominant position.

As for the (in)voluntary contributions to common prosperity initiatives, the companies are in near unison in their vociferous support of these measures.

Source: Octahedron Capital, A Few Things We Learned in 2Q’21

In my view, these fund flows, whether in the form of fines, increased taxes or mandatory common prosperity contributions, are all simply a form of transfer back to the government. In totality, it does not appear to be overly burdensome. The fines can be absorbed, the tax rate is still reasonable, and the societal contributions may very well help their business by supporting their stakeholders - a more intentional form of marketing spend.

D. Winners keep winning

A big focus of regulation has been the removal of exclusivity provisions known as 二选一 (“Two Choose One”) whereby dominant online platforms banned suppliers from working with competitors. It is part of greater antitrust actions, which include banning anticompetitive practices such as discriminatory pricing and bundling.

While this benefits the consumers and small businesses that depend on these platforms, I think these developments will help the incumbents’ competitive position relative to potential new entrants. They already enjoy entry barriers from their massive scale, network effects, and ecosystem. Now pile on burdensome government regulation and capital advantages as access to the U.S. financial markets is halted and prospective investors are deterred from this sector.

The U.S. tech giants do not have explicit exclusivity constraints on platform usage - most ecommerce sellers, for example, do not sell solely on Amazon - but that has not impeded their irresistible march toward dominance.

While there are no shortage of competitive threats, I would much prefer to be one of the larger circles in the below chart. A new dot would have a tremendous uphill climb ahead of it. Apart from Bytedance and Kuaishou, all of the other significant players already fall within the Alibaba or Tencent spheres of influence.

Source: Bernstein, via @briefnorris tweet

E. Directional arrow of progress still points to China opening markets

China regulatory actions have so far been directed domestically, and not at the international business community.

Ray Dalio provides context, explaining that while there are risks and opportunities, the overall direction of China’s actions to develop their capital markets, support entrepreneurship and encourage open foreign investment has never changed.

China certainly needs the help, as the WSJ points out:

China’s financial system “can charitably be described as a mess. It’s dominated by state-owned banks that constitute an enormous economic sinkhole. They soak up the prodigious savings accumulated by Chinese households, for which the banks pay almost no interest. They then divert the bulk of that money into ultracheap loans to state-owned or politically favored companies.”

“This leaves the country’s genuine entrepreneurs, who run productive small and medium-sized enterprises in the private sector, scrounging around for capital in a vast gray market of loosely regulated moneylenders, complex bond products and creative trade-finance arrangements.”

Xi Jinping has been consistently reassuring the international business community for years now (see 2015, and in 2020).

• “China is ready to significantly reduce restrictions on foreign investment”

• “Without reforms or further opening up, there will be no progress.”

More recently, other party members have offered the following (WSJ):

• Fang Xinghai, (vice chairman of the China Securities Regulatory Commission): “China has no intention to decouple from global markets, and especially from the U.S.”

• Fang: “The government is reviewing so-called variable interest entities…but it sees VIEs as a necessary and vital part of how Chinese firms engage with global markets.”

• Liu He (Vice Premier): “China is trying to balance development and security. Doing so meant protecting competition and consumers, and this would be good for smaller companies.”

Indeed, the trend over the past few decades has been China opening up its markets to the rest of the world.

Source: BlackRock, China: The Essentials

In spite of the trade war rhetoric between U.S. and China, the two countries signed a trade deal in early 2020 that removed barriers for U.S. financial institutions to expand in the China market. BlackRock won approval to offer mutual funds to individual investors in China. Fidelity and JP Morgan have also set up wholly owned mutual fund units in China. Invesco is looking to manage part of China’s $400B national pension fund. Goldman Sachs got approval to own 51% of a wealth-management joint venture with Industrial & Commercial Bank of China.

Foreign investors have certainly sustained significant collateral damage from China’s regulatory actions. But it hasn’t slowed international companies from continuing their pursuit of the Chinese consumer.

China is prioritizing establishing the right set of ground rules to promote healthy growth over the near-term returns and concerns of international investors. It’s been painful to be sure, but it’s an understandable and perhaps justifiable set of growing pains. If you believe their pointed rhetoric against the Internet platform monopolists, then it seems reasonable to also believe that they intend to continue down the path of opening markets.

F. Tiger parents and golden children

The dream for “national rejuvenation” is made reality by showcasing the premier Chinese technology companies to the world.

In 2015, tech executives from leading U.S. and Chinese companies met with Xi Jinping in Seattle in his first American visit.

Source: Silicon Dragon Ventures

Cue the snark.

These companies were once the superstars and the pride of China who are now being reprimanded. I don’t believe sentiment has shifted such that they would be intentionally crippled.

Who represents China at the leading edge of tech? Who joins for the next photo shoot? While China is understandably concerned about maintaining control, they do want their companies to be successful and exemplary.

Tiger parents think they know what is best. They can certainly be overbearing.

Jack Ma has infamously laid low for the past year, sparking intense speculation about his whereabouts and serving as a cautionary tale. He seems to have recently resurfaced, though there had been accounts of him taking up oil painting earlier in the year.

Few recall he’s already quite accomplished in that domain, having already sold one of his works for charity in 2015.

That was such a different time, as the below photo shows.

Source: LA Times, Alibaba founder Jack Ma sells his own painting for $5.4 million

G. VIE risk remains, though arguably declines as CCP scrutiny increases

The challenge with the variable interest entity structure for Chinese companies is that it is based on inconsistent statements. To investors, the company says that it owns its operations, but to Chinese regulators, they say that the business is owned by Chinese and not by foreigners.

The Chinese government has historically turned a blind eye to it even though it could theoretically declare the structure illegal and refuse to enforce the VIE’s contracts at any time. Meanwhile, the sector has relied on this structure while continuing to grow tremendously.

The hope was that China would eventually allow private Chinese companies to directly list abroad and eliminate the need for a VIE in the first place. That’s unlikely to happen.

China has made it a lot tougher for Chinese companies to go public overseas, which will be subject to review for data security prior to IPO. This has led to several IPOs getting cancelled.

Paul Gillis, expert on all things China accounting related, explains that he doubts that this is the end of U.S. IPOs for Chinese companies. China still wants access to foreign capital markets but will want control of the process. To achieve that, they will likely maintain the VIE, even though the structure itself has always been on shaky legal ground. He believes that it may actually be good for investors since companies that receive approval for listing will also receive the first official (indirect) sanctioning of the VIE structure.

H. Is this flurry of regulatory activity all just political positioning?

Some speculate that this explosion of regulation is really due to government officials positioning themselves in advance of the next national congress in October 2022, which happens every 5 years.

“Chinese regulators engage in turf wars, too, as they jostle to expand their influence,” notes David Wertime of Protocol. For example, China's powerful State Administration for Market Regulation (SAMR) was likewise established in 2018 to end rivalries among three antitrust agencies.

Although a lot has happened in the past year, it’s not over yet, as regulations are expected to continue rolling out through 2025.

Source: South China Morning Post, China Internet 2021

Shai Oster, however, theorizes that a lot of this activity is driven by the proximity of the next national congress, slated for October 2022.

The context for that event is that Xi Jinping will likely be elected to another 5-year term, breaking the term limit precedent, and possibly setting the stage to rule China indefinitely. For a party member, it will be a particularly critical time to be well positioned. As such, there is a mad scramble among the party as this period comes to a close to demonstrate their accomplishments and loyalty. Performance review is coming soon and this is their last chance to make an impression. “No mid-ranking bureaucrat will be punished for overreaching to demonstrate their commitment to Xi Jinping thought.“ Oster suspects that things will quiet down starting approximately 6 months prior to the congress.

Perhaps the CCP and the typical tech monopoly are not so different after all.

If so, the optics matter, and the bark will probably turn out to be worse than the bite. This seems generally consistent with the magnitude of the fines discussed earlier.

I. Scale economies shared, mandated by the ultimate activist

I’m a big fan of Nick Sleep’s philosophy of scale economies shared as a source of enduring competitive advantage. Costco and Amazon are the most common examples of companies that bolster their competitive positions in this way by giving back to their customers.

In a way, all of this regulatory activity forces Alibaba and Tencent to share their scale benefits across their stakeholders. It may be painful in the near-term, but it likely strengthens their longer-term positioning. It does not appear that the government has been specifically targeting Alibaba and Tencent since these regulations have been applied broadly.

China’s motivations appear to be grounded in control, national security, and broad prosperity. Driving down valuations in the near-term are merely a side effect. If that were to be sustained, then that would detract from their goal of opening up markets and being an attractive place for investment.

Overall, I believe these actions will create tremendous value while resetting the balance of power among the various stakeholders. Among the Internet platforms, I think that Alibaba and Tencent will continue to be the best positioned to reap this value. China may very well be doing these companies a favor with their regulatory actions.

3. U.S. regulatory and trade war related actions are a concern.

The U.S., in contrast to China, has been openly threatening to cut off Chinese access to American financial markets. This is where the greater risk lies in my view.

A. China may be the last bipartisan issue left in Washington

Anti-China sentiment is popular in the U.S. From concerns over the growing military power of China, to China’s “authoritarian capitalism”, to its spotty human rights record, to widespread suspicions about China’s role in the provenance of COVID-19, it is popular to blame China.

As NBC notes, “The issue brings together every wing of American politics, from progressive populists to ‘America First’ nationalists to traditional security hawks.”

“Our relationship with the PRC will be competitive when it should be, collaborative when it can be, and adversarial when it must be. The common denominator is the need to engage the PRC from a position of strength,” a U.S. State Department spokesperson told Al Jazeera.

As it relates to Chinese Internet companies against this backdrop, the potential pain to investors comes in the form of trading bans and blacklists.

B. PCAOB: a Chinese-sounding American regulating body

Sarbanes-Oxley required that all accounting firms be inspected by the Public Company Accounting Oversight Board (PCAOB), the U.S. audit regulator, at least every three years. This includes foreign accounting firms.

Typically, companies that fail to meet disclosure requirements are delisted. The stock is then removed from a major U.S. exchange to a lower tier market in one of the over-the-counter categories (OTC). It’s less liquid and less prestigious, but still tradeable. In fact, there are approximately 10,000 OTC securities according to Schwab.

China has pushed back on these audits for two reasons: (1) they consider allowing a foreign regulator to enforce foreign law on Chinese soil to be an infringement of China’s sovereignty, and (2) they are concerned that audit work papers may contain state secrets (which basically includes any transaction with a China state owned enterprise, such as a mobile phone bill).

There are also new disclosure requirements that must be included in the issuer’s annual report. This includes the percentage of the company owned by foreign government entities, and whether any entities have a controlling financial interest in the covered issuer. Specific to China, the issuer must also disclose each official of the CCP who is a member of the board of directors.

There seems to be an attitude that because Chinese companies won’t submit to PCAOB audits, that this is a clear sign that they are cooking the books.

In fact, SEC Chair Gary Gensler recently wrote an WSJ opinion piece calling out China and Hong Kong for not allowing the PCAOB to “audit the auditors,” a key component of Sarbanes-Oxley.

Paul Gillis explains that many countries, not just China, initially resisted allowing the PCAOB to come to their countries to inspect their books citing similar concerns.

The Holding Foreign Companies Accountable Act in 2020 goes even farther, however. Rather than simply delist, it prohibits trading in an issuer’s stock if a foreign jurisdiction prevents an inspection by American regulators for 3 consecutive years. That puts Chinese companies on track to be banned from trading in the U.S. in 2024, and possibly earlier.

While certain companies may indeed be fraudulent, I suspect the vast number would follow their standard government relations playbook and just comply. The dilemma is that they’ve been caught in the crossfire of competing and conflicting regulatory mandates between the U.S. and Chinese governments.

There may be more to come, as the U.S. could simply take a stricter position on Chinese companies. For example, the U.S. could force delistings of VIE companies, full stop. It used to be that Chinese companies would go public in the U.S. via reverse merger by acquiring shell companies, but that practice has since been restricted.

With China unlikely to allow additional regulatory scrutiny of its companies, and the SEC affirming its intention to enforce the laws, it seems likely that an inevitable wave of trading halts and delisting orders is coming.

C. Making a blacklist, checking it twice

The U.S. has a number of national security blacklists that may implicate Chinese companies. This Akin Gump article provides a useful summary, which relates to restrictions based on concerns of those companies’ relationships with the Chinese military.

The two of note are the Entity List and the Communist Chinese Military Companies CCMC list (which changed over to the NS-CMIC List in June 2021). The Entity List is an outright ban restricting American companies exporting technology to Chinese firms, as well as restrictions on trading in those companies’ securities. The CMIC list prohibits trading of the companies’ securities, though generally investors have a year to sell.

Notable companies that are included on these lists include Huawei, SMIC, and Xiaomi. When Xiaomi was added to the CCMC list in January 2021, its share price declined ~10%.

SupChina’s excellent guide and timeline on China’s tech crackdown suggests that investors should lean toward sectors that align with China’s strategic goals such as AI, semiconductors, 5G, advanced manufacturing and green energy. However, that might be problematic for U.S. investors if those sectors also happen to be caught in U.S. blacklists.

It could potentially extend to Internet platform companies as well. In late 2020, the U.S. had already contemplated blacklisting Alibaba and Tencent, which would prohibit Americans from investing in them. Further, they were going to ban TikTok and WeChat amid concerns of user data security and potential Chinese surveillance risks, a decision that was later reversed by the Biden administration in 2021.

Alibaba’s recent foray into chip design to support their cloud business is both great news from a business perspective, but also not-so-great if it increases U.S. blacklisting risk. If the key to failure is trying to please everyone, then better, I suppose, to improve positioning with Chinese regulators by graduating into the “real” tech of semiconductors.

Some investors advocate swapping their holdings in Chinese companies from U.S. ADRs to the Hong Kong stock exchange. Alibaba ADRs have this conversion right embedded. That, unfortunately, won’t help if these companies are placed on a U.S. blacklist.

D. What happens in a trading ban?

As a practical matter, it’s not the end of the world if a trading ban were to take place. There would still be a period of time, potentially up to a year, for U.S. persons to divest those securities. The rules keep changing, but the below reflects the latest.

Source: Lexology, Biden Revises Ban on U.S. Investors Buying Certain Chinese Securities, June 2021

For U.S. investors in China, the risk from U.S. regulatory activity is meaningful, and potentially more so than from China.

4. Western companies may not be immune and risks appear to be underappreciated

While Chinese companies have seen their share prices crushed in recent months, Western companies have been relatively unscathed. Some may interpret that as further evidence of capitalism’s superiority over communism. It’s unclear to me whether that is warranted under the circumstances. It seems to understate several risks and suggests that investors may be taking the following areas for granted.

A. Companies have continued access to Chinese markets

Despite the escalating trade war rhetoric, it doesn’t seem to have materially altered the strategic importance of China to Western companies.

Many companies point to tapping the Chinese consumer as a critical priority and growth area. Think Apple, Tesla, Nike, GM and Starbucks.

The below slide is a bit dated and admittedly not from the most reputable source, but I think the point is still valid. There are a lot of S&P companies that depend on China for a significant portion of revenue and growth.

Source: WallStreetBets

A lot depends on the whims of the U.S. and Chinese governments.

Certain sectors, such as semiconductors, derive a significant portion of their revenue from China. If battle lines were to be drawn, it seems probable that these companies would get pulled in.

Going back to the Xiaomi example, the article notes that since Xiaomi was not included on the Entity list, its commercial relationships with American suppliers such as Qualcomm were not impacted (as of yet). Qualcomm did suffer a drop after Huawei was sanctioned, but it would seem their business is far more vulnerable to regulatory action than the Chinese companies.

Not to be outdone by the U.S., China has also introduced a blacklist - the Unreliable Entity list (不可靠实体清单规定). No specific companies have been identified yet. Rather, only broad guidelines were described, implicating companies that would endanger Chinese national sovereignty, security or development interests, or discriminate against a Chinese entity.

This was widely seen as a preparation for potential Chinese retaliation on U.S. companies,

“a potent weapon in the escalating trade war [in reaction to actions taken against Huawei and TikTok)…Analysts have suggested that U.S. companies such as Apple, Tesla, and FedEx might have the most to lose if they end up on the receiving end of Chinese sanctions.“

Foreign companies worry that they are about to become “sacrificial pawns in a game of political chess.”

American market indices don’t seem to reflect this risk to the same extent as Chinese stocks.

B. Chinese-style regulation will not or cannot happen here

Western media such as the Economist generally cast China’s regulatory activities in a negative light.

They criticize the crackdowns as “China’s regulatory immaturity on full display,” the work of just “50 or so people” that will “likely prove self-defeating,” as it will “raise suspicion abroad,” hamper their ambitions to set global tech standards, and “dull the entrepreneurial spirit within China."

However, they also acknowledge that these policing actions were overdue and that China’s moves,

“echoes concerns that motivate regulators and politicians in the West: that digital markets tend towards monopolies and that tech firms hoard data, abuse suppliers, exploit workers and undermine public morality.”

These concerns are not that different from what FTC Chair Lina Khan wrote about in her seminal paper, Amazon’s Antitrust Paradox, which observed that the current consumer welfare doctrine underappreciated the risks of predatory pricing and anticompetitive vertical integration. The two approaches to address this were:

1. Promote competition by breaking up or preventing mergers within industries where dominance is apparent.

2. Accept dominant online platforms as natural monopolies or oligopolies and seek to regulate their power instead, with the most common forms being: (1) requiring nondiscrimination in price and service, (2) setting limits on rate-setting, and (3) imposing capitalization and investment requirements.

It’s not that different from what China has been doing already.

Interestingly, Facebook in particular has cited China as an argument for why they should not be regulated or broken up. As this 2018 Recode interview put it in the headline, “Mark Zuckerberg says breaking up Facebook would pave the way for China’s tech companies to dominate.” That argument seems less convincing now.

Indeed, the FTC filed an amended complaint in August against Facebook (the first was dismissed in June), alleging they had illegally acquired innovative competitors Instagram and WhatsApp and burying successful app developers. The agency is now seeking to unwind those deals. This is in contrast to China’s response, which was to slap weak fines across the entire industry.

Based on share prices, the market seems to take a dim view toward the prospects that U.S. regulators will be effective in prosecuting its antitrust cases against the Internet giants. It may even think that a potential breakup would unlock additional shareholder value to offset any negative impact.

That may be accurate for the time being. Entrenched interests are powerful and well funded, the government is increasingly polarized and ineffective, and the tech companies are staying combative and defensive. But it wouldn’t be for a lack of effort on the part of regulators. If the companies keep testing the limits, the U.S. may very well be one inflammatory speech away from reach a tipping point similar to what China experienced last year.

C. Continued superiority of U.S. capital markets

Quick, how much larger are the NASDAQ and New York Stock Exchange compared to Hong Kong and Shanghai?

Source: KPMG, Mainland China and Hong Kong IPO markets 2021 mid-year review

The gap in H1 2021 is much narrower than I would have expected. I would not have predicted the 2020 rankings at all.

Hong Kong in particular is becoming a top listing destination.

Source: Fortune, Chinese tech IPOs fuel Hong Kong stock exchange’s best first half ever

I found these statistics startling. My impression has long been that U.S. capital markets are indisputably the premier destination for listed companies. Recent relative market performance between the U.S. and China would suggest the triumph of American capitalism. While generally still true, it seems the lead may not be quite as wide as I would have thought.

When Alibaba went public as the biggest IPO ever in 2014, it famously chose to do so on the New York Stock Exchange rather than Hong Kong. The company clashed with Hong Kong regulators over their refusal to relax its one-share-one-vote stance to accept Alibaba’s shareholding structure that permitted the insiders control of the majority of board seats. When Alibaba decided to pass, this was widely perceived as a loss for Hong Kong.

It turns out that Chinese tech companies often chose to list in the U.S. not only to tap into a broader and more sophisticated investor pool, but also because they simply didn’t qualify to list on Hong Kong and China exchanges. They were often tripped up by their “weighted voting rights” (WVR) structures and lack of profitability. Ironically, VIE structures were also subject to a lot more scrutiny, whereas they were permissible in the U.S.

This boils down to the core difference in how these markets operate:

• China and Hong Kong: Regulators review and approve

• U.S.: Disclose the risks, and let the buyer beware

In this way, U.S. exchanges allow unprofitable, pre-revenue, VIE shell companies with multiple share classes to go public. Some tech companies such as SNAP and GOOG float share classes that do not even have voting rights. The U.S. has its own share of fraudulent companies, and SPACs seem to be an American phenomenon.

Hong Kong has since relaxed their standards to compete for new listings, but it’s standards are still more strict than the U.S. Alibaba did eventually list in Hong Kong in 2019.

That change has marked the beginning of a homecoming trend for Chinese companies across industries, and it’s starting to show up in their IPO volume statistics:

Source: KPMG, Mainland China and Hong Kong IPO markets 2021 mid-year review

I wouldn’t be too alarmed for the future of American capital markets. Most investors trust a company listed in the U.S. than listed elsewhere, and that is unlikely to change. These recent Hong Kong offerings have also been primarily dual listings.

The point is that perhaps I shouldn’t automatically assume that a U.S. listing bestows a seal of quality, or that it will always stay the premier listing destination. Paying attention to the activity in Hong Kong seems worthwhile.

D. The longer-term effects of sanctions for the U.S.

In his 2020 letter, Dan Wang wrote that the effect of U.S. sanctions against Chinese companies has forced them to pursue domestic alternatives.

“By withholding components that Chinese companies have relied upon, the US government has turned American firms into unreliable suppliers. Chinese companies have responded by de-Americanizing their supply chains because they have no choice.”

He expands on the unintended consequences for the U.S. companies. On the one hand, it aligns the interests of Chinese tech companies with the CCP.

Hardly any of China’s largest technology companies have escaped some form or threat of US sanctions, and many more are wondering if they will end up on some poorly-understood blacklist. Thus the US government has aligned the interests of China’s leading tech companies with the state’s interest in self-sufficiency and technological greatness.

It also weakens U.S. companies.

“US politicians can observe the sometimes-devastating impacts of sanctions. What they don’t seem to realize—or want to believe—is that they’re simultaneously pummeling the American brand writ large. I’ve documented for Dragonomics the uncomfortable questions American companies tell me they’re starting to face on whether they can credibly be long-term suppliers.”

Overall, it’s hard not to come to the conclusion that these activities may ultimately be self-defeating.

“At a time when it’s more important than ever to advance its semiconductor companies, the government is crippling their sales to their largest or fastest-growing market. When research capabilities at US universities need to grow, the government is denying them students. And when the US should be attracting more talent to its shores, the government has made it more difficult for people to immigrate. Thus the US looks committed to a strategy of destroying the scientific and industrial establishment in order to save it.”

Conclusion: Zoom out

The last year has been brutal. Institutions have been shifting funds out of China until the dust settles.

Source: Octahedron Capital, A Few Things We Learned in 2Q’21

Zooming out on that chart, 30-50% drawdowns for China seem to be the norm and happen regularly every few years.

This time around, the culprits are draconian government regulations and a looming Evergrande default. Compare that to the narratives surrounding previous declines:

2018 - Chinese markets’ 2018 performance was their worst in a decade

“Beijing’s ongoing trade war with Washington dominated headlines for much of the year…Even before the escalation in trade tensions with the U.S. this year, Beijing was already trying to manage a slowdown in its economy after three decades of breakneck growth…’The toolbox is becoming emptier and emptier’

2016 - U.S., world stock markets slide as panic in China spreads

“Against a backdrop of a weak economy and, some argue, an overvalued currency, confidence in China had long been in short supply. But investors also blamed the panic here on ill-considered and poorly explained moves by the authorities this week.”

2013 - China ends year as Asia’s weakest market

“China may be the world’s fastest-growing major economy, but it can also lay claim to a more dubious superlative: home of the worst-performing stock market in Asia.”

There are good reasons to be skeptical, but haters gonna hate.

What am I missing?

A possible outcome is that there will be risk of ruin, or at least forced selling, as a result of unanticipated regulatory activity or escalating trade war hostilities. This doesn’t go away, but I believe the probability is low. The specter of catastrophic regulation hung over many disruptive technology companies such as Uber and Airbnb, which has faded to a distant memory now.

A slightly more likely outcome is that the business models of the Internet platforms have been permanently impaired. As stated earlier though, I don’t believe this to be the case, and I think the incumbents will come out just fine.

The most probable outcome is that China continues to progress and modernize, Internet platforms shrug off these latest mandates, and Chinese markets continue to open up to global investors. Choppiness is to be expected, but ten years from now, I can’t help but think that the indices will be much higher, and the leading companies much larger and more valuable, than they are today.

In fact, the one area that might be overlooked given all the doomsday news is underestimating the power and resiliency of the Internet platforms.

For the long-term holder, the odds would indicate an opportune time to build a position. To me, the price already reflects the risk. Shares have already started to recover a bit since I started writing this article (many weeks in the making now).

For me, it’s all sort of mechanical at this point. It’s the time of year when I appreciate the correlations between Alibaba vs. Softbank and Tencent vs. Prosus. It’s not perfect, but it’s close enough. The venture portfolios (Softbank, Prosus) are also a welcome addition.

Alibaba vs. Softbank (2021 YTD) - BigCharts:

Tencent vs. Prosus (2021 YTD) - BigCharts:

BlackRock has recommended investors raise allocations to China by two to three times, saying that China should no longer be considered an emerging market. That would suggest China’s weighting of 4.2% in the MSCI All-World index should be raised to above 10%. It makes sense to me, even though it feels really really hard to do.

Is this a strong buy opportunity, or a clear signal to sell? As Scott Galloway would say, the answer is yes. His below tweet likely confirms whatever you already believe.

*** Note: For entertainment and informational purposes only. Not investment advice. Please do your own research. ***

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Note: For entertainment and informational purposes only. Not investment advice. Please do your own research.

Summary

Sprouts Farmers Market (ticker SFM) offers a farmers market grocery experience with a focus on fresh and healthy foods sourced locally at an excellent value. After going public at $18/share to great fanfare in 2013 (first day close at $40+), the company has seen multiple leadership changes, leaned on debt expansion to fund growth and share buybacks, and endured a languishing stock (currently <$25). After Jack Sinclair (ex Walmart) joined the company as CEO in 2019, the company has reset its strategy, repaired the balance sheet, invested in its fresh supply chain, and is now poised to resume opening new stores. Management is targeting 10%+ annual unit growth and sees a path to double its footprint of ~360 stores today. The company has consistently produced operating cash flows >$300M+ and trades at <$3B market cap. While it operates in a competitive and slow growth business, the company has a differentiated customer proposition, a long growth runway, and generates enough cash to both allocate capital toward growth while also buying back a lot of shares. I see a case for the stock to appreciate ~3x-5x+ in the next 10+ years.

Contents:

• Introduction

• Investment Highlights

• Sprouts Long-Term Strategy

• Leadership

• Competition

• Q2’21 Performance was Underwhelming

• Valuation Thoughts

• Risks

• Conclusion

Introduction

Peter Lynch had three key rules to investing:

1. Only buy what you understand

2. Always do your homework

3. Invest for the long run

He outlined 6 categories of stocks. His favorite was the Fast-Growers category, stocks that were small, moderately fast-growing companies that could be purchased at a reasonable price. The best expression of this was often in retail where once a concept was proven out in a particular region, it could be scaled across the country, providing tremendous visibility into the pathway for growth.

Sprouts is not quite a Fast Grower, but it’s a company that has been growing well for its industry, which is rightly perceived as boring, low-growth, low margin, and intensely competitive.

I’ve been shopping at Sprouts since the first store opened in the area around 2010. It’s part of a regular rotation for us, which includes Costco, Whole Foods and Trader Joe’s.

It’s a stock that I’ve been eyeing for many years, but it’s finally at a point where I think the entry point is attractive.

Investment Highlights

The business has been remarkably consistent. Revenue has grown at a 10% compound annual growth rate (CAGR) over the past 6 years from $3.6B to $6.2B in 2021 (H1’21 annualized). Gross margins have been in the mid 30% range, return on invested capital (ROIC) in the low teens, and operating cash flow margins around 6%.

The company has expanded the store count significantly since 2015 - from 205 stores to 363 stores as of Q2’21 - while maintaining decent same sales store comps. This also represents a CAGR of ~10% for that period. The company in fact had yet to experience a quarter of decline of comparable store growth until 2021, likely due to the COVID bump in 2020. Taking a more normalized view of performance (e.g., 2017-2019) suggests same store sales growth of ~2% to 3%.

The company got a bit ahead of itself in capital allocation in 2016-2018, spending more on share repurchases and new store openings than what they were generating in operating cash flow.

This was funded primarily by taking on increased debt starting in 2016 and peaking in 2019. In fact, the cash balance was quite minimal for these years, though the company was never really in serious trouble. Since Sinclair came on, the company has started to pay down its debt and has returned to a much healthier net debt balance. They paused share repurchases in 2020 in favor of paying down debt, but they recently restarted their buybacks in Q2’21.

Most capex spend is devoted to growth vs. maintenance. See their investor presentation (Aug 2021) below.

The is in contrast to the mainstream grocers. Kroger, for example, has a different capital allocation given their much larger and mature footprint. It’s less about opening new stores, and more about optimizing their existing ones. The ‘Profitable Sales Growth’ category is primarily store remodels and merchandising initiatives that are specifically linked to Kroger’s 2-4% annual identical store growth goals.

Source: Kroger 2020 Fact Book

In my view, the ~70% of Kroger’s capex spend related to ‘Digital Acceleration’, ‘Margin Expansion’, and ‘Profitable Sales Growth’ roughly ties to what Sprouts deems ‘Sales Initiatives and Infrastructure.’

I’m more inclined to view those efforts as necessary upgrades to keep pace, rather than true sources of new growth.

Overall, I estimate the growth vs. maintenance capex split to be 2/3 vs 1/3. In other words, Sprouts spends ~3% sales on capex, with ~1% going to maintenance, and ~2% going toward growth.

Sprouts has a lot of room for expansion. The long potential growth runway is the key differentiation relative to the other public grocery companies.

There is a solid ROI in opening new stores, and they have ample cash generation to fund this growth. The company is currently shifting to a new smaller store format (21k to 25k square feet), compared to their current 29k average. Management expects the typical new format store to cost ~$3.2M to open (saving 20%). They expect the store to generate $17M annual sales with 8% EBITDA margins by year 4, or ~$1.4M in EBITDA per store. These assumptions still need to be validated as the first new format smaller store only recently opened.

The following chart from the Young Hamilton Analyzing Good Businesses substack focuses on Five Below and is a bit dated, but I found the Sprouts and Whole Foods metrics instructive. Specifically, it costs 4-5x more to open a new Whole Foods vs. a Sprouts.

Even assuming $4-5M to open a new store, the company could open 20-25 new stores per $100M in capex spend. This could be funded based on the operating cash flow as indicated earlier.

2021 has been a year to establish the foundation to support their future growth, primarily in opening two distribution centers in their Colorado and Florida markets. Colorado appears to be about improving efficiency while Florida is an expansion market. They will also be opening a new distribution center to support their expansion in PA/NJ/MD area. Management has indicated that they expect to restart 10% unit growth starting in 2022, and they seemed primed to do that.

Retailers that have developed a solid and profitable unit concept that can be rolled out efficiently at scale have typically done pretty well during their growth expansion phase.

Sprouts Long-Term Strategy

In Q2 2020, shortly after Sinclair joined as CEO, Sprouts put out a revised strategy deck for 2020 and Beyond. The following slides are taken from their latest investor deck (Aug 2021):

They are targeting Health Enthusiasts and Experience Seekers who care about fresh, natural and organic food options. This spans across incomes and age demographics.

They are moving away from inefficient loss-leader customer acquisition strategies in favor of better optimization and ROI. They used to promote weekly loss-leader specials (e.g., 10 for $1 corn) that were marketed via physical mailers. These used to be released on Wednesdays and could be stacked, so I would make an effort to go to Sprouts specifically on Wednesdays.

The company has since pivoted to a digital-first marketing platform and has backed away from these specials. The coupons I receive now come via email and are geared toward promoting larger basket sizes ($15 off $100) or highlighting their differentiators (e.g., 25% off organic produce).

They still have a ways to go, but once Sprouts attracts a customer, they do seem to score well relative to other grocery options.

They also rolled out their e-commerce capabilities during COVID via Instacart. I’ve used it a couple times but prefer to shop in person. Sprouts charges a nominal fee ($1.99) for pick-up. E-commerce penetration appears to be settling around ~11%.

But the key is that Sprouts’ product assortment is differentiated and local. 68% of items are attribute driven per the below slide. I can’t find anything in Sprouts from the large processed food companies (e.g., PepsiCo, Nestle, General Mills, etc.). There are also entire sections - vitamins, bulk grains/nuts/spices - that we no longer use.

They are also improving their operations by reducing the footprint for new stores from 30k to 23k square feet, while also opening two new distribution centers in FL and CO to increase their fresh supply chain coverage and locate stores <250 miles.

While seemingly obvious, this was not always the case. The WA stores for example are still on an island relative to the rest of the DC network. I could see this approach and focus on fresh and local products eventually creating slight process, cost and supplier relationship advantages within specific regions.

The below video describes the 135k Aurora CO distribution center which will support 45 stores across Utah, Colorado, and New Mexico.

Sprouts strategy in summary:

1. Win target customers through their refined brand and marketing efforts

2. Expand the store count with the new smaller format

3. Improve the supply chain and distribution center system for efficiencies and to offer fresh and local products

4. Reinvest to fund 10%+ unit growth and use the rest of the cash to repurchase shares

Leadership

Under new management. Jack Sinclair was brought on as CEO in 2019. He previously was EVP US Grocery for Walmart from 2007 to 2015 and also spent 14 years at Safeway. The other C-level executives have impressive and relevant backgrounds as can be seen below. The key takeaway is that almost all of them joined in 2020.

Unfortunately, that means management currently doesn’t own much stock in Sprouts, at least not yet. From the 2020 Proxy statement:

However, the company does have stock ownership guidelines:

Within five years of appointment to their position, our Chief Executive Officer must obtain and maintain beneficial ownership of shares of Sprouts stock equal in market value to five times his current annual base salary, and our other executive officers must maintain beneficial ownership of shares of Sprouts stock equal in market value to two times his or her respective current annual base salary.

Management is incentivized by a performance based cash bonus based on: pre-tax earnings (75% weighting) and comparable store sales growth (25% weighting). 2020 was a huge year for these execs, as they earned 3x of their performance bonus.

The Board also appears solid and relevant, with 7 of 8 directors independent, and board members having average tenure of 5 years.

The chairman Joseph Fortunato was formerly the CEO of GNC.

The rest is a mix of operators (CEO of Five Below, President of Trader Joe’s, President of PetSmart), tech (CIO of PepsiCo), marketing (CMO of Jack in the Box), finance (CFO Under Armour, PetSmart),

On the employee front, the company seems to be doing a solid job. They publish the following metrics in their 2020 ESG report.

Overall, the leadership looks good to me, but I would prefer to see more skin in the game. I would like to see their ownership stakes grow over the coming years.

Competition

In the U.S., there are ~40,000 grocery stores. Below are the largest names:

• Walmart: 4,200

• Kroger: 2,700

• Albertsons (Safeway, Albertsons, and Vons): 2,300

• Publix: 1,200

• Ahold: 1,900

• Aldi: 2,500

• Whole Foods: 500

• Trader Joe’s: ~550

• Costco: ~550

Not on this list is Sprouts and its 363 stores.

Grocery is a notoriously competitive and low-margin business. To illustrate, the following table from Checkbook assesses local grocery stores in the Bay Area. Sprouts is slightly better than middle-of-the-pack overall: decent quality at good prices. While a solid choice, it doesn’t really stand out in any dimension.

The above chart also excludes Sprouts’ most relevant competitor: Trader Joe’s.

While their assortment is different, Sprouts simply does not inspire the same loyalty or crowds that Trader Joe’s does. Regrettably, Trader Joe’s is private and not available for investment.

But that may be ok. Below is a map of locations for Sprouts (blue), Trader Joe’s (orange), and Whole Foods (green) in the Los Angeles / Orange County area.

This is what it looks like in the Bay Area (South Bay).

It always seemed to me that Sprouts and Trader Joe’s seemed to cluster together, and the above maps would appear to confirm that observation.

Many of these Sprouts stores have been open for a number of years. The proximity of Whole Foods and Trader Joe’s does not seem to have negatively impacted Sprouts’ overall comparable store growth numbers in the past. The bottom line is that their stores and locations do not appear to be at risk of oversaturation for awhile.

As a shopper, I go to Sprouts several times a month and spend several thousand dollars a year with them. I also visit Trader Joe’s, Costco and Whole Foods regularly as well. The below reflects my perspective as a shopper. I note that my behavior may not reflect the habits or preferences of the general population.

• Trader Joe’s assortment is truly unique with more than 80% private label. The best deals are in processed foods, snacks, and alcohol. We typically don’t buy produce or meats there.

• Whole Foods is called “whole paycheck” for a reason, where you (over)pay for the quality, except their private label items. The interior is pristine, but it feels increasingly impersonal with the proliferation of professional shoppers.

• Costco has limited bulk selection and is excellent, but not the place for produce or perishables. This is a bi-weekly stop for staples.

• Sprouts typically offers the best value x quality trade-off for fruit, vegetables and meat. It has decent private label items (e.g., organic milk, eggs, healthy snacks). Sprouts also tends to be less crowded compared to the others.

• We generally stay away from the mainstream grocery stores.

As a grocery store, Sprouts is simply solid, and nothing too spectacular.

The one area where it does stand out is in financial performance. I put together the following comparison table from Kroger’s 10-K and Whole Foods last 10-K from 2017.

Kroger defines ‘Fresh’ as produce, floral, meat, seafood, deli, bakery and fresh prepared. Sprouts defines ‘Perishable’ as produce, meat, seafood, deli, bakery, floral and dairy and dairy alternatives.

Whole Foods has somewhat surprisingly not done that well since its acquisition by Amazon in 2017. Amazon doesn’t break out Whole Foods separately but lumps it in with Physical Stores. Sales have basically been flat to slightly down since 2017. Given how Amazon operates, it wouldn’t be surprising if operating margins have trended down as well.

On a per unit basis, Sprouts seems to hold its own compared to Whole Foods. On a sales basis, the average Whole Foods store pre-acquisition did ~2x the volume of a Sprouts store (~$17M). However, Whole Foods uses a larger footprint and is more expensive to launch and operate. On an operating income basis, the gap is not as large. As Sprouts continues to reduce its average store size with the new format (which supposedly will have comparable sales), the average Sprouts store may eventually contribute as much if not more cash flow than the average Whole Foods store.

Kroger has invested a lot into its digital initiatives and recently broke into the top 10 in online sales, but online is still a lower percentage of sales compared to Sprouts. Their margins are lower, though their private label percentage is higher. They also have more debt and not as many new store expansion opportunities for growth.

Sprouts meanwhile has excellent margins, a stronger balance sheet, and a clear line of sight for growth. Arguably, there are opportunities to improve margins further given the improvements from supply chain and marketing to be realized as well as the relatively lower percentage of sales coming from private label goods [Statista].

Provided it can maintain its performance, the outlook for Sprouts looks pretty good. That is the caveat, however.

Q2’21 Performance was Underwhelming

Sprout's Q2 earnings release (presentation, transcript) in early August, and the financial results were not great. Management pointed to the dynamics of re-opening coming off last year’s COVID spike as the reason. Customers were traveling and dining out again, which affected their sales.

• Comparable store sales growth: (10.0%)

• 2-year store sales growth: (0.6%)

• Reduced 2021 guidance pretty significantly:

  • Sales Growth: “Flat to Up Slightly” to “Sales down low single digits”

  • New Stores: “~20 new stores” to “13-20 new stores”

  • Comps: “low to mid single digit” to “negative 5% to 7%”

Prior outlook at Q1’21:

Revised outlook lower for Q2’21:

On the other hand, some of the the operational parts showed promising signs:

• Distribution centers: Launched both of their new DCs in CO and FL (June). More than 85% of stores are now within 250 miles of DCs

• New format stores: 2 new format stores opened in Q2, with plans to open 3 more in 2021.

• Marketing: This was mixed given the financial results. The brand and marketing efforts were noted to have increased awareness and purchase intent, but hadn’t yet translated into increased traffic or actual purchases. This would be the next step, but they are staying the course.

More importantly, the company started repurchasing shares. They spent $87M toward the end of Q2 (average price $26.75), and another $25M after the end of quarter. They still have ~$188M in repurchase authority remaining out of the $300M repurchase authorization they announced in March.

Given their first half operating cash flows was $177M, it’s possible they could exhaust that remaining authority by the end of the year. If so, and depending on their stock price, they will likely end the year at under 108M shares, down from 114M currently, and from 118M at the start of the year. That would represent a ~9% reduction in share count. We’ll see whether or not that happens.

Given the massive cut in outlook, I would have expected a negative reaction in stock price, but that didn’t seem to be the case. The stock traded relatively flat.

However, compared to the other grocery companies, the recent divergence in stock performance since the last quarter’s earnings is notable:

Sprouts has basically been flat the last year, while both Kroger and Albertsons saw dramatic spikes. Very dramatic in the case of Albertsons.

Albertsons also had a (10%) decrease in identical store sales growth following their July earnings release, but they raised their 2021 outlook:

• Identical sales: (5%) to (6%), previously (6%) to (7.5%)

• 2-year stack growth: 10.9% to 11.9%, previously 9.4% to 10.9%

• Quarter end: June 19, 2021

Krogers saw a (4.1%) decrease in identical store sales growth following their July earnings release. They also raised their 2021 outlook:

• Identical sales: (4.0%) - (2.5%), previously (3.0%) - (5.0%)

• 2-year stack growth: 10.1% - 11.6%, previously 9.1% - 11.1%

• Quarter end: May 22, 2021

The key difference seems to be the revised annual outlook: the upward revisions were fairly minor, but Sprouts’ downward revision was major.

This is most likely unique to Sprouts, but it’s possible there may be market-wide effects. In the Sprouts call transcript, management offered the following color around timing of the weakness:

“While April experienced strong results both top and bottom line, we were disappointed with May and June.”

Sprouts announced earnings on August 5, while Albertsons announced on July 29, and Kroger on June 17.

Given the odd quarter end dates for Albertsons and Krogers (which happened earlier than Sprouts), I wonder how much the difference in sales performance was due to different time periods. However, it did not seem to affect the 2021 outlook that they provided.

In general, the reopening hasn’t been as kind to Sprouts as to the other grocers. Placer.ai has some interesting stats in a post on Sprouts’ traffic in early 2021 - negative and more negative in California:

The silver lining pointed out in that post is that CA had been slower to reopen relative to the rest of the country during that time, and Sprouts is overly concentrated in CA.

For the other grocers, there has been a noticeable recovery:

Most of the grocers saw a large uptick in traffic compared to 2019 starting in the summer months. It’s possible that this will all correct itself in short order.

Grocery had been trading at attractive multiples earlier in the year. Berkshire Hathaway has been building a position in Kroger, and now owns 8% of the company.

I’ve been evaluating Kroger to understand why, but I end up concluding that Sprouts is the more attractive opportunity for me. As mentioned earlier, Kroger appears to be mostly spending to remodel and optimize existing stores rather than launching new stores, and it has much more debt. It’s tough to grow from such a large base, and most of its increases in store count has come via acquisition. That may actually bode well for Sprouts down the line.

Kroger is definitely targeting a decent total shareholder return per below [2020 Fact Book] and the stock has already had meaningful price appreciation, so what do I know?

Valuation Thoughts

I believe there is a 10+ year runway of growth for Sprouts, primarily through continued new store expansion.

There are four key variables and assumptions in my view:

1. Store count. How many stores can this grow to from current store count of 363?

2. Comparable store sales growth. How much sales will each store produce?

3. Multiple expansion. Will SFM continue to trade at its current multiple?

4. Share count. How many fewer shares will there be in 10 years?

The low case assumes that in 10 years, store count doubles, average store sales increases by 20%, the multiple stays the same, and the share count is reduced by 25%. That results in a roughly 3x outcome.

Reducing shares by 25% over 10 years implies that Sprouts repurchases ~3% of shares outstanding per year. I think they could actually do a lot more than that, as they’ve already retired 4% of shares in H1’21 alone). If the stock continues to stay depressed, then the impact of the share repurchases will be more pronounced. Repurchasing ~6% of outstanding shares per year would cut the share count in half over 10 years. A 3-5x return over 10 years from here feels like a plausible outcome to me.

The high case assumes more aggressive growth in store count, average sales and multiple expansion, as well as the share buybacks. These variables affect one another though (e.g., multiple expansion will affect the number of shares repurchased), so the upside is more uncertain. I indicate the assumptions to achieve a 10x return in 10 years, and I do think it is a real possibility.

That assumes the following:

• Margin profile continues to hold. Any deterioration in the business will obviously weaken the reinvestment flywheel.

• Capacity to expand is not affected by competition or new consumer grocery buying behavior

• Execution to expand store count by 10% per year efficiently.

The wildcard is if the narrative around the company changes, and Sprouts inherits the Whole Foods mantle as the leading pure play organic food retailer, resulting in a much richer multiple. This is yet to be widely accepted by the market, and it ultimately may never happen.

I believe there is the cash and the execution to continue launching 30-40 stores per year for many years to come. I feel shaky in the consistency of the margins, but I was pleasantly surprised to see their historical performance. I am also encouraged by the company recent initiatives (e.g., locating fulfillment centers closer to stores) which would seem to suggest that further margin improvement is possible.

Simple, stable, high cash flow businesses with feel-good stories and long reinvestment runways where most capex is devoted to growth shouldn’t trade at ~10x operating cash flow in this interest rate environment. Grocery stores are also essential businesses and theoretically act as inflation hedges (provided prices can be passed to customers).

The annual growth is not eye-popping, but Sprouts is still likely to grow 10%+ per year for years to come.

That takes us to how the stock has traded.

Sprouts went public on Aug 6, 2013:

• Priced at $18, closed first trading day at $40.11

• 163 stores in 8 states at the time, mostly in the Southwest

• ~150M shares

Since 2013, they’ve more than doubled their store count, maintained their margins, and cut their outstanding share count by ~25%, but the stock has basically been on a steady multi-year decline. It has recently leveled off a bit though.

Nick Sleep (Nomad Investment Partnership letters) famously concentrated his investments into scale-economies-shared businesses Costco, Amazon and Berkshire Hathaway.

He first wrote about Costco in 2002. Some of the details about Costco at the time bear a resemblance to Sprouts:

The density coast to coast implies room for around 1,000 US stores (currently 284)

At 10% growth per annum, this implies the firm has another 13 years of growth ahead

The share price has declined from a year 2000 high of U$55 to U$30 (Nomad’s purchase price) as margins declined slightly (they are measured in basis points at this firm) with the cost of several new distribution centers which will support the next few year’s growth.

At U$30 the firm is valued as a cash cow, with higher levels of profitability (as capacity utilisation increases) and modest levels of growth justifying a valuation over U$50 per share. Costco is as perfect a growth stock as we have analysed and is available in the stock market at a close to half price.

I should clarify that Sinclair is not Sinegal (Costco’s CEO) and Sprouts does not enjoy an indomitable scale-economics-shared business model like Costco. Sprouts doesn’t even have a loyalty program (yet). There are similarities in the growth opportunity profile, but that’s where it ends for now.

Risks

In the bear case, the company’s poor Q2 performance represents the start of the decline. They fail to attract a core loyal customer base. The concept isn’t differentiated enough and doesn’t work - the store footprint is too small to be a one-stop shop, healthy organic foods are available elsewhere, and consumer behavior shifts to online. Consumers prefer to shop at fewer stores post-COVID, and Sprouts just doesn’t make the cut. The historical margins are unsustainable, and the company is unable to execute on its strategy of funding new store growth and buying back shares. The market continues to perceive the company as a no-growth play whose best days are behind it. Management turns over yet again or becomes susceptible to lowball M&A offers, as they aren’t truly owner operators. The company leverages up to pursue expansion or repurchases inefficiently. The stock price declines further and the company is eventually taken private at a rock-bottom price.

In the bull case, the company is successful in carving out a niche as the go-to successor to Whole Foods to cater toward health-conscious consumers at an affordable price. The company executes on its new store format and growth plans while maintaining if not growing its margins. Sprouts starts to cultivate a cost and efficiency advantages as well as network effects around local suppliers and their fresh regional supply chains. With their unique offering, Sprouts becomes an enticing and shiny acquisition target for larger players desperate for growth and ESG bona fides. If it stays independent, the company continues to grow its store count and retires a huge chunk of their outstanding shares. Management oversees a steady decade-long run of growth, accumulate a sizable ownership position, and eventually retire as the architects of a successful turnaround.

Conclusion

Based on Sprouts’ track record and initiatives in the works, I’m inclined to believe that Q2 was a blip rather than the start of a decline. My sense is that the divergence in stock performance following this quarter was an overreaction.

However, the company doesn’t really have any stand-out advantages. There is a slight case to be made for counter-positioning, brand, and local scale economies, network effects and process strength, but I’m not confident these are really durable advantages. The switching cost barrier just doesn’t seem that high for grocery.

I’ll be keeping an eye on the following milestones over the next few quarters:

1. New store format return on investment profile - do management’s assumptions still hold? There should be at least 5 data points coming out of 2021.

2. How quickly can new store counts expand? 10%+ growth would indicate 35-40 new stores in 2022.

3. Can they revive comparable store growth? Will we see evidence of the new marketing efforts working?

4. What is the impact to margins? Margins have been stable, but they are still higher than other grocers. Will potential inflation and competition supersede the positive effects of the distribution centers and other marketing initiatives?

5. Is management increasing their ownership stake? The current lack of management skin in the game prevents me from sizing up this position.

If they can sustain their margin profile and continue to grow their store count, then I think there is a strong case for a 3x+ return over 10 years. If they start to hit the conditions from the bull case, then I can see a much greater upside. The kicker is if the market starts to value cash flows more and rerates the stock higher.

Overall, I think this is a long-term hold that I can feel good about. I started building a position in the low 20s earlier in the year and plan to scale further (target 2-3%) while monitoring future performance.

Other sources:

• Sprouts institutional ownership - TIKR

• Sprouts on social media: Instagram, Pinterest, Facebook

• Placer.ai - Grocery Update - Summer 2021 - blog

• Arch Capital - Sprouts writeup (July 2021)

• Forbes - Opportunity Is Sprouting At Sprouts Farmers Market - article - Nov. 24, 2020

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Note: For entertainment and informational purposes only. Not investment advice. Please do your own research.

This is how Origin Materials [site] describes itself:

Origin Materials is the world's leading carbon negative materials company.

Origin’s mission is to enable the world’s transition to sustainable materials.

Over the past 10 years, Origin has developed a platform for turning the carbon found in inexpensive, plentiful, non-food biomass such as sustainable wood residues into useful materials while capturing carbon in the process.

Origin’s patented technology platform can help revolutionize the production of a wide range of end products, including clothing, textiles, plastics, packaging, car parts, tires, carpeting, toys, and more with a ~$1 trillion addressable market.

In addition, Origin’s technology platform is expected to provide stable pricing largely decoupled from the petroleum supply chain, which is exposed to more volatility than supply chains based on sustainable wood residues.

Origin’s patented drop-in core technology, economics and carbon impact are supported by a growing list of major global customers and investors.

In short, the company claims to have figured out how to turn wood residue into plastics and other useful materials in a process that is:

• carbon negative;

• cost-competitive with petroleum-based products; and

• can be dropped into existing supply chains.

Earlier this month, the company announced that its core materials chloromethyl furfural (CMF) and hydrothermal carbon (HTC) are now able to display a unique USDA certified biobased product label [press release].

The company raised ~$470M cash via a SPAC in order to commercialize its technology and fund the construction of two plants. Since completing its SPAC merger with Artius Capital in June 2021, the stock has cratered, along with the rest of the SPAC market. It’s traded between ~$5-$7 over the past few days.

At these levels, this strikes me as a fascinating moonshot venture idea that happens to be publicly traded.

What is Origin?

The following Analyst Day presentation (April 2021) provides an excellent overview of the company.

The following are the three key investor presentations:

• Origin Q2 presentation - August 2021 [link]

• Analyst Day Presentation - April 2021 [link]

• Investor Presentation - February 2021 [link]

Investment Highlights

1. Governments and corporations are declaring aggressive decarbonization and net zero goals in the coming decades.

2. Origin has developed a technology that can make plastic (among many other materials) out of wood residue (sawdust, wood chips), rather than petroleum.

Origin claims its solution is superior as it is:

1. Drop-in ready, supply-chain ready, and therefore scalable and adoptable by the industry as a viable alternative to fossil-based feedstocks

2. Negative-to-low carbon as its feedstock can be sustainably harvested and renewable

3. Origin’s technology has been vetted by leading consumer products companies such as PepsiCo, Danone and Nestle, among an increasing growing list. The company claims to have tripled capacity reservations since February and now has capacity reserved for $3.5B (August 2021).

Origin has claimed its technology will “revolutionize the production of a wide range of end products, including clothing, textiles, plastics, packaging, car parts, tires, carpeting, toys, and more with a ~$1 trillion addressable market.” In their Q2 earnings release, the company announced a number of commercial deals with leading companies representing these other verticals that indicate the broad applicability for this technology.

Examples include:

• Automotive - Ford Motor Company and Solvay. Origin and Ford are launching the Net Zero Automotive program focused on industrializing new materials to drive decarbonization in the automotive industry, with potential applications through the interior and exterior of the vehicle, including bumpers, paint pigment, door panels, tire filler, underbonnet foam sheet, black plastic, head rests, seat cushions and arm rests.

• Chemical - Mitsubishi Gas Chemical.  Mitsubishi will utilize Origin technology to industrialize advanced carbon negative chemicals and materials for applications in the automotive, medical, food, information and communication, energy, and infrastructure sectors. Mitsubishi was also an investor in the PIPE.

• Apparel - PrimaLoft. PrimaLoft will develop carbon negative insulating fiber for outdoor gear, bedding and apparel. PrimaLoft’s brand partners include Patagonia, Stone Island, L.L. Bean, Lululemon, adidas and Nike.

• Packaging - Packaging Matters. To advance carbon negative packaging solutions, building on an existing 10-year supply agreement.

• Supply Chain - Palantir Technologies. To accelerate the world’s transition to net zero carbon with a focus on decarbonizing the global materials supply chain.

During the Q2’21 earnings call [transcript], management provided additional color on the customer contracts:

So they're typically over $100 million. They're 5 to 10 years in length and they're typically with big companies and they would normally start with what we call a capacity reservation, which specifies the product, the price, the quantity and the duration of the contract. And then we'll move that into an offtake agreement, certainly in time for project financing of the plants.

4. PepsiCo, Danone and Nestle have also invested ~$40M and own ~8% of the company [prospectus]. A partial cap table is shown below.

5. The company now needs to prove out commercial scale of their technology to produce these materials. They are building two plants - Origin 1 and Origin 2 - slated for delivery in late 2022 and mid 2025. Origin 1 is meant to be more of a proof-of-concept facility, while Origin 2 is meant for commercial scale.

As of Q2, they are tracking ahead of the schedule laid out during the SPAC process for Origin 1. Note that these facilities have been delayed many times before.

6. Artius, the SPAC sponsor, conducted extensive diligence and have excellent track records in the finance and corporate realm. Charles Drucker was former Chairman and CEO of Vantiv/WorldPay, and Boon Sim previously was Head of Global M&A at Credit Suisse and Head of Americas and International at Temasek.

In the intro to the Analyst Day video, Boon Sim noted that the team conducted over 3 months of extensive due diligence on Origin:

1. Retained Bain Consulting and two specialist chemical consulting firms to vet the technology, scalability, unit economics and total addressable market.

2. Conducted 40+ key customer and potential customer calls. Covered key customers like Pepsi, Danone and Nestle. All of these key customers confirmed to them that the technology works and extensively tested by them. Confirmed that it is the only company that produce carbon negative materials that has an ISO compliant Life Cycle Assessment (LCA) report from Deloitte [link] to support their claims.

The Artius team was very involved in the diligence [Prospectus]:

During the weeks of January 18, 2021 and January 25, 2021, representatives of Artius and its advisors held multiple teleconferences with Origin and its advisors to continue to conduct due diligence of Origin’s business. These conversations included (i) several due diligence calls with key customers, (ii) intellectual property due diligence discussions on January 21, 2021, January 26, 2021 and January 29, 2021, (iii) financial forecast and plant economics discussions on January 18, 2021, January 22, 2021, January 23, 2021 and January 25, 2021, (iv) technical due diligence discussions on chemistry technology and manufacturing processes on January 21, 2021, January 22, 2021, January 27, 2021 and January 28, 2021, (v) capital requirements, plant design and construction diligence discussions on January 25, 2021 and January 27, 2021, and (vi) a legal due diligence discussion on Jauary 27, 2021. Several of these teleconferences were attended by members of the Artius Board of Directors.

An investor posted lengthy notes on Twitter to two calls (July 2021, June 2021) with Origin’s management team and the SPAC sponsors.

• 40 customer calls, 60-90 minutes long, and Boon and Charles were on each one

• Engaged two major consultants to assess the technology, patents and unit economics

• Product is chemically identical to PET, which has been confirmed by Nestle, Danone, and Pepsi. Those customers alone could satisfy demand worth ~$8B and account for 20 manufacturing plants.

• The sponsors are in it for 5-10+ years

• The key to their thesis is that the product is cost competitive with petroleum-based products.

The board of directors also seems to offer extensive and relevant experience across chemicals (Du Pont, BP) and consumer products (Clorox, P&G). The CEO goes into detail on each board member’s strengths in the following Reddit AMA video.

How is Origin using its BOD from the chemical industry to grow the business?

• Karen Richardson - BP and high growth - Chair role

• Benno Dorer - CEO of Clorox - they are excellent at chemicals products and understand consumer

• Kathy Fish - Chief Product Officer at P&G - using performant materials in consumer products

• William Harvey - Du Pont, ran packaging arm - understanding from large scale producers of product

7. Construction and execution is the key risk, but the company appears to be taking the right steps to mitigate.

Koch Modular (Koch Industries subsidiary) is the construction partner for Origin 1.

From the earlier referenced management call notes, Koch had given performance guarantees on the hydraulics, thermal and mechanical performance of the construction of the plant.

In the Q2 earnings presentation, the company noted that the core modules were ready for installation.

The company also claimed to have sufficient capital to complete both plants with $100M to spare.

8. Insiders have demonstrated their bullishness by backstopping the deal.

The deal announcement in February 2021 was made at the height of the SPAC frenzy and included an oversubscribed PIPE.

Transaction is expected to provide up to $925 million in gross proceeds, comprised of Artius’ $725 million of cash held in trust, assuming no redemptions, and an oversubscribed $200 million fully committed PIPE at $10.00 per share, including investments from Danone, Nestlé, PepsiCo, Mitsubishi Gas Chemical and AECI, as well as certain funds and accounts managed by Sylebra Capital, Senator Investment Group, Electron Capital Partners, BNP Paribas AM Energy Transition Fund and affiliates of Apollo.

Legacy Origin customers and investors Pepsi, Nestlé and Danone purchased 97,500, 100,000 and 100,000 shares of our Common Stock in the PIPE transaction.

Since then, the SPAC markets have endured a tough past few months. Recently completed deals have had massive redemptions.

The Origin deal was also subject to a minimum $525M closing cash condition. This was put at risk as the company sustained a high level of redemptions.

In order to close, Apollo invested another $30M into the deal as part of a backstop agreement [June 14, 2021]. The SPAC sponsor Charles Drucker invested another $6.5M in the PIPE at the deal closing. [Form 4]

While the SPAC sponsor did get ~18M shares by getting the deal over the finish line, they had also agreed to a number of vesting restrictions for 4.5M of those shares subject to share price performance conditions.

As can be seen from the cap table and footnotes below, there are currently 136.7M shares outstanding, but there can potentially be up to ~210M shares assuming the stock reaches $25 per share.

After the deal closed, the stock subsequently collapsed to ~$5.

The board chair Karen Richardson [Form 4], SPAC sponsor Boon Sim [Form 4], and co-CEO Rich Riley [Form 4] have all made purchases in the past week.

While insiders may choose to sell for a number of reasons, when insiders exhibit cluster buying on the open market, that generally is a good indicator that the stock is undervalued.

Risks

Technology risk: Seems too good to be true. Is this Theranos, or is this not? As a pre-revenue company, there is a significant risk that this all goes to zero, even if the technology works out. It’s hard to dismiss the growing list of legitimate customers, many of whom are investors. Hopefully this is not a crowded trade relying on the diligence and conviction of others. I may very well be guilty of that myself.

Execution / Construction risk: The construction could be delayed, it turns out to be much more costly than originally estimated, etc. The company has already missed delivery deadlines in the past, though that seems to have been before Artius’ involvement. At the current price, the market seems to be expecting bad news, that it’s inevitable that this will get delayed. It doesn’t seem to give much credit to the company tripling its offtake volumes this year. It seems odd that there seems to be less skepticism on the technology, and more in the construction. Skepticism for SPAC companies is warranted. If the company is successful in proving out Origin 1, then I would expect the market to dramatically adjust their expectations accordingly.

Financing risk: Management claims they will still have $100M remaining even after completing Origin 2. They’ve also indicated that their financing assumptions (50% LTV to 70% LTV) may be conservative. I’m skeptical that their current cash balance is sufficient, but I feel confident that their investor base will help them bridge the gap. My hunch is that some of their existing investors (e.g., Apollo) may also be involved in future debt financings to fund their construction projects.

Commercialization risk: Even if the plants are eventually built, it may turn out that the technology cannot be deployed cost-effectively at scale. Many of the customer offtake agreements have exit clauses in the event certain deadlines are not hit. Management is confident that any such restrictions could be extended because their customers are looking for this solution. If it turns out Origin’s materials are not actually cost-competitive, then that may change their appetite to wait or to purchase in volume. However, management believes there are opportunities to pursue joint ventures with industry players to license the technology, so even if these plants do not work out, there may still be value in the technology regardless if the company is unable to commercialize the technology successfully themselves.

Competition risk: Is this truly a unique technology? I am not smart enough to say otherwise. The Deloitte LCA report was over my head. Management claims there is a significant process advantage given their multi-year headstart with this technology. Again, I recognize that I am relying on the diligence performed by Artius as well as the customer announcements. At this price, it’s not necessary for the the technology to be truly unique, as long as there customer demand for the end product.

Valuation

The stock has been extremely volatile over the past few weeks, and a 10% daily swing is to be expected.

With 136.7M shares outstanding and ~$470M net cash on the balance sheet, a share price of $5 to $7 implies the enterprise value is ~$200M to ~$500M.

Even with the cash balance, there is a meaningful risk of ruin here, but the upside is undeniable. Setting aside the investment component, there is also the giddy hope that a technology like this could actually work.

I’m opportunistically building an ~1% moonshot position and looking out for the following milestones:

• Origin 1 modules installed (end of 2021)

• Licensing partner announced

• Revenue recognized (not till 2023)

Were this a private venture opportunity, this would strike me as a very attractive risk reward. Yet, this is now publicly traded. This will be a fascinating company to follow through the coming years.

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Other notes and sources:

Original financial projections below for reference [Prospectus, page 117], but I’m not really putting any weight on it. This either works, or it doesn’t work.

The ValwithCatalyst twitter account had incredible invaluable information on this opportunity. It included a link to an excellent Value Investors Club writeup as well as to the below video which goes into depth.

Note: For entertainment and informational purposes only. Not investment advice. Please do your own research.

Wish’s second quarter was just shockingly atrocious. My prior thesis has effectively been shredded. They are not suspiciously undervalued anymore. The whole business model is suspect.

The bewildering part is that management seems to have been caught completely off guard by these developments. Peter pointed to a combination of re-openings leading to less user activity, unexpectedly high performance marketing costs leading to poor ROI, and slow app performance leading to a poor user experience.

It’s surprising how a company which had managed to compete effectively with Amazon and Alibaba for so long, which overcame seemingly overwhelming existential supply chain disruption issues during COVID, and which had convincingly billed itself as a strong data science / technology company, has managed to get so tripped up by this set of arguably foreseeable circumstances.

On the surface, the performance in the quarter doesn’t look that bad. A year-over-year revenue decline of 6% ($656M in 2021 vs. $701M in 2020) seems understandable coming off a tremendous Q2 2020 COVID result. It still far surpasses the $420M revenue from Q2 2019.

The problem is that core marketplace revenue has declined far more (29% down) than what has been made up in logistics revenue growth, which unfortunately is lower gross margin. The quarter apparently had “a strong start”, but then gave way to a massive decline that led to the underperformance.

Unfortunately, that negative performance shows no signs of abating. In lieu of providing Q3 outlook, Peter indicated:

Q2 MAUs were down 22% year-over-year and active buyers were actually down 44%, year-over-year. And this trend actually continued into July as MAUs are down 9%, even compared to June.

…to provide some context quarter to-date total revenue through July 2021 was down approximately 40% compared to the prior quarter, while marketplace revenue was down approximately 55% compared to the same period. With a pullback in digital ad spending, we expect third quarter revenue to decline further.

They are no longer confident that they can acquire customers profitably and so are cutting off new customer acquisition in favor of bolstering retention. While no formal Q3 revenue guidance was provided, the company was strongly hinting that the business was rapidly deteriorating and that Q3 would look to be about half of Q2 based on its current trajectory.

Even the quality of the shareholder letters between Q1 and Q2 was drastically different. It’s like they were written by completely different management teams.

What’s curious is that there were a number of positive developments coming into the quarter. They had announced several key executive appointments, including Jackie Reses as executive chair in May, and two former Google executives to become CTO and CPO in just the last few weeks. The company had been granted an EU Payment Services License in July, which provided an early hint at their payments ambitions.

I had thought their prior guidance for flattish growth in Q2 was an overly conservative estimate given their excellent past performance in order to provide buffer for lapping their breakout COVID quarter. Well, I was wrong in painfully spectacular fashion. Let me count the ways:

False Assumption #1: The business could be run for profit by turning off marketing. That was the first question in the earnings call Q&A. Management no longer stands behind that claim based on elevated advertising costs and a broken LTV/CAC customer acquisition model. That had been my key assumption to protect the downside - that this business could be run for cash if they stopped investing for growth. That can’t work when the business can decay so rapidly.

False Assumption #2: The business had resiliency given the high proportion of revenue from existing customers. Revenue from existing customers had been 70% of the business according to the IPO prospectus. Well, that can’t be true if your business can decline ~50% quarter over quarter.

False Assumption #3: The secret sauce of the business was in their data science and technology, as reflected in their functional headcount distribution and past performance. If that were true, then they would have caught and rectified their performance issues before it deteriorated to this level. At this point, it’s not clear that they have a viable business model.

The CFO resignation announcement toward the end of June now takes on an entirely different light. I had rationalized that departure at the time thinking that the company was actually looking to make a change, but should have realized the alarm bells when no replacement was announced. On the call, no update on the CFO search is expected until the end of the year. When the CTO and CPO joined in July, I assumed that their decisions reflected the earlier departure. Now I wonder how much they really knew about the company’s performance.

So what to do now?

What used to be for me a deep value long-term growth investment is now a speculative bet that this newly assembled management team can revamp the product and business model to staunch the bleeding and reinvigorate growth.

The downside protections have evaporated.

• The cash balance is rapidly dwindling. There is still ~$1.6B cash, but they are now burning ~$200M a quarter.

• Management no longer stands behind the claim that they can run the business at a profit by turning off marketing. The several years of FCF breakeven performance leading up to the IPO can no longer be relied upon.

• Even with the marketing, metrics across the board - active buyers, revenue, gross profit - are declining by 20-50% across all geographies.

Unfortunately, there weren’t any good answers provided during the call to provide confidence that this decline could be halted in the near-term. It does not seem that the solution is known yet. The only logical thing to do is what the company is doing now: dial down spend significantly to diagnose the issue. That, however, has grave implications to growth.

I was discouraged that none of the new executives showed up on the call. When Reses joined as executive chair in May and had a brief appearance during the Q1 call, I was hoping that that she would be a constant presence and start to help tell the company’s story better. Unfortunately, there’s really no way to salvage this last quarter’s story. Her compensation package, which previously seemed so attractively performance-weighted, now appears hollow and provides hardly any incentive to stay.

The potential downside from here looks dire. It also, unfortunately, looks frighteningly probable. In this scenario, the company can’t figure out what went wrong and continues its breathtaking decline. Employees that got jilted in the IPO leave in droves for greener pastures, if they haven’t already. One or more of the recently hired executive team concludes they didn’t sign up for this mess and decides to bail on the company.

Even if they right the ship somehow, it’s hard to have much confidence in a business that is so susceptible to wild swings. The business seems to be more volatile than the stock price right now.

Following earnings, JP Morgan issued a double downgrade and cut their price target to $5. That seems fair to me.

The company still looks to generate ~$1.0 to $1.5B in gross profit for the year, but not even management can tell you what to expect at this point. It’s unclear how much actual cash flow can be extracted from that gross profit, if at all. Including the ~$1.6B in cash remaining, I struggle to justify paying more than $2.5B to $3B for the whole business today. That’s a $4-$5 stock price, and there’s still 70M in options outstanding remaining to be exercised.

The potential upside is uncertain. In this scenario, perhaps these last few months turn out to be a mere blip, a decline artificially enhanced by the COVID highs. Perhaps one or several insiders increases their ownership at these depressed prices. Perhaps the company finds a way to push through as it has so many times before. Maybe the company ultimately resets at a lower revenue baseline with logistics and local, which would still be a $1B revenue business. Or, they just start from scratch with an entirely new app. It’s hard to count out a company with a driven founder CEO at the helm with ~$1.6B to work with (though we’re told not to expect anything until H2’22 at the earliest).

My intent in investing is to buy and hold for the long-term. The hardest part is holding. If I stick my head in the sand and revisit in 3-5 years, this could all potentially play out ok. Stranger things have happened in these markets. As much as I’d like to believe it, which psychological trap would I be succumbing to the most if I counted on that?

The business, as it currently stands, looks broken. What used to be a promising, high-growth, global-scale differentiated commerce player at an excellent value has deteriorated into a meme stock with an unclear future.

I candidly admit that I had quite a bit of conviction in the asymmetric risk reward of this opportunity. That conviction has almost entirely disintegrated. I see as much downside as upside now.

Warren Buffett famously sold all of his airline stock holdings at the COVID low. Based on the information that was known then, I think it was a justifiable decision. Based on the information that I know now about Wish, I think it would be justifiable to exit the position completely, at least until there is evidence that the business has found some stability.

As I said before, it’s hard to count out this company and this CEO. I revisited Joe Lonsdale’s reflections on the Wish investment at the time of IPO in December - seems like such a long time ago now.

In Silicon Valley, many built businesses catering to their wealthy friends – but cost-conscious consumers are a much larger market.

With no one else addressing this segment of the market, Peter realized that Wish could become the e-commerce platform for cost-conscious consumers. Wish could do a better job than the incumbent discount retailers in serving these consumers. Rather than relying on humans to guess what merchandise to stock the shelves with, Wish could predict consumer preferences by gathering data at scale and conducting experiments to figure out which items people actually wanted to buy.

…

Wish’s incredible journey is proof of what happens when you bet on top talent, focus on solving overlooked problems, and persevere.

I do believe those traits are worth betting on. The key missing piece is evidence that there is a viable e-commerce business model to address the cost conscious segment of the market. They’ve had it for years, and lost it for a quarter. Is it too much to think they’ll figure it out and recover? I hope that’s not wishful thinking.

This was a swing and a miss, but I think I still would have swung based on what I knew.

I’m not exiting all the way just yet, but I certainly had way too much exposure based on where the opportunity is today.

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Note: For entertainment and informational purposes only. Not investment advice. Please do your own research.

Two enterprise software startups poised to modernize and transform commercial real estate, rapidly winning broad adoption and owned by the industry’s leading players. Underfollowed and dismissed due to SPAC stigma and seemingly preposterous valuation multiples. Yet, there are intriguing and promising early signs of an emerging duopoly, with potential to become the iOS and Android for a staid but massive industry.

CONTENTS

• Introduction

• Thesis

• Investment Highlights

• Why Smart-Enablement Technology is Poised for Adoption

• Enter Latch and SmartRent

• Who Wins?

• Value Creation

• Ownership

• 7 Powers

• Valuation Thoughts

• Risks and A Note on SPACs

• Bottom Line

Introduction

It’s often said that investing in real estate is the path to wealth.

Lately, I’ve been spending quite a bit of time looking for an appropriate real estate play: rental properties, REITs, private equity, crowdfunding platforms. There is no shortage of potential opportunities to explore, and no lack of companies and individuals available to help you along that journey.

Earlier this year, I found myself caught up in the latest commercial real estate deals from such sites as Crowdstreet, RealtyMogul, and Cadre. These appear to be quite enticing at first glance. I had little interest in managing a rental property directly, and the properties in my area were too expensive for investment anyway. These platforms seemed to provide access to previously hard to find opportunities, and I would be able to participate as a passive investor without any of the headaches associated with property management. There were so many different types of deals, asset classes and capital structure areas to pore through, and they all seemed to offer compelling returns from a cash flow and IRR perspective.

After looking through dozens of these opportunities, however, I gradually became less and less enamored with them. I started noticing a common financial profile across the opportunities: 3-7 year hold periods, 50-70% debt levels, 5-8% target cash yields, and 15-20% target IRRs. On the surface, these seemed to offer a great return, but there were a lot of factors to consider: the experience and history of the sponsor, the amount of skin they had in the project, the location and history of the property, the reams of operating agreements to read through, and the layers upon layers of stakeholders and fees. These new platforms all had snazzy interfaces and promised to democratize real estate investing, but it also made me wonder why these deals were becoming accessible to me now.

It also seemed that the most attractive projects were typically snapped up immediately and allocations were scarce. Those that were available for investment implicitly raised the yellow flag for why they were available. Surely, I was missing something, for otherwise, the savvier investors would have claimed the investment already.

What did I know about the prospects for some value-add multi-family or hotel conversion for some Florida suburb? How much could I comfortably put into any one deal? Was it really worth the effort to do the research, not to mention all of the ongoing overhead of K-1 filings, special tax consequences and illiquidity? I concluded that it didn’t make sense.

REITs then seemed to be a cleaner and simpler alternative. But the most desirable companies with the best property portfolios of course all had lofty valuations. Many also had high debt levels and/or would continually issue dilutive shares to expand their portfolios. Apart from the premier companies, the rest seemed to be more or less undifferentiated collections of properties with similar financial characteristics. There were some decent opportunities, but this ultimately felt like an alternative for fixed income rather than true appreciation.

What I really wanted was to find some concentration of power, an area where I could enjoy the compounding effects of a growing business with a defensible moat.

I believe that opportunity exists within real estate technology, particularly in areas where emerging players have started to achieve adoption and investment from the industry leaders and are rapidly de-risking their paths toward becoming the industry standard.

To cut to the chase, there are two companies - Latch and SmartRent - that appear to be the leaders within smart enablement for multifamily.

To me, there are striking parallels to Apple iOS and Android in smart phones, or Mac and Windows in personal computing. It’s a brash claim, but I believe the comparison to platform software is appropriate.

In fact, there are elements here that may make this superior to software. These are sticky, long-term, recurring revenue solutions where the industry has more or less declared the winners. The industry itself doesn’t get much attention and is often dismissed as boring and archaic and destined to fall post-COVID, even though global real estate is the biggest asset class out there (HSBC, NAREIT).

Both companies will have tapped the public markets via a SPAC, an approach to fundraising which has gained a lot of notoriety recently and which is currently in disfavor. The consensus among the financial establishment is that SPACs are a poor deal for retail investors and are generally for low quality companies. I understand the position, but I think there are remarkable opportunities within SPACs for those that care to look.

Between the two, I find SmartRent to be more appealing at this time, but I don’t know which one will ultimately “win.” Fortunately, I don’t think it’s necessary to pick a winner. I think it is becoming increasingly apparent that the two of them will take the lion’s share of the industry. Therefore, I think the appropriate step is to bet on both of them.

Thesis

The commercial real estate industry is an enormous legacy market that is ripe for technological disruption. COVID has accelerated this transition.

Smart-enablement technology (i.e., an enterprise software solution for multi-user real estate assets) solves critical pain points for real estate owners and operators: access control, delivery and guest management, smart home devices and sensors, connectivity, energy management, parking management, and self-guided tours. A single operating system allows enterprise-level controls for any smart home technology deployed across an asset or a portfolio. This has obvious and tremendous benefits for real estate owners: (1) cost reduction, (2) simplified and superior user experiences, and (3) opportunities for rent increases.

The market is enormous. Per SmartRent, in the US, there are ~43M institutionally owned residential rental units that will likely become smart-enabled in the next few years. Fewer than 500k of those units have any kind of smart-enablement today. In the EU, per Latch, there are 93M units. Beyond residential, other adjacencies include commercial office, student housing, senior housing, military housing, and hospitality (hotel and vacation rental).

Real estate owners, while they recognize the benefits of this technology, are ill equipped to develop their own solutions. This industry is culturally cautious toward early technology adoption and not likely to experiment with unproven solutions. Once a leader in a space emerges, however, they are likely to exhibit predictable behavior and follow the herd. The industry is also relatively small and the majority of assets are controlled by a few hundred players and decision makers. Therefore, the technology solution(s) that do win adoption among the industry leaders will very likely become anointed as the industry standard and have a clear path to broad adoption.

Latch and SmartRent have emerged as the chosen enterprise software solutions. Several leading real estate owners have already adopted and deployed this across their entire portfolios.

The leading RE owners are not only Latch and SmartRent’s most important customers, they are also among their largest investors. Both Latch and SmartRent have or will soon enter the public markets via SPAC, led by key commercial real estate institutions.

Both Latch and SmartRent earn recurring revenue of $5 to $25+ per door per month under multi-year contracts (6+ years) that are typically paid upfront.

The market appears to underappreciate these companies, likely because: (1) property technology and real estate is simply not that glamorous, (2) these companies at first glance appear to be IoT hardware, a space notorious for intense competition, low margins and unrealized potential, (3) the current financials significantly understate the future earnings power given the long installation cycles in real estate and do not adequately reflect the pipeline visibility, and (4) the market currently has a poor opinion of SPACs in general and automatically assumes such companies are of lower quality. These companies are also generally underfollowed by Wall Street initially.

Although Latch and SmartRent are direct competitors, there are signs that they will evolve toward distinct marketing positions:

• Latch as the higher-end luxury solution that designs their own hardware and offers a premium aesthetic and brand (i.e., Apple / Peloton) with a founding team out of Apple and Google.

• SmartRent as the more versatile, hardware-agnostic and configurable offering (i.e., Android / PC), with an executive team that came from commercial real estate.

I do not know who will win, but I am confident that the market will be won between the two of them. Therefore, I believe the appropriate play is to invest in both.

The “combined company” currently trades at a total value of ~$4B (enterprise value of ~$3B with ~$1B in cash). I believe that valuation is supportable if their solutions are deployed to ~4M doors. I believe that is very achievable and may already be supported by their current pipelines.

If they reach 4M doors and solidify their value proposition, then I think they will have a clear growth path within multifamily and other multi-user commercial real estate categories globally to achieve a 10x+ adoption (i.e., 40M+ doors).

Investment Highlights

Below are the key reasons I think this is such a compelling opportunity.

Powerful market position with rapidly growing moats. Network effects and switching costs within a customer’s portfolio after the software is deployed and hardware installed. Economies of scale as they gradually become the industry standard. SmartRent has process power in their deployment team and hardware agnostic approach that adapts to all price points. Latch is starting to build a premium brand that is being highlighted by their customers as a key marketing point. They have locked up the key RE players as investors and customers. Coupled with being public and having significant cash reserves to fuel their growth, this creates formidable barriers for would-be challengers.

Predictable, recurring software-like economics. Unlike residential smart home which is about selling hardware to consumers, commercial smart home is about the software. The average contract life is 6 years, and most contracts are completely prepaid. Once deployed, the software and hardware is fixed to the building and becomes part of the asset for future owners. Software is charged on a monthly per-unit basis of $5 to ~$25+ per month, depending on modules adopted.

Strong sponsorship and alignment of interests. Their key customers are the leading real estate owners and property managers in CRE and multifamily. The biggest names each control 50k to 100k units.

Both companies will have exceptionally strong permanent capital bases. Their key customers are also their biggest investors. Latch was taken public by Tishman Speyer in June and counts Brookfield as an early investor. SmartRent is being taken public by Fifth Wall - the leading property tech VC firm which boasts ~70 global leading commercial real estate companies as limited partners.

Predictable path to scale and growth. (1) Deploy within existing customer property portfolios. (2) Expand modules within deployed properties (“land and expand”). (3) New customer acquisition efforts become easier and less expensive over time as these two become the industry standard.

Financials are currently understated and underappreciated by the market. Their revenues mask the potential in the software component of the business given the long sales and deployment cycle for commercial real estate. Even though both have several hundred thousand units booked, it will take years for the revenue to ramp. The hard work to convince the industry to adopt has already happened. It is now simply a matter for the industry to steadily deploy the solution across their portfolios. This will become apparent in ensuing years.

Both companies have compelling valuations and intriguing risk-reward. Latch is ~$1.3B EV. SmartRent is ~$1.8B EV. Each has or will have ~$0.5B in cash post SPAC merger. The “combined” company is ~$3B EV and has ~$1B cash.

Enormous global opportunity across all multi-user real estate asset classes. While both are starting with US multifamily, both are already starting to branch out to other asset classes: single family rentals and student housing for SmartRent and commercial office for Latch. Expansion to other categories is simply a matter of observing what relevant assets are owned by their investors. Beyond the multi-user asset classes, there is also an intriguing opportunity to eventually offer value-add services to residents/tenants.

Why Smart-Enablement Technology is Poised for Adoption in the Commercial Real Estate Industry

Smart home is an incredibly crowded, hyped and competitive space.

All of the major tech players have a smart home system: Amazon Alexa, Apple HomeKit, Google Assistant, and Samsung SmartThings.

Picking from among these ecosystems can be quite overwhelming - just take a look at this comparison or Tom’s Guide.

Diving into specific device hardware opens up even more choices. I was first curious about smart locks / access control, and this quickly became a rabbit hole. As a starting point, Wirecutter has a list for the best smart locks.

This broader industry breakdown for physical access control by Group 337 provides a glimpse into just how crowded this playing field is.

It will definitely take some time for the dust to settle. It may also very well turn out that even were a winner to emerge, there may not be much profit to be made in this industry. Selling hardware is a notoriously difficult business.

I have no idea what will happen on the residential side. I think the picture is different for commercial.

This apartment manager’s guide to smart locks provides a useful primer to what property managers look for.

In a multifamily building, smart locks have two equally important users: The property manager and the resident. Devices built for single family homes aren’t designed to cater to both.

Smart locks for apartments should meet a few fundamental requirements: the bare necessities. Make sure your smart lock checks these boxes:

1. Multiple, customizable user permissions

2. Temporary digital keys

3. Integration with access control system

4. Fire Code Rating

Multifamily properties are held to a different safety standards than single family homes, especially for fire safety. Smart locks must meet the same fire safety requirements as other building materials. Unfortunately, this doesn’t always happen.

Building materials used in multifamily construction– including walls, doors, and locks– must receive a fire resistance rating from an objective research group like Underwriters Laboratory (UL). Fire resistance rating is defined by how long a material can survive against direct flames.

This starts to narrow considerably the pool of potential companies when it comes to smart locks specifically.

There are still a lot of options, but one company in particularly starts to stand out when it comes to multifamily: Latch.

They are still a very young company, but they really seem to know what their customer (i.e., the property owner) is looking for.

Even just the smart lock by itself was worth it to this owner of an 18-unit complex in Brooklyn. The first half of the video is an interview with Latch regarding the company and product. The second half includes a view of the installation as well as the cost breakdown and ROI consideration.

There are noted time and cost savings in not having to issue new keys or having someone onsite handle visitors and deliveries. There are also revenue opportunities associated with being able to charge higher rents.

The combined effect is to increase net operating income (NOI) and therefore increased valuations for their assets.

Zooming out on the industry and technology adoption in general, it’s recognized as important, particularly coming out of COVID, but it’s still early. Below are a few charts from Ernst & Young’s report on tech adoption in commercial real estate.

35% of respondents are still piloting, evaluating or assessing the market. The challenges to adoption are understandable:

• Other priorities. “Limited resources and competing priorities often trump new technology solutions”

• Integration. “Too many companies in the proptech and systems space are not integrated”

• Talent. 53% recognize they do not have the required tech talent

• Culture. Traditional if-it-isn’t-broken-don’t-fix-it culture toward legacy systems that continue to function, though not as effectively as currently available technology. 

On the other hand, ownership of properties and therefore the decision-makers are highly concentrated. Once a technology does pass muster, the rest of the industry will likely adopt en masse.

Enter Latch and SmartRent

These resources provide an excellent starting point:

• Latch: Analyst Day presentation (March 2021)

• SmartRent: blog post on SmartRent that comprehensively explains the company, opportunity and rationale by their SPAC sponsor Fifth Wall (April 2021)

Below, I’m going to mix materials liberally from these two companies to explain why their solutions are so compelling to commercial real estate owners and operators.

Latch started off as a smart lock developer, but they’ve increasingly expanded their solution to become a platform with LatchOS (enterprise software platform to manage smart devices), LatchID (single ID to enable users to unlock any Latch device), and Works with Latch ecosystem partners such as Google Nest, ecobee and Honeywell.

SmartRent from the beginning was an enterprise software company dedicated to commercial real estate with a hardware agnostic approach. Real estate owners can plug and play the hardware they want based on the appropriate price point and aesthetic for a particular property.

The value to owners and operators is super compelling. Examples include:

• 70-90% decrease in water damage expense due to connected leak detectors in all units

• 20-50% leasing cost savings through self-guided property management

• 20-30% utility cost savings through smart thermostat management.

Such technology deployment also enables owners to increase their rent by $25-$100 per unit per month, so the deployment effectively pays for itself.

Source: SmartRent presentation

These are sold on a monthly recurring revenue software subscription. The stated range is $13-$34 per unit per month depending on modules deployed.

Latch quotes a $7-$12 per unit per month software price, but their set of offerings is currently more limited.

Both are getting adoption from the key multifamily property owners and the reviews have been stellar.

The below testimonials are from some of the largest owners of multifamily in the U.S.

For SmartRent:

For Latch:

AvalonBay - SVP of Strategic Initiatives:

Brookfield Managing Director talking about Latch, and an article on a retrofit property in Manhattan.

Greystar - launching at Greystar’s Laureat property.

Empire State Realty Trust - launching LatchOS at Empire State Building.

<note: Tishman Speyer had an investor relations site dedicated to the Latch merger which contained additional interview videos, but since the TSIA SPAC merger closed, I’m unable to find that site for links>

This set of management, customer and investor interview transcripts for SmartRent provides valuable context for how critical and valuable this is for the industry.

In particular, this segment on how Fifth Wall selected SmartRent was illuminating:

This is effectively what Fifth Wall does. We are in many ways in the business of trying to know what the real estate industry is going to do before it does it, so to understand its adoption decisions of technology prior to it becoming obvious to the entire market. That comes obviously from the 70 strategic LPs that have invested in Fifth Wall's funds, many of which are on this page today.

As I mentioned, we ran this RFP looking at the entire ecosystem. About a year ago, it was pretty abundantly clear to us that I think about five of these dominoes had fallen. There are probably five check marks on this page. But having surveyed the rest of the institutional national footprint, owner, operator, developers of multifamily, we recognized that SmartRent was going to be the industry standard solution.

But this is where Latch and SmartRent are different from other smart home companies. They are intentionally going after commercial real estate, specifically multifamily. They are going after the biggest owners and managers of properties. And they are getting adoption.

Latch also has an impressive customer roster:

For reference, these are the critical names in institutional multifamily: NMHC 50 largest apartment owners. Between the two of them, Latch and SmartRent effectively have substantially all of the top names covered.

These owners and operators are not just pilot testing on one or two properties. Once they’ve determined that the technology makes sense to roll out, they tend to deploy it across their entire portfolio.

SmartRent shares case studies for two top 10 apartment REITS who went from pilot to near full portfolio deployment in approximately 3 years.

The Latch brand is starting to gain traction. Below is a sample page for an apartment complex owned by Prometheus, a West Coast luxury multifamily apartment owner operator with ~13k units that has deployed Latch.

Practically every Prometheus apartment complex now highlights “LATCH keyless entry” as a technology amenity. The combination of Latch, Nest and EV charging seems particularly potent. Eventually, these types of features (access control, smart home, electric vehicle charging stations) will be table stakes in all apartments.

The sales cycle is long though. It can take years to from contract signing and booking recognized, to when the hardware purchase is issued, to when the hardware is installed, to when they start to recognize software revenue.

Latch shares the below:

However, once installed, the economics are incredibly lucrative.

• Long-term: 6+ years for Latch, 5-7 years for SmartRent

• Prepaid: 97% for Latch, 75% for SmartRent

• High gross margin: ~90% for Latch, ~74% for SmartRent

Latch provides detail down to the unit economic level:

Once a customer signs on and installs the software / hardware, the opportunity to “land and expand” with additional modules becomes straightforward. Latch saw 154% booked revenue expansion from 2019 to 2020.

These dynamics also means there is tremendous visibility into the pipeline. Growth can come from: (1) expansion within deployed assets - installed units, (2) expansion across a customer’s asset portfolio - committed units, and (3) further penetration across the industry.

The key influential decision makers in this industry are fairly concentrated, with a few hundred critical customers that control deployment for millions of units. It takes time to sell the first development, but once that is in place, the path to rolling out across a customer’s portfolio becomes smooth.

At some point, if it hasn’t happened already, these companies will become the de facto industry standard. If and when that happens, the cost to acquire the marginal customer should go down dramatically. The cost savings and revenue upside benefits will become apparent to the rest of the industry. The initial customers were expensive to acquire and pilot with, but retaining them should be inexpensive.

Their investors are their both their most important customers and their most valuable business development resource as industry evangelists.

The Latch deal was led by Tishman Speyer. They are a huge owner with global marquee assets across multiple categories - residential, office, life sciences, and mixed use.

SmartRent is led by Fifth Wall, a venture fund whose strategic LPs represent an incredible global real estate network. Collectively, they represent ~2M multifamily units, ~22% of all new single family homes built, and ~1.4B hospitality units owned, operated and developed.

Fifth Wall really drives home the point regarding visibility into the pipeline and the customer ramp:

The same dynamic takes place with respect to enterprise sales to the real estate industry. Which is, whichever company can overwhelmingly sign up and engage the top 20 owners in a given space wins the category. That company quickly is running downhill and becomes market standard for the entire real estate ecosystem. It's an artifact of the fact that the real estate industry is a late-adopting industry, so there are a number of owners that own 10,000 units, 5,000 units. These are smaller regional owners. Typically, what they are going to do is they're going to look to the names on this list to see which smart home operating system have they adopted to ultimately make their decisions. You have this very profound signaling effect and this herding behavior that overwhelmingly leads to one company becoming a market standard technology. When you look at a page like this in light of that dynamic, this looks like game, set, match for the multifamily industry when it comes to a smart operating system. I think the other dynamic that's probably important to call out here is that for the multifamily space, these multifamily assets trade fairly liquidly. They almost trade like stocks between different institutional owners. But what's different about SmartRent versus other kinds of enterprise software is it's both a software solution, but it also is on premise. This is installed. It goes with the asset. So you almost have this negative churn dynamic, where there's this cross-fertilization opportunity, where when one of these large institutional owners trades an asset to a smaller, more regional owner, they obviously get that asset with SmartRent. It becomes obviously almost, like I said, a downhill foot race where you're just growing into the rest in the long tail of the multifamily industry, which is, as you can see on the left side of this page, enormous. There are a lot of units where nothing is installed today. So this early lead, typically, I would say almost categorically, becomes deterministic over time. The same pattern plays out in real estate tech over and over.

Although there are only a few hundred thousand units deployed today, the path to tens of millions of installations appears to grow clearer each day.

Who Wins?

As mentioned previously, I don’t think it’s necessary to predict who “wins” to have a successful investment outcome.

I think this comes down to: (1) management, (2) strength of the product and ecosystem, and (3) ease of adoption.

There is definitely a clear difference in the backgrounds of the management teams. For Latch, management is heavily skewed toward tech - Apple and Google feature prominently.

The Apple aesthetic is also quite noticeable in the product design and overall marketing.

What seems to be missing, however, are executives with actual real estate experience.

Latch has been investing heavily in their revenue team this year to go after new customers. This team clearly has an impressive background; however, the issue I see is that their experience is primarily in technology, and less in real estate. There will likely be a significant learning curve to sell into real estate companies and to get the product deployed.

Contrast that to the management team from SmartRent. Their CEO was the former CTO of a multifamily REIT. The deep industry expertise is emphasized.

This is a key point of differentiation, which coupled with Fifth Wall’s LP base, would suggest a wide base of prospective customers.

For product, I’m drawn toward the unified hardware and software solution that Latch provides. This is an approach that has worked well for other companies, notably Apple and Peloton. When paired with a premium brand, that offers an attractive path toward higher margins and viral adoption. It remains to be seen how well that works in a more B2B setting such as commercial real estate, though I did find it intriguing that Latch keyless entry is starting to be highlighted as a selling point (do a search for apartment rentals with “Latch keyless entry” on Craigslist in your area to see for yourself).

On the other hand, I like the idea of a hardware-agnostic platform and can understand the appeal for property owners that would value flexibility and choice. In theory, there are potential compatibility pitfalls that might trip up such an approach. A combined hardware and software solution should tend to be more seamless. Device makers should work to ensure a strong integration with the de facto industry standard, so I suspect that any integration gaps should close over time.

To that end, I like SmartRent’s approach to having their own deployment team, which now numbers over 100 individuals on staff to ensure integrations are handled well. Latch, meanwhile, relies on a network of third party installers. My sense is that the deployment will be a significant competitive advantage in SmartRent’s favor in the near term. From the property owner’s perspective, it should remove any doubt toward a successful integration knowing that SmartRent has invested so heavily in that area. It speaks toward management’s understanding for the pain points that these owners and operators are really concerned about.

Source: FWAA S-1 (pp 134)

If forced to pick, I would expect SmartRent to have more overall units with their technology deployed. However, it wouldn’t surprise me if Latch becomes the more valuable company over time given their premium positioning.

Fortunately, I don’t think it’s necessary to limit yourself here. Both can do just fine.

Value Creation

Michael Mauboussin of Morgan Stanley recently put out a fascinating paper - The Economics of Customer Businesses - that I think is very helpful toward understanding the value of Latch and SmartRent.

The key insight is understanding the customer as the basic unit of analysis from a corporate valuation perspective. The framework breaks down corporate value into two components: existing customers vs. new customers.

The key assumptions lie in the value of a customer (new vs. existing): namely what is the expected revenue per customer and what are the costs to acquire and retain that customer.

The following diagram breaks down further the four key numbers that factor into the Value Creation that a company such as Latch or SmartRent offers: (1) the customer’s maximum Willingness to Pay, (2) the price that the company charges for the service, (3) the cost for the company to provide that service, and (4) the minimum price that a supplier would accept to provide the good to the company.

• Company’s Value Creation = Price minus Cost

• Customer’s surplus = Willingness to Pay minus Price

• Supplier’s surplus = Cost minus Willingness to Sell

The company’s objective would be to both: (A) raise the customer’s Willingness to Pay by introducing additional capabilities, expanding the ecosystem and bolstering the network effects, and (B) lower the supplier’s Willingness to Sell by reducing their costs or improving their productivity. This would then allow the company to expand their Value Creation by raising or de-risking Price while also reducing their Cost.

I believe there are encouraging signs of this taking place. Both SmartRent and Latch are introducing more modules and expanding into other CRE categories such as office. They are partnering with Google Nest, Ecobee and other smart home providers to improve the value and stickiness of LatchOS. The partner ecosystem also feeds into the network effect. As more buildings within an owner’s portfolio and stakeholders within the owner’s ecosystem adopt the software, that only increases the stickiness further. If all of this results in owners being able to raise their rents, that only improves the cycle further.

On the cost side, I think this is still early. Theoretically, driving more adoption within owners’ portfolios should lead to improved visibility into ramp up and retrofitting and predictable future volumes. For Latch, there is also the economies of scale argument to reduce production costs further. The production cost and reliability should only improve over time. For both Latch and SmartRent, increased adoption will incentivize other smart home device makers to ensure their devices are compatible. The ability to roll out software updates remotely should also help on the cost side.

These cost savings are immensely valuable to the property owner / developer. With cap rates in the 4-5% range for multifamily, each incremental net operating income dollar (whether achieved through cost savings or rent increases) is worth 20-25x in improved asset value at exit.

The other critical input is the expected adoption speed for this innovation. The paper includes the below table which outlines five key criteria that inform adoption speed and the number of years to “take off.”

In my opinion, Latch and SmartRent rate well across all five of these dimensions. I would score them as either a 4 or a 5 from the perspective of the commercial real estate owner. The Relative Advantage is apparent from a cost, convenience and security perspective compared to traditional lock replacement. Visibility is also obvious, and Latch’s efforts around branding (a “Latch” building) are important there. Triability is also strong, as residents are mandated to use the app and ecosystem upon moving in. Engaging with a Latch building is also relatively simple - you just go visit someone there. Simplicity is obvious for both. Compatibility should only improve with time to become increasingly seamless.

• Relative Advantage: 4 (obvious)

• Visibility: 5 (obvious)

• Triability: 4 (just go to a Latch building)

• Simplicity: 5 (obvious)

• Compatibility: 4

This suggests a fast to very fast adoption. Given the apparent ROI advantages and rapidly expanding proof points in the market, it would surprise me if a property owner didn’t want to deploy such a technology as soon as practicable. Latch talks about more than 1 in 10 new multifamily developments adopting their solution, but I would expect this proportion to grow quickly. My guess is that substantially all new developments will soon choose to adopt either Latch or SmartRent.

I also suspect that the cost to acquire the incremental customer may go down over time. Typically, customer acquisition cost (CAC) increases as you move from the Innovators to Early Adopters to the Majority of users. There are elements of that increased marginal cost taking place now as both companies will be ramping up to support their growth efforts. However, I think there’s a strong chance that the brand, network effects and economies of scale will push the CAC down over time. There is a subtle viral element to adoption of smart-enablement technology. The key decision maker is the property owner, but the other stakeholders - residents, property managers, vendors, partners, visitors, etc. - all benefit as well. Engaging with such a building acts as a free trial for new participants in the ecosystem.

Once those customers are acquired, then the question becomes what does it take to retain those customers. Latch and SmartRent have so far experienced 0 churn. If that continues, then that would be off the charts compared to the typical monthly churn rates that other industries experience.

In summary,

1. Latch and SmartRent customers will have high willingness to pay given the cost savings and revenue upside potential and ecosystem. This suggests high stickiness of the solution as well as the ability to charge handsomely for the software. They are well positioned to create a lot of value for their customers and also are well set up to capture that value too.

2. These customers will be quite valuable given long contract terms, the ability to layer on additional modules, low to zero churn, and likely diminishing acquisition costs if and when they become the industry standard.

3. These solutions possess characteristics that point toward fast adoption, which is a bit unexpected given typical preconceptions for this industry.

All of these factors indicate that acquired customers will be extremely valuable to Latch and SmartRent. As such, it makes sense to spend and invest aggressively to win these customers over.

Even better if your customers also happen to be your major shareholders.

Ownership

Below is a summary of the shareholder bases for Latch and SmartRent coming out of the SPAC merger. Latch completed their merger on June 4, 2021, and the SmartRent is an estimate assuming no redemption by SPAC shareholders.

Note that the Latch share count excludes ~15M warrants. SmartRent does not have any warrants.

Latch’s main venture shareholders are Avenir and Lux.

Avenir runs a concentrated venture portfolio that reflects their choices for what they consider “The future of ____.” Andrew Sugrue was on the Invest Like the Best podcast in May and described why they were so impressed by Latch:

I think what we found to be so different about Latch is first of all, the hardware is really complicated to build. This isn't something that you can just stand up in a contract manufacturer. When you add in components, Silicon chips, plastics and cameras, etc. into a lock, it combusts at lower temperatures than a traditional hardware-only lock device. Which means for multifamily where you have very stringent fire code regulations, the hardware itself is really complicated to build, which is why there is no other competitive product on the market, despite the fact that Latch has been in business for a number of years.

But I fully assume that our hardware advantages could commoditize over time. What we really want to build is the density of the network. One of the things that's so interesting about Latch is it drives a high ROI to its customer base. When you as a building owner install Latch, you see a real demonstrable ROI. You save costs on the operations of the business from labor in buildings, from placing lost keys from changing out key cylinders every year. But most importantly, you drive higher rents. So there's a phenomenal ROI associated with deploying these devices, which is why you see the majority of the top 20 property owners now on our platform, and that continuing to grow over time, that ability to grow within our customer base. As we've proven out that ROI, people have embraced it. And that's a benefit of selling to enterprises. If you can drive great returns to them that dramatically exceed their cost of capital, they'll deploy your solution.

But I think the thing that I get most excited about with Latch is version 3.0 of what people didn't expect. The first version was this is a hardware device that people think is commoditized. They don't realize the fact that this is a really complex software problem that Latch uniquely solves and becomes very sticky. On average, our customers are paying us 5 years upfront for the software. You can't turn off the product because your doors no longer work. So talk about a sticky customer relationship, a locked-in customer, pun intended there. But what I get so excited about is coming back to our consumer predisposition in the world is the fact that we have an unfair customer acquisition angle. When you move into a Latch building, you have to download the Latch app, right? That's your onboarding flow. It says, "Patrick, welcome to 172 Broadway. Here's your access credentials to the building. Do you have renter's insurance? Your building requires renter's insurance. No? Click here for a Latch offer." If you go look at Lemonade, any of these insurance businesses, renter's insurance businesses, they spend the disproportionate amount of their gross profit dollars on customer acquisition. Because these are very infrequently consumed products. You buy these when you move. They have to advertise to a broad base of customers knowing that people are moving every 7 years in the residential world, every 1.5 years in the multi-family world. You have to catch that person at the time they need it. When we can reinvest those 40% of dollars premium value spent on marketing and instead reduce cost to customers, that's a huge conversion opportunity.

The second thing when you're checking, it says, "Do you want internet installed when you move into your building?" Well, of course, you do. No one wants to wait for the Time Warner Cable guy to come. I think there's a few categories that have lower NPS than the cable industry. We can provide those services at cheaper costs to our customers and drive high conversion on that. So fundamentally, the way I think about Latch is this unfair advantage. You have customers who are using your app 5 times a day. Those are 5 times a day that we can solve more of their problems and monetize it by leveraging this very unique attribute of our business, which is we've got a home screen app with high frequency, and we have density of demand. That is the key to any of these last-mile logistics businesses, key to the on-demand economy is having density of demand. We have that without spending a dollar on marketing.

This is the Lux take on Latch (click below to see the full thread):

Latch’s key real estate shareholders are Tishman and Brookfield, who invested in or led earlier private rounds. This is Tishman CEO Rob Speyer on why he was so keen on Latch - “This is exactly the kind of transaction we had in mind.”

Latch’s key PIPE investors included Chamath Palihapitiya, Blackrock and Fidelity.

Chamath anchored the PIPE. He’s been a polarizing figure of late for his role in evangelizing SPACs. I think it’s important to recognize whether the deal that he is promoting is a reasonable one for retail investors. In general, I find that he’s at his best in identifying companies that have found product market fit, have demonstrated compelling unit economics, and simply need to scale. This is, after all, what he did at Facebook. Importantly, he was not the sponsor for the Latch SPAC but was instead a PIPE investor, which means he purchased shares as any other retail investor and does not have a promote incentive.

Chamath (in)famously made the claim on Twitter that Latch was the “best SaaS company” he had ever seen or invested in.

This seemed like a hyperbolic claim at the time, even coming from him. However, the dynamics of the business indicate there is very promising evidence to support that contention.

The ownership for Latch strikes me as long-term and tech-oriented. The real estate investors are leading players that own premium assets across multiple asset categories. Eventually, I can see a Brookfield or Tishman rolling out Latch and LatchID across all of their residential and office buildings, enabling their residents and tenants to move seamlessly between home and work.

The ownership on the SmartRent side is also extremely impressive.

Venture investors include RET Ventures, Bain Capital Ventures, and Spark Capital.

The SPAC was led by Fifth Wall, which like RET Ventures, has a property technology focus and counts many real estate companies around the world as limited partners.

The PIPE investment was anchored by leading real estate organizations in adjacent industries:

• Starwood - 3rd largest of multifamily units in the US

• Lennar - one of the largest homebuilders in the US

• Invitation Homes - largest owner of single family homes in the US

Fifth Wall sums up the investment rationale:

What's really compelling and I think unique about the SmartRent story is that this is a company that allows investors to articulate a secular bet around smart home adoption at an enterprise level, selling an enterprise grade solution and capturing that upside with really attractive recurring revenue characteristics in a hardware agnostic way where you get to free ride to some extent on the tailwinds of all of this R&D that is pouring into smarter and smarter devices for homes.

SmartRent will be Fifth Wall's largest investment in prop tech because we are so confident in the business and so confident in its growth trajectory, we've agreed to a very long-term lockup of our sponsor shares. They're obviously an all primary deal.

While some premier players have selected Latch, the rest of the industry has coalesced around SmartRent. Recall the RFP that Fifth Wall mentioned running on behalf of their real estate clients where SmartRent was the clear choice. For large owners of residential units across the spectrum of classes and price points, SmartRent’s hardware agnostic approach is the more versatile and suitable choice.

Again, there appears to be a strong, symbiotic and long-term relationship between SmartRent and their key investors/customers.

7 Powers

This is the rare situation where I think you could plausibly argue that all seven powers are present.

Scale economies. They are both well positioned to take the lion’s share of multifamily over the next few years. With scale, it becomes more cost effective to develop additional modules and improve the technology. Once they get a foothold within an asset in a customer’s portfolio, it becomes likely they become deployed across the portfolio.

Network effects. The software becomes more powerful as additional hardware providers such as Google and Honeywell are linked into the ecosystem. Any new smart enablement hardware player will eventually be compelled to ensure they have seamless integrations into the leading software (similar to iOS and Android). Customers will likely realize additional value by deploying the same solution across their entire portfolio of real estate assets.

Counterpositioning. By focusing on commercial real estate, there is less likely to be competition from other major tech players. As primarily enterprise software software plays for multifamily to start, both are less dependent on the crowded and cutthroat smart enablement hardware market. Both Latch and SmartRent are also arguably counterpositioned against each other (i.e., the Apple and Android).

Switching costs. Once the software is deployed and real estate owners are enjoying the benefits and cost savings of smart enablement, it becomes increasingly difficult to switch to another provider.

Cornered resource. In this case, Latch and SmartRent have preferential access to the leading real estate owners and operators. By having their key customers as their investors, it effectively locks out any other would-be competitor from gaining market share from them. These real estate players will also be less likely to fund a new competitor since they are already investors and customers of the presumptive leaders in the space.

Brand. More applicable for Latch than SmartRent, as Latch is already starting to see their brand being promoted as key selling points in listings. The brand recognition among the industry’s decision makers will be key to driving more cost-effective adoption as well as prevent other new entrants from gaining share.

Process power. More applicable for SmartRent than Latch, as SmartRent has built up a sizable deployment team across the country to ensure that their integrations are smooth and painless for customers.

Is is an exaggeration to claim these are the “best” SaaS companies you’ve ever seen? There’s a lot to like here.

Valuation Thoughts

The investment thesis requires believing the following:

1. Owners and operators of multifamily and multi-user properties will choose to adopt and deploy smart enablement technology.

2. SmartRent and Latch will collectively win most of the market. Purchase decisions will gravitate toward the two market leaders today where leading RE companies have already begun deploying at scale.

3. SmartRent and Latch will successfully maintain their recurring fee model AND they will steadily grow their pricing by introducing additional service modules.

4. Focus on the recurring software fees. Assume the hardware and professional services costs can be provided at close to breakeven.

I consider these software fees to be like collecting a bit of rent eventually on each smart enabled apartment. That is why this is such a mouth-watering opportunity.

Financials are still nascent

The purported steady state metrics are compelling and attractive: (1) long 5-7 year contract life, (2) high software 70-90% gross margins, (3) 0% observed churn, (4) most customers prepay.

However, it’s still too early to validate the software story from the financials. These numbers are still quite tiny and not fully broken out for software. The gross margin picture is nowhere near 70%+ right now.

Latch financial projections (Latch investor presentation):

SmartRent financial projections (SmartRent investor presentation):

Both companies are just starting to scale up and will likely grow their software revenues at over 100% for several years to come. This should roughly track the number of installed units. Given the cash flow dynamics of their prepaid contracts, they are also projecting that they will be free cash flow positive starting in 2022 for SmartRent, and in 2023 for Latch.

I would love to see a clear connection from installed units to recurring software revenue to gross profit, but it’s still really early. The software component of revenue is simply too small right now to derive a meaningful signal.

For example, per their Q1’21 press release, SmartRent had $19M in total revenue in Q1’21, but only ~$3.2M of that was software (“hosted”) revenue. They deployed 32k units in Q1 and ended the quarter with 188k units overall. I estimate they made ~$6 hosted revenue per month per unit assuming they had ~500k deployed-unit-months in Q1.

Both companies are just starting up the S-curve in their deployment. Typically, these hockey stick projections would deserve a healthy dose of skepticism. In this case, however, I actually think these projections may turn out to be too conservative. Even though they will end 2021 with under a million units deployed combined, they have already signed up most of the key players. I think the main constraint toward revenue growth will simply be the time and resources it takes to deploy these solutions. They may very well get the commitments to deploy across customer portfolios much sooner. It would not surprise me if the number of committed units and visibility into future revenue turns out much more positively over the coming quarters.

As mentioned above, what really matters is the recurring software revenue. I ignore revenue from hardware and professional services, and I assume these can be provided at breakeven.

Based on the recurring software revenue, I assume each installed unit is worth ~$1,000 in enterprise value.

My math is really high level and I use round numbers for convenience. $5 to $25+ in monthly revenue collected per deployed unit translates to $60 to $300+ in annual software revenue per unit. Based on that range, I assume an average annual software gross profit of $100 per unit. The $1,000 value assumes a 10x gross profit multiple applied to the software component.

There are admittedly a wide range outcomes, and they are presently realizing revenues at only the low end of the range. This will also depend on EBITDA margins over time. In my view, software-like margins ought to be achievable here, particularly as user acquisition costs go down over time as these become the industry standards. You can adjust what makes sense for you accordingly.

Below are some illustrative comparisons. There are notable differences - consumer vs. enterprise, different market saturation levels, and different ARPU, retention and profitability profiles.

• Netflix: 207M paid subscribers, $240B EV => ~$1.2k per sub

• Spotify: 158M premium subscribers, $50B EV => ~$300 per sub

• Peloton: ~2.4M paid subscribers, $35B EV => ~$15k per sub

• New York Times: ~8M paid, $7B EV => ~$900 per sub

Assuming you can get comfortable with $1k in enterprise value per installed unit, then that translates to $1B in enterprise value per 1M installed units.

At a current “combined” valuation of ~$4B, this suggests the market believes the two companies can get to ~4M installed units. I believe that is highly achievable given the current customer and investor base and the units that they control. I think they may very well have that visibility today.

What matters in the long term then becomes how many units this can this scale to, and how soon the market will come to this view. Based on ~40M rental units in the US, this suggests a 5x return assuming these two companies reach 50% adoption.

50% likely feels high at first glance. But review their existing customer/investor list and review the list of the top multifamily owners from above. Almost all of these players have already been claimed by these two. It appears that we are at the beginning of a duopolistic winners-take-most iOS/Android dynamic taking place.

This is just within the US. Now factor in global multifamily (93M units in EU per Latch) and other multi-user real estate asset classes (office building, student housing, senior housing, hotels, Airbnb, and military housing), and the opportunity increases quite dramatically. Also factor in the potential to continue to add modules, value added services such as cleaning and pet walking, and advertising to this audience.

The bet is on if and when the market catches up to their install trajectory. Each additional customer signed and installation completed improves those odds.

Historical valuations:

Latch was founded in 2014 and has had a meteoric rise over the last few years:

• Jan 2021 - Latch announces merger with Tishman Speyer at enterprise valuation of $1 billion, raises $500M+ [WSJ]

• August 2019 - Latch raises $56M round led by Avenir at $400M valuation [WSJ]

• August 2018 - Latch raises $70M round led by Brookfield at $250M valuation [WSJ]

Valuation has roughly doubled every 18 months for Latch. It’s impressive, but not unjustified given their impressive growth and performance.

SmartRent was founded in 2017 and has raised ~$100M. I haven’t been able to find publicly available sources for their valuation history, but it is likely they have also seen a rapid uptick in price appreciation.

• May 2020: SmartRent raises $60M Series C [press release] led by Spark Capital.

• June 2019: SmartRent raises $32M Series B [press release] led by Bain Capital Ventures. Valued at $120M [Pitchbook blurb]

Interestingly, during the SPAC negotiations, they agreed to a significant haircut to the original proposed deal terms to lock in their PIPE investors (Starwood, Invitation Homes and Lennar).

On March 6, 2021, FWAA delivered to SmartRent a non-binding indication of interest reflecting a pre-money equity valuation for SmartRent of approximately $2.5 billion…

In the following days, based on further review of valuation matters and market conditions, the parties agreed to lower the pre-money equity valuation for SmartRent from approximately $2.5 billion to approximately $1.75 billion…

On April 15, 2021, following discussions with a prospective strategic investor in the PIPE Transaction that was interested in participating as an anchor investor at a lower valuation, SmartRent concluded that the strategic and long term benefits to the post-closing combined company of bringing in such strategic investor to anchor the PIPE Transaction would outweigh a reduction in valuation. Following discussions among the FWAA and SmartRent management teams and the placement agents, FWAA and SmartRent agreed that the fully distributed enterprise value for the transaction would be decreased from $1.8 billion to $1.7 billion. As such, the equity consideration payable to SmartRent’s shareholders would be reduced to $1.577 billion.

That’s close to a 40% discount from the original indication of interest. Part of the discount may be a reflection of rapidly deteriorating market conditions for SPACs and high growth stocks during that time, but it’s interesting that the haircut was so significant given Fifth Wall had already been an investor in SmartRent and ought to have been familiar with the business. I understand the appeal for SmartRent to lock in these strategic investors, as it locks them in as potential strategic customers too. At any rate, I welcome the opportunity to invest at these more favorable terms.

How I’m Thinking About These:

I’m very bullish about the combined potential for these companies as public companies. However, since these are public companies, I think my bar for them is also much higher in terms of dissecting their financials. Were these companies raising late stage financings as newly minted unicorns, I think I would be even more bullish and enthusiastic to invest.

There is a case to be made that both of these companies are going public a little too early. Many articles will point to the meager revenues in 2020 ($18M for Latch, and $53M for SmartRent), extrapolate extremely frothy multiples, and quickly conclude that this is simply more evidence that we are in a SPAC bubble.

When I approach these as an IPO, that interpretation makes sense. Yet, I don’t think the current financials accurately capture the incredible opportunity in front of these companies.

If you fast forward a year and they have another year of 100%+ growth under their belts, I think the markets may price these companies much differently.

The downside is that growth slows down and they don’t ever acquire a new customer. Given their traction and their investor base, however, I think that is just highly unlikely. The qualitative elements of the business are too striking. The downside is also muted by the combined ~$1B cash balance.

I can also see these attracting M&A interest. Google, Microsoft, and Apple all seem like potential acquirers for these companies from a software and smart home perspective. Latch and Apple in particular seem to align on many dimensions including brand and user experience. As these companies mature and the cash flow dynamics clarify, I think these will likely also attract the interest of buyers of strong niche enterprise software companies. I’m not sure they’ll be available for sale though. If I were a Tishman or Brookfield or Starwood, I would not want to lose control of what will likely become mission critical software to run my properties.

Both SmartRent and Latch trade at ~$12 per share currently, which I think is an attractive price for such terrific high potential companies. I’m bullish enough now to see a path to 20M+ installs. The question will be if and when the market comes around to that point of view. I think that will very quickly become evident with a few more quarters of public performance.

Catalysts:

Both companies seem to be underfollowed and underrecognized given their industry and that they’re going public via SPAC rather than under the fanfare and sellside support of a traditional IPO. The view that these companies may be the best SaaS companies out there is not a widely held opinion right now.

Latch has been in the news somewhat, but SmartRent has hardly received any coverage at all. They seem to be known within their industry, but not really appreciated or followed outside of it.

Latch’s merger transaction closed in early June. The company received $453M cash out of the transaction, out of a possible $490M from the $300M TSIA SPAC and $190M PIPE.

Latch made a number of announcements in the last few months.

• Launched LatchID. This enables a Latch user to maintain identification and authenticated through home through office in any Latch-enabled property. To me, it’s analogous to using Google or Facebook ID to log in to most other sites on the Internet. This strengthens the network effect for users of Latch and encourages those property owners to continue to deploy Latch in their portfolio.

• Launched Latch for Commercial Office. This includes all LatchOS modules - smart access, visitor and delivery management, smart device and sensor control, connectivity, and personalization. Visitor access is interesting for the viral effect. This is technically a pilot, but what office properties to start with: The Empire State Building, Rockefeller Center and Brookfield Place. Talk about iconic.

This represents a significant inflection point in my view. Previously, they had only deployed in multifamily. Now they’ve made the leap to another multi-user buildings, and also signed a new customer in Empire State Realty that is focused on office.

SmartRent’s merger transaction is slated to close sometime in Q3. Until the shareholders vote on the transaction, there is always the risk that the merger falls through. I suspect that risk will be very low for SmartRent given the merger agreement specifically calls out Supporting SmartRent Stockholders who represent the majority of votes (57% of common, 78% of preferred) who will vote in favor of the transaction.

In the meantime, SmartRent is also showing signs of expanding to other verticals, with recent hirings for a student housing business unit.

The most potent catalyst will be from increased visibility in operating in the public markets. Both companies simply need to deliver a few quarters of continued performance and growing traction. Keep strengthening the ecosystem with new products and integrations, keep deploying units at 100%+, keep demonstrating expanding revenue within existing customers, keep showing ~100% customer retention, and keep collecting ~6 years of contract economics upfront.

If that happens, then it seems inevitable that they would grow out of their current valuations.

Risks

But first, however, they’ll need to grow into their current valuations.

1. The financials do not yet reflect the opportunity, and there is a lot of room for improvement in the disclosures.

Revenues right now for both companies are miniscule relative to the valuations.

There is a lot of noise in their numbers right now. Most revenue is coming from hardware and installation, rather than software. There is also not that much in the way of disclosures to isolate the performance from software.

SmartRent (Q1 earnings release) had $19M revenue in Q1, and $3M in software revenue.

Latch (Q1 earnings release) had $6.6M revenue in Q1, and $1.6M in software revenue.

What matters are deployed units and bookings and how that translates to annual recurring revenue (ARR).

SmartRent:

• Deployed units: 32k units in Q1, 188k deployed units overall

• Bookings: 45k units in Q1. Total committed units over 600k. Dollar volume not disclosed

• ARR: $5.3M in Q1. ARR was $3.4M at the end of 2020.

• Deferred revenue: $64M (unclear of share from software revenue)

Latch:

• Deployed units: not disclosed. 369k Cumulative Booked Units

• Bookings: $71.7M ($43M of software bookings).

• ARR: not disclosed. Booked ARR of $39M (based on signed LOI)

• Deferred revenue: $18M

For SmartRent, I can infer an annual contract value of ~$60 for the Q1 units based on the 32k units deployed and the net increase in ARR of ~$1.9M in Q1. This is consistent with the ~$5 per month initial deployment, though the expectation is that they will be increasing contract value with additional modules over time. There is no data to suggest that is happening at this point, but it is still early.

For Latch, I’m not really able to tease out how they’re doing on the software at this point. Frankly, their disclosures are too convoluted and not that helpful. It’s hard to tease out whether the software growth thesis is playing out based on what is available. Sharing booked ARR rather than ARR inflates the state of the business, since there are lengthy (~1-2 year) lags from the time of booking to when the units are deployed and revenue is recognized. $39M in booked ARR is indicative of ARR two years out. Current ARR is likely only ~$7M based on their current software revenue.

At any rate, current ARR suggests an implied enterprise value to ARR multiple of ~200x-300x. That is simply preposterous.

The numbers are small though, and these two have already made significant and critical headway with most of the key industry players as customers. We just need to see this progress reflected in the ongoing performance.

For each quarter, I would like to see:

• How many new units were deployed?

• How many new unit commitments were signed?

• What was the net increase in ARR? How much ARR is coming from new deployed units versus revenue expansion from existing units?

• How much are they spending to win that new ARR? David Saks of Craft Ventures has an excellent article on appropriate efficiency for SaaS companies (The Burn Multiple). The burn multiple for both companies are off the charts bad right now, but likely a justified investment in my opinion if they do manage to secure the leading property owners, operators and developers.

Given the runway, there is potential to grow deployed units by 100%+ annually for the next several years. There is potential to grow ARR among existing units by significant amounts (~50%) as well.

Assuming that plays out, then the ramp in ARR could prove to be quite dramatic. Based on Bessemer Venture Partner’s chart below illustrating years to scale from $1M to $100M ARR, they could be in some strong company. $100M ARR translates to $100 annual contract value for 1M deployed units.

My expectation is that this will be reflected in the financials soon enough, but it may be worth waiting to see if this comes to fruition. This may be too many layers of assumptions for most.

2. SPAC is a four-letter word.

There is a lot of skepticism associated with SPACs, and they are generally not viewed as a good bet for individual investors. This is for good reason, as many SPACs are structured to benefit the sponsor at the expense of the shareholder. Companies that have gone public via SPAC have generally been of lower quality and less mature than companies that go public through traditional underwritten paths.

The following paper (A Sober Look at SPACs) goes into great detail about the various ways that investors may suffer. Most of the damage comes from dilution of the investor’s shares, stemming from the sponsor’s promote shares, underwriting fees, and warrants. The median cost of dilution across SPACs is roughly 50%, though there can be a wide range of outcomes.

However, I understand why Latch and SmartRent pursued the SPAC path. They get massive growth funding injections, they get to go public faster, and they were able to select and lock in critical long-term investors who happen to also be their strategic customers.

SmartRent has relatively favorable terms from a retail investor perspective as far as SPACs go. The promote shares are subject to price targets and a 3-year lockup. There are no warrants available. The core investors are all major prospective SmartRent customers.

Latch also has a strong investor base and had relatively low redemptions (<5%).

Since Latch and SmartRent will be lumped in with other SPAC companies, there will likely be a lot of volatility in their share prices in the beginning. This volatility will provide attractive opportunities to build a position.

3. These are young companies and will endure growing pains.

While they have achieved remarkable success in winning adoption among the key players, there is also risk that it could all go away.

A nightmare scenario would be a security breach that provides unintended access to an intruder or reveals tenant privacy information. A loss of trust in their technology that compels their customers to rip out their software, and it’s effectively game over.

Delays or difficulty in installation would also turn off their customers. This may be a more significant challenge for SmartRent as they enable support for more third party devices, but they are also investing heavily in their deployment team.

Both also need to pay better attention to their tenant experience. While tenants are not their primary stakeholder, it’s not in their interest to turn off the customers of their customers. The app store ratings leave much to be desired. Both have decent ratings (4.5, 4.7) on the Apple app store, but recent reviews have been pretty scathing - Latch reviews and SmartRent reviews.

A recurring problem is that the app doesn’t always work and requires users to restart the app multiple times. For Latch, the sheer number of recent 1 star reviews leaves me scratching my head as to how the average is still a 4.7.

Testimonials from real estate owners tell a different story: they absolutely love it. However, if prospective tenants start to actively complain and move out, then that opinion among owners and operators could reverse quite rapidly.

This may be a symptom of lack of focus. On the Latch side in particular, it seems that they are rapidly pursuing in many growth paths at once, with LatchID and office pilots as examples. This is fantastic aggressive growth, but might be a double-edged sword if they neglect the fundamental user experience.

This will also affect the employee experience. Based on Glassdoor reviews, SmartRent appears to be the better company to work for:

• Latch has a 3.9 rating, 68% recommend, and 76% CEO approval

• SmartRent has a 4.5 rating, 93% recommend, and not enough data on CEO.

There will be growing pains, and they’ll need to strike the right balance. The good news is that these issues should be solvable.

4. Why this could all go wrong…

Their product just doesn’t work - faulty integrations, poor user experience, unacceptable vulnerabilities.

Real estate owners and operators and developers choose to not adopt smart enablement for whatever reason.

There is a huge delta between their rack rates and realized revenue (i.e., they need to discount their contracts heavily in order to win business).

They don’t provide clean financials in an attempt to obfuscate the true performance of their software business.

Another competitor steps in with a superior offering and wins over their market, including their existing customers. It turns out their 0 churn was not durable.

For SmartRent, they may not successfully close their SPAC merger.

They make poor investment decisions, lose focus, and bleed users, customers and employees.

Bottom Line

Despite the risks mentioned above, I’m very bullish on these two and like the potential for a multi-bagger outcome in the long-term.

The dynamics of the business are incredibly attractive and lucrative, and the investor and customer base provide a lot of confidence in the growth trajectory. I believe a real estate owner will only pick one solution, and once that solution is installed, it will prove to be incredibly sticky and difficult to displace. As a result, I think this will be a winners-take-most industry in the long run.

Compared to other, more traditional real estate plays, I find these to be much more interesting and with much better upside. Why pursue a complicated illiquid private equity development deal or settle for 3-6% tax-inefficient yields in a debt-laden REIT when I can invest in founder-led software businesses that occupy strong positions to become entrenched within the entire industry?

I like how they are currently underfollowed given their industry and how they may be overlooked or dismissed since they are SPACs.

I think both are at attractive valuations at their current price of ~$12. This may be a controversial take. They are on the surface ridiculously expensive by any measure based on their current financials. But I really like the odds for their eventual positioning in this industry. Were they never to drop below their current price again, I would regret not having bought more based on what I’ve learned.

That would be unlikely though. As SPACs and as younger companies, there is a good chance that both companies trade lower in the near term. There is a lot of volatility and little investor awareness in the early days. Many investors will not consider investing until after the SPAC merger is completed, and many will not follow until after a few quarters of public data. This would be the prudent path, but it’s hard to predict whether that is what will actually happen. My approach is to gradually build into my desired position over the course of a few months and quarters. Prices at $10/sh and below would be an outstanding buy in my opinion.

Bear case, these companies basically play out their current hand with their existing investor and customer bases and never sign another new customer. Perhaps the technology doesn’t work well and opens the door to other players for the industry to consider. Their deployment numbers would flatten and peak at just a few million units. This seems to be what the market is pricing in right now, as though it’s waiting for the data to confirm the path to wider adoption.

Base case, for me, is 50% of US multifamily, which suggests a ~5x business in 5+ years. This may be on the aggressive side, but I believe the evidence is there to suggest widespread adoption will happen.

Upside case includes: (1) expansion to other service modules to increase monthly revenues, (2) expansion to other multi-user real estate asset classes, (3) expansion to international, and (4) the introduction of value added services. A 10x+ multiple ($40B combined valuation) would not be out of the question.

My rough guess, which may be overly optimistic, is 20% probability for the bear case, and 80% probability for base case or upside case. I expect the probability for base case or better to increase with each passing quarter.

These feel like hold forever investments. The growth path is long with ample compounding reinvestment opportunities. They have the lead and have been anointed by the industry. Apart from the founders exiting the business completely or something nefarious occurring that makes me lose trust in the leadership, I’m not sure there will be a reason to sell.

These companies control their own destiny. I’m excited to watch this play out.

Note: For entertainment and informational purposes only. Not investment advice. Please do your own research.

Resources

SmartRent (FWAA, to become SMRT)

• SmartRent [site]

• Fifth Wall blog post announcing SPAC transaction - READ THIS [link]

• Investor Presentation announcing SPAC transaction (Apr 2021) [link]

• SmartRent Q1’2021 Earnings [link]

• SmartRent customer and investor interview transcripts [SEC filing]

• SmartRent S-1 [link]

Latch (LTCH, formerly TSIA)

• Latch Investor Call transcript (Jan 2021) [link]

• Analyst Day presentation (Mar 2021) [link]

• Latch Q1’2021 Earnings [link]

• Latch S-1 [prospectus]

• Avenir Capital interview (Invest Like the Best podcast) [transcript]

Industry

• Ernst & Young: How commercial real estate firms use technology to secure a future [link, report at bottom]

• Deloitte: 2021 commercial real estate outlook [link]

• NAR: Commercial Real Estate Trends and Outlook 2021 [link]

Writeups

• Reddit: The Apartment Manager’s Guide to Smart Locks [link]

• SeekingAlpha - SmartRent: The Android of Real Estate and Comparison Vs. Latch [link]

• SeekingAlpha - Latch: The Apple of Real Estate [link]

• Chamath Latch PIPE investment 1 pager [link]

SPACs

• Buyer beware. [A Sober Look at SPACs]

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The below is purely for information and entertainment purposes. I may or may not have a position in the securities mentioned. Please do your own research.

CONTENTS

• Introduction

• So Who Are These Guys?

• Busted IPO

• Investment Highlights

• Financials

• Four Common Criticisms and Responses

• Key Shareholders

• Management team

• CEO

• Employees

• What's The Chatter?

• Secret Powers

• Valuation Thoughts

• Range of Outcomes

• Catalysts

• Sell Scenarios

• Bottom Line

INTRODUCTION

When I started in investment banking in 2004, my boss was very optimistic about a young innovative software company that the firm had just helped take public. It priced its IPO at $11/share that June and popped to $17. That summer, the stock dropped fairly significantly, dipping below $10/share at times. My boss loved this company and its visionary CEO, and he recommended that I buy the stock. Even though we were pitching them as a pioneer case study to every prospective client and I was staring at the share price practically every day that summer, I couldn’t really convince myself to get behind it. The vertical it served seemed very niche, the financials were highly negative, the business model seemed almost like a Ponzi scheme, and the fundamental innovation appeared to be nothing more than a different pricing model. To this day, I still don’t fully fathom Salesforce.com or why it’s valued as high or grown as large as it has. The company has had a quite a run since 2004, returning over 80x since the IPO. In retrospect, I probably should have put a little something into CRM back then. Of course I did not. I put my money in a company called TiVo instead – clearly a company that was destined to change the world.

The thing about asymmetric investment opportunities is that they are only obvious in hindsight. If it were apparent, then the potential would already be reflected in the price. Such an opportunity must be widely overlooked or misunderstood for it to even exist. It might even stare you in the face for a whole summer and even then you might not recognize it. Every once in a while though, the stars align and a remarkable asymmetric opportunity presents itself provided you know where to look and are willing to keep an open mind. 17 years after that fateful summer, I’m noticing astonishing parallels to a company called ContextLogic, dba Wish.

You may or may not be aware of them, but chances are that you are not their target demographic. But they are enormous, they are growing quickly, and they are well-positioned to capitalize on a global trend that is largely dismissed if not outright disdained by their key competitors.

They are also really good at hiding in plain sight.

Wish sponsors Lakers patch for $36M over 3 years, entering into the agreement in 2017, the year before LeBron signed with the Lakers. What fabulous timing. This was “basically, a no-brainer” deal, according to their CEO, even before Lebron and Anthony Davis joined and they won a championship. Note this relationship may likely to end after this season, as the Lakers will likely seek more favorable terms.

SO WHO ARE THESE GUYS…?

This Vox article from 2019 provides a decent primer – Wish, the super popular, ultra-cheap shopping app, explained.

Some highlights:

• Last year [2018], Wish says it saw revenue double from the year prior, to $1.9 billion. The company earns money by taking a 15 percent cut of each sale [implies GMV of ~$12B in 2018]

• It has raised $1.3 billion since it was founded in 2011, and at its last funding round in 2017, was valued at more than $8.7 billion.

• It was also the world’s most-downloaded e-commerce app of 2018, with 161 million installs globally…[Amazon had 134 million installs].

• Marketing toward lower-income customers wasn’t part of the original business plan, says Tarek Fahmy, a Wish engineering executive, who joined the company in 2012, but as it saw that customers were prioritizing price above all else, “we recognized that this was a significantly underserved market, especially when it came to e-commerce.”

• …the concept for Wish actually comes from something far more old-school: the mall. The app was designed to mimic the experience of wandering and getting lost in a place filled with stuff to buy as far as the eye can see

• Once they’ve downloaded the app, Wish users scroll through the app for an average of 20 minutes per day…Wish is resolutely mobile-first, taking cues from Instagram’s infinite feed and popular gaming apps with elements like a daily “Blitz Buy” wheel users can spin to unlock limited-time deals and pop-ups that promise further unspecified discounts if shoppers add an item to their cart.

At this point, if you dare, you should try to install the Wish app (consult the 4.7 rating and 2.1M reviews in the app store). Collect your “free” item (but pay for shipping) and fork over your relevant shipping and payment details. Try the Blitz daily, a 10-minute shopping spree with extra savings. Something might catch your eye, and you may or may not be induced to make an impulse purchase.

Is this for real? What do you suppose the customer ratings for this are?

There are no shortage of Ripoff! reports. The reviews at Better Business Bureau leave much to be desired.

Over at Trustpilot, the picture looks a bit more balanced, but the “Bad” ratings are still a whopping 26%.

Ultimately I’m not able to conclude anything definitively. The reviews are a mixed bag for Amazon, eBay, Walmart, or AliExpress too. It’s not the best experience, but then it's not their priority, and my expectations are reasonably tempered anyway. When I consider the denominator for these reviews corresponds to roughly a billion transactions per year, it's actually not egregious. In fact, that yield might be considered tolerable if not acceptable.

So is there a business here?

At Shoptalk 2017, Wish’s CEO Peter Szulczewski (I will just call him “CEO” from here) gave a presentation entitled the Failure of eCommerce and outlined two key reasons.

The first is Product Failure.

Wish contends that there has been a failure to support a diversity of shopping experiences. This goes back to reimagining the wandering-aimlessly-in-a-shopping-mall experience referenced in the Vox article. The prevailing shopping experience championed by Amazon to great effect is heavily search-based. Most Amazon consumers are not really shopping; rather they are consuming information, communicating, transacting. Most successful commerce players emphasize the search box first, which is effective but critically not the only way to shop. Wish deliberately focuses on vague shopping experiences, don’t-know-what-you-want, discovery-oriented, something that is more casual, enjoyable and entertaining. At the time, their CEO highlighted that <10% of Wish purchases involved a search query, the exact opposite proportion of Amazon.

Take a look at the key metrics supporting their entertaining, discovery-based shopping experience. The metrics that stand out to me are 9 minutes of engagement per day, and 500 distinct products seen per active user.

For a supposedly crappy shopping experience, that level of engagement is surprising and impressive. I have a hard time comprehending this personally, but then I’m not the target customer, so perhaps that is to be expected.

The second failure is Demographic Failure of people that have been left behind. Not everyone is looking for shipping speed. Many shoppers are value oriented, prioritize price over all else, including shopping experience, logistics, packaging, even reliability.

This is counterintuitive, but I am near certain the Wish team has examined this every which way it can. We’re in a fortunate position that this type of inventory is more or less a novelty for us. But huge swaths of the world are not so fortunate, and they prioritize price above all else. And there are a lot of them.

What that means is that humble neighborhoods can in fact be quite lucrative. The below is a nondescript neighborhood outside Miami (circa 2017).

And those neighborhoods are actually quite representative of the overall United States.

Now take those numbers globally, and the opportunity starts to get really interesting. There are a lot of people potentially getting left behind.

BUSTED IPO

Wish went public in December 2020, shortly after massive debuts by Airbnb and Doordash, in a market where growth names, particularly in technology, were partying like it's 1999. With an offering managed by Goldman, JP Morgan and Bank of America, they priced their IPO at $24 (the high end of the range), raising $1.1B at a ~$17B valuation (fully diluted).

Some key details on the shares:

• Dual class: Class A and Class B (20x voting)

• Class B shareholders control 82% of the voting rights. Class B shares have a sunset clause where they automatically convert to Class A on the 7th anniversary of the IPO (December 18, 2027).

• Current share count: 618M shares outstanding, as of 3/17/2021. This is split between 501M Class A shares and 117M Class B shares

• Use of proceeds: …for working capital, operating expenses, sales and marketing expenses to fund the growth of our business, and capital expenditures. In addition, we may use a portion of the net proceeds to acquire complementary businesses, products, services, or technologies.

• No selling shareholders at IPO

The stock fell 16% on the first day of trading. After quickly recovering and reaching a high of ~$31 in early February, the stock has experienced a dramatic fall. They currently trade below $12, representing a ~50% discount to the IPO a mere 5 months ago.

Is this a juicy bargain, or is this the deserved outcome for a scammy, nefarious company?

INVESTMENT HIGHLIGHTS

Their Q4’20 Financial Results deck lays out the nominal investment case.

Their stated mission is to “bring an affordable and entertaining mobile shopping experience to billions of consumers around the world.”

In my view, this doesn’t really tell the whole story. The management team readily admits that they did not set out to do the above - see the earlier Vox article. They stumbled onto it, but it masks the company’s true core competency and source of value.

That lies in their business model: Wish relies on cost-effectively adding new users, converting those users into buyers and improvement engagement and monetization.

At its heart, this company is a powerful data-driven machine learning system that optimizes efficient customer acquisition. The mission statement is simply the incidental output of that incredible machine. It has directed them to aggressively pursue a massive, underserved market opportunity in lower-income, price-focused demographic, however counterintuitive or distasteful that may seem to the lay observer.

These are the real investment highlights for me:

Incredible scale already achieved in a massive, underserved and underappreciated market. They alternate with Amazon as the #1 commerce app in the world for the past several years (Jan 2020 global shopping app rankings, and May 2020 and Jan 2021 (Statista). In 2020, they had 107M monthly active users (+19% YoY); 550k merchants; 64M active buyers (made a purchase within the last 12 months) (+5%). However, they did this while de-emphasizing customer acquisition in certain markets due to the pandemic, leading to a 10% decline in MAU in Q4. When they aren’t #1 or growing massively, it seems that it’s usually intentional (or so they say).

They achieved huge growth while operating at effectively FCF breakeven. They scaled revenue from $445M in 2016 to $2.5B in 2020 (5x revenue growth in 4 years) with cumulative operating cash flow of +$13M. They’ve deliberately been running at a slight GAAP loss since ~2016.

They run a capital-light business and have a solid balance sheet with $2B cash and no debt. They don’t own any warehouses, production facilities, and only minimal inventory (<3% revenue). Their capex is 0.1% of revenue.

Their strong data science and technology advantage claim seems pretty legitimate. 50% of its 875 employees are technical/data science. The CEO worked on Google AdWords in the early days. Revenue per employee is $2.9M. These are very very favorable comps to Google and Facebook at IPO.

The CEO owns 20%+ of the company and has very aligned incentives. CEO founded company in 2010 and owns 20% while taking a low salary. He also has a performance comp plan over the next 7 years that incentivizes a 4x-11x return from current stock levels.

They have an all-star investor roster and board. Founders Fund (Peter Thiel), Temasek, GGV, Formation8 (Joe Lonsdale) who are all 5%+ owners.

They have been trading at roughly half their December IPO price of $24 over the past month ($12-$15). They are trading at <2x EV/revenue run rate multiples. At their current <$8B market cap (with $2B cash), they are actually trading for less than their 2017 valuation of $8.7B mentioned in the Vox article.

Finally, they have a stunning counter-positioning advantage. They ostensibly compete with Amazon, Alibaba and Shopify, which they have identified as their key competitors. With the exception of Alibaba and Ali Express, no one seems to truly prioritize competing with them, in spite of the objective metrics and characteristics of this market segment.

FINANCIALS

Let’s try to poke holes in their numbers and key metrics.

The two key drivers are the durability of their revenue growth and the efficiency of their customer acquisition.

Revenue Growth: While the five year revenue CAGR has been unquestionably stellar, it’s been hampered by softening growth in recent years.

There has been a clear softening in their marketplaces revenue since 2018. They say only 10% revenue growth in 2019, and the growth was essentially flat if you back out the logistics portion of the revenue. Management indicated in their filings that this was due to “intentional moderation of growth resulting from prioritizing the launch of our logistics platform over new user acquisition.”

It is challenging to validate whether that moderation in growth was truly an anomaly given the subsequent impact to the business due to the pandemic. The headline growth returned to a more healthy-looking 34% in 2020, but this was juiced by the uptick in logistics revenue. Marketplace revenue on its own grew only ~15%.

That soft marketplace revenue highlights two key headwinds for Wish: (1) their heavy concentration on Chinese sellers, which represented 94% in 2018, and (2) the impact of significantly higher shipping costs due to the substantial reduction of Universal Postal Union (UPU) treaty subsidies, which affected China-based sellers in particular.

COVID exacerbated those headwinds. Wish saw the biggest impact from COVID in Q1’20 when they suffered an 8% revenue decline. That overconcentration made them the biggest e-commerce marketplace loser during COVID-19 according to Marketplace Pulse (though this assessment was made back in June 2020). Wish subsequently rebounded to 67% growth in Q2’20 as China recovered. However, Q3 and Q4 returned to sub 20% growth.

To counter these headwinds, Wish has highlighted their newly launched logistics revenue stream as well as their efforts to grow their seller base outside of China. Logistics has experienced enormous growth, and despite the small base, logistics revenue represented over 25% of their total revenue in Q4.

On the seller front, they have been accelerating NA, EU, and LatAm merchant acquisition (234% growth since 2019). They grew US merchants in the network by 435% YoY in 2020. It’s easy, however, to show a massive growth number from a low initial base. Additionally, merchant count growth may not necessarily translate to increased shave of volume. The signs are good, but it’s still early.

I frankly don’t know how to assess their logistics business at this point. They seem to be creating a local merchant network of pick up points. I understand the appeal to a store owner who will be eager to drive foot traffic, but I am skeptical about how efficient this model can be. They’ve claimed 50k merchants so far, which sounds like a sizable number, but it’s unclear how much volume is actually being driven through this. Thus far, a fair chunk of the local pick-up merchants I saw on the app held only a small scattered handful of SKUs at best. However, management highlighted in the last earnings that this business already comprises 25% of volume for certain markets such as Mexico and Italy. It’s also unclear what the margin profile is for this revenue compared to the marketplace revenue, but intuitively it would make sense for this revenue stream to be less profitable.

The question remains whether the revenue deceleration is temporary or whether the focus on logistics masks an overall weakening in the overall health and volume of the marketplace. It is somewhat curious that the Company does not disclose GMV or transactions on the platform. The lack of disclosure would suggest that the GMV trend is not flattering to their desired narrative. $2B revenue at their standard 15% take rate would imply ~$13B GMV. There may be pressure on the take rate, pressure in retaining or acquiring new sellers, which would negatively impact growth and margins. This will be something to keep an eye on.

The competition is formidable. Wish describes them as follows:

Our online competitors include large, global ecommerce platforms such as Amazon, Alibaba, and Shopify as well as more traditional discount retailers such as Walmart and Target. Our offline competitors also include scaled discount retailers that offer heavily discounted and off-season products, such as Dollar General and TJ Maxx. We are able to compete for Wish users based on our massive product selection, low prices and daily discounts, deeply-personalized and differentiated shopping experience powered by our data science and optimized for the mobile device, and entertainment derived from various engaging and interactive features of our platform.

Their biggest competitors in Amazon and Alibaba have been better positioned to address the headwinds that Wish faces.

Amazon may actually share similar seller demographics. According to Marketplace Pulse, 75% of new sellers on Amazon are from China (US, UK, Germany and Japan), per an analysis of 40k+ new 2021 sellers. The concentration from China has increased in recent years in all of Amazon’s core marketplaces. They’ve been clued in on the China opportunity since at least 2015, per this internal email, when GMV increased from $1B to $4B. China sellers likely represent upwards of $100B GMV of Amazon’s ~$300B GMV from marketplace sellers in 2020.

The primary advantage on Amazon is leveraging fulfillment by Amazon, giving the benefit of 2-day fulfillment. The UPU change would have been a non-factor for Amazon selling. Plus, there is simply no contest in brand perception or customer service between these two companies.

AliExpress is the most direct competitor to Wish. There wasn’t any mention of AliExpress in Alibaba’s 2020 Investor Day materials, but they were covered in 2019. For LTM Aug 2019, they had $10B+ GMV and 79M+ active customers, which is on par if not larger than Wish. This comparison between AliExpress and Wish on Quora has some interesting tidbits. AliExpress seems to be concentrated in Russia, Brazil, U.S., Spain and Turkey. There have been rumors of AliExpress Russia going public, with a recent GMV of $3B.

AliExpress also benefits from Alibaba’s global logistics network. In their Dec quarter 2020 release, Alibaba disclosed that Cainiao had deployed more than 200 international chartered cargo flights for AliExpress, which resulted in a reduction of average delivery time by 3.5 days. They also disclosed that growth in GMV at AliExpress had recovered to pre-pandemic levels.

Shopify is also out there, though so far Shopify has been pretty vocal about their plans not to build a marketplace (Shopify Won’t Build a Marketplace), instead doing things like partnering with Facebook. Their leadership has consistently stated that they are looking to help sellers build direct relationships with their consumers, and the marketplace model would not serve that goal.

All of the above does not paint the most promising future for Wish. It’s tough to imagine a more formidable set of competitors. On the other hand, they’ve been contending with these dynamics for their entire existence and have done just fine. Global e-commerce is both intensely competitive and growing fast, and Wish may very well continue to thrive just riding the secular trend. Wish’s strategy to deliberately focus on the low-end makes sense in light of the competition, and it still represents a huge runway for them. A few years from now, it may very well turn out that all of this handwringing will have been over nothing more than a barely perceptible blip, a mere blemish against a glorious rocket-ship growth trajectory. However, this is clearly a concern for the time being.

Customer Acquisition: This is their bread and butter, and their number one risk factor: Our efforts to acquire new users and engage existing users may not be successful or may be more costly than we expect, which could prevent us from maintaining or increasing our revenue.

They’ve spent more than $1.5B on sales and marketing in each of the past 3 years, though at declining percentages of revenue, from 91% to 67% in 2020. That’s good.

They closely monitor lifetime value (LTV) and customer acquisition costs (CAC, though they call it buyer acquisition cost, BAC). They define LTV as cumulative gross profit. CAC is total digital advertising expense targeting new installations divided by new buyers acquired during that period.

Buyers from recent cohorts have hit ~$30 LTV by year 3, with recent cohorts exhibiting higher LTV per buyer. In the prospectus, the company noted their 2016 cohort achieved a 2.8x LTV to BAC ratio by year 4. Eyeballing the numbers implies ~$10 CAC for the 2016 cohort. The above callout notes the CAC payback for all cohorts since 2016 is approximately 2 years. LTV for year 2 for 2017, 2018 and 2019 looks to cluster around ~$25, suggesting a substantial increase in customer acquisition cost since 2016.

Notably, all of that spend has not seemed to have much impact on their actual buyer count. Their active buyers have been relatively flat the past 3 years, going from 64M to 62M to 64M from 2018 to 2020. That’s not the most encouraging sign.

The $1.7B in marketing spend is a tremendous amount for those LTM active buyer results. It implies they must experience some breathtaking churn. It’s almost as though they need to acquire most of their customers every single year. At the above $25 CAC, that would imply spending $1B on customer acquisition would allow them to acquire 40M buyers. The cost of buyer acquisition at the margin likely increases dramatically, but I am left scratching my head as to why

Their buyers are spending more though. Those 64M buyers generated $2.5B in revenue, or approximately $40 in revenue per buyer. At a 15% take rate, that suggests the average buyer is spending ~$260 on the app. I find that level of spend surprising, considering this is supposedly a lower income demographic. That compares well to the other key marketplaces.

• The average eBay buyer spends $540 ($100B GMV, 185M active buyers, 12700 employees)

• The average Etsy buyer spends $126 ($10.3B GMS, 82M active buyers, 1414 employees)

• The average Amazon buyer spends ~$1,300 ($386B GMV, 300M+ buyers, assumes 200M Prime buyers are 2/3 of Amazon buyers)

While the marketing spend and flat active buyer results suggest that buyers are churning at a high rate, that does not seem to be showing up in the revenue from New vs. Existing Buyers. Existing buyers generate 69% of revenue in LTM (9/30/20), up from 57% LTM (3/31/17).

Existing buyers on Wish collectively spend ~$10B+. Out of that 64M buyer base then, there must be a core group of loyalist buyers (5M ? 10M? 20M?) who actually spend quite a bit on Wish. I wonder who these people are, and I wonder how much it takes to keep them coming back for more. Perhaps many are businesses and resellers sourcing inventory from Wish. Perhaps they're addicted to the Buyer Blitz game and costing Wish in hefty subsidies.

So there you have it. It's a business with rapidly decelerating revenue growth, it competes with some of the largest players in the world, it's heavily dependent on Chinese sellers, and the cost of acquiring the marginal buyer has skyrocketed, resulting in their spending billions on marketing just to run in place on active buyers. No wonder the stock has dropped over 60% in the last 3 months.

FOUR COMMON CRITICISMS AND RESPONSES

Let's keep piling it on.

People just don’t get them it seems. Management recognizes that, noting that its investor base comes from the top 10% of the country, while Wish’s market is targeting the bottom 50% of the world. There’s a lot of education that has happened and needs to happen, but they are quite confident. “It's a long-term journey and as long as we execute and get to our vision, then the markets will reward us for that." These are typically platitudes, but it may be more than that for them.

Educating new investors has been part of the journey. In this Recode interview from Dec 2016, the CEO goes into the four common criticisms that they keep hearing and how they address them. The interview is clearly dated and the data points are stale, the underlying reasoning hasn't changed.

Criticism #1 – Seriously…who buy’s this stuff? Some variation of “I don’t shop on Wish, I don’t understand it, I don’t know anyone who shops on Wish, I can’t believe anyone would.”

This is a misconception. Everyone thinks purchase experience is most important thing (fast, reliable, product quality). Wish’s customers prioritize price above all else and are willing to sacrifice product quality, reliability and shipping speed to get it. It is a massive market, and this is reflected in the numbers (back in 2016):

• 60% consumers have bought at least 5 items

• 16 items per year

• 2M items transacted per day

• 1B items bought annually

• $2B GMV by year 3. More than doubling every year.

• 70% of DAUs look at 500 items per day.

CEO wrote a post entitled the Invisible Half in 2016, using the election of Trump as an analogue to the consequences of overlooking the underserved masses. Many people thought, “I wouldn’t vote for Trump, I don’t know anyone who would vote for Trump, therefore there is no way Trump can win.” Similarly, they think, “I wouldn’t shop on Wish, I don’t know anyone who shops on Wish, therefore no one shops on Wish.”

Criticism #2 – This is a house of cards dependent on wildly exorbitant and inefficient marketing spend.

This is also a misconception. However, it’s a good question, so being the data driven company they are, they tested it. In 2016, they shut off Facebook marketing for some time to prove unit economics for existing customers. They decided to run 10 months at cash flow positive just to prove that they could. They discovered that customers came back and bought more. They restarted growth user acquisition efforts in mid 2016. Even with those dynamics, they grew revenue 3x in 2016 while doubling gross profit and running at breakeven. LTV in the last 6 months grew 9% MoM while CAC stayed static.

Strategically, it was very critical for them to reach sufficient scale to be relevant to sellers. For marketplace businesses, merchants won’t care about you if you’re not a significant part of their business so Wish needed to drive a lot of volume for them, at least 20% of the merchant’s aggregate volume. Merchants’ margins also needed to be high enough selling on Wish that was comparable to other platforms.

Back in 2016, they already had $1B in cash on their balance sheet and had $4.2M GAAP net income. Their strategy was and has been to operate at breakeven.

Criticism #3: Delivery times measured in weeks? Surely you’re joking...

Conceded as valid criticism. Not great. 15 days -> 6 days. Top priority is logistics. Wish Express – 6 days delivery. Long run, 2/3 of transactions will be delivered in under 6 days.

Criticism #4: Company hasn’t done well at hiring talent outside of engineering / technology / data science.

I suppose there’s an element of truth to this, but this seems to be mostly a humblebrag. Many non-technical candidates at the time were scared away by the other criticisms, but that seems to have been starting to change at the time. Facebook’s head of customer service was recently brought over and customer satisfaction ratings (positive vs. negative) improved from 50s to the high 80s, comparable with Amazon.

To them, the first two criticisms are misconceptions, and they faced that challenge repeatedly during fundraising. There are some big-name shareholders on their cap table that they’ve managed to convince to share that view.

KEY SHAREHOLDERS

Funding History: Crunchbase($2.1B total prior to IPO)

• Aug 2019 – H - $300M – General Atlantic

• May 2017 – G - $500M - Everbright Fund

• May 2016 – F - $500M – Temasek

• June 2015 – E - $500M – DST Global

• June 2014 – C - $50M – Founders Fund

• Other rounds…

Key Shareholders: Crunchbase, Fintel for latest 13Fs

• Formation 8 (Joe Lonsdale, BOD): 62.2M shares (12.9%). Co-led $19M Series A in 2014

• Founders Fund (Peter Thiel): 46.7M shares (9.8%). Led $50M in 2014

• DST Global Advisors : 103.8M shares (21.7%). Led $500M in 2015

• Temasek: 26.8M shares (5.6%). Led $500M in 2016

• GGV Capital (Hans Tung, BOD): 26.2M shares (6.4%). Co-led $19M Series A in 2014

• Peter Szulczewski (founder, CEO, BOD): 134M shares (22%). 59% voting power.

• Danny Zhang (co-founder): 26.7M shares (5.3%)

• Note: all of them own >5%, which means they have additional 13d disclosure requirements if they ever decide to sell down.

Board of Directors:

• Julie Bradley (ex CFO TripAdvisor)

• Ari Emanuel (Endeavor CEO)

• Joe Lonsdale (8VC, founder Palantir, Addepar)

• Tanzeen Syed (General Atlantic, ex-Temasek)

• Stephanie Tilenius (ex KPCB, Google, eBay)

• Hans Tung (GGV, on BOD of Poshmark, StockX, Xiaomi, etc.)

• Jacqueline Reses (ex Square Capital head, ex Yahoo chief BD, ex BOD of Alibaba)

These are some of my observations:

• They’ve been at a ~$9B valuation for a number of years now.

• They have a history of raising money even though they don’t really need it or use it.

• The key shareholders all own 5% of the company or more, but many of the later folks may actually be flat to slightly underwater at these price levels.

• If it turns out the key shareholders are not looking to sell, then the float of this stock looks severely constrained. It’s basically the 46M IPO shares, and the RSUs that get sold for tax withholding, so the float is roughly 10-15% of total shares.

MANAGEMENT TEAM

Let’s take a look at the named executive officers:

• CEO – Peter Szulczewski (39, ex Google Search)

• CFO – Rajiv Bahri (56, ex Jasper CFO, Trimble CFO, Kraft Foods 18 years)

• General Counsel – Devang Shah (48, ex Zynga GC, UTStarcom, Longs Drugs, Skadden)

• VP Ops – Thomas Chuang (43, Ops and Finance since 2014, GGV Capital, PwC)

• VP Data Science – Pai Lu (35, ex Airbnb, PARC scientist, USC PhD)

I compiled data from the various filings to get a view for how much the founders and management team own. Once the 2020 proxy statement comes out, I’ll be able to get a much cleaner view.

The management team appears to have low base salaries, and the compensation is skewed toward the stock. However, even the equity compensation strikes me as lower than I would have expected. Apart from the founders and the CFO, no one is really getting life-changing generational wealth as of yet. The dollar figures assumed the IPO price of $24, so these are currently ~50% down.

The disclosed management team does seem somewhat sparse, but it appears that many key members of the executive team are just not named in the filings or on their website. The company did disclose all of the CEO’s direct reports in a correspondence letter filed with the SEC, which presents a more fleshed out organizational structure.

Clearly, the CEO is the person in charge here, warranting a specific key-man risk factor callout in the SEC filings. The letter goes on to note that he controls 40% of the vote as well as 5 of the 9 Board votes.

Per the earlier table, the CEO owns approximately 22% of the company, his co-founder who is no longer active with the company owns another 4%, and the other named executives own about 0.55%.

While not detailed out specifically in the prospectus, I believe the real secret sauce and talent at Wish resides within the orgs of the five executives in Engineering and Data Science:

· Co-founder and ex COO and CTO – Sheng (Danny) Zhang (LinkedIn). Left circa 2019

· SVP of Engineering – Previously Tarek Fahmy (LinkedIn). 8 years, left in October 2020 to pursue motorsports

· VP of Engineering – Bill Cao (LinkedIn).

· VP of Infrastructure Engineering – Xi (Kevin) Long (LinkedIn)

· VP of Data Science – Pai Lu

· VP of Engineering, Data – Jack Xie (VPE, LinkedIn, 10 years)

Taking a look at Wish’s patents list (Justia), the same five individuals keep popping up on each patent: the CEO, Zhang, Fahmy, Xie and Yuli Ye (Head of Machine Learning, LinkedIn, 6 years).

I hope these individuals are compensated more in line with market, though many of the tech folks do seem to have stayed with the company for a long time. I can understand the founder and SVP leaving to pursue other interests after 8-10 years working there. I also noted the strong tie to the University of Waterloo.

There seems to have been a decent amount of insider selling in February and March (gurufocus). Most of these appear to be related to automatic selling related to covering withholding taxes for vesting RSUs. My interpretation of the lock-up language is that employees and insiders are prevented from making any direct sales until after the Company’s second public earnings release, which is slated for May 12, 2021. I would be surprised if anyone were to voluntarily sell down meaningfully at these levels, so this would be an area to key an eye on in the coming months.

CEO

There’s not that much coverage around him, but the breadcrumbs that can be scrounged up paint a fascinating and compelling portrait.

I think all you really need to know about Piotr Sculczewski and the company he founded is contained in his short letter to shareholders and partners in the prospectus(page 63). Some excerpts:

I grew up in Soviet-controlled Poland in the 1980’s where I learned first-hand what it is like to not have access to basic goods and services.

After leaving Poland, I went to the University of Waterloo to study mathematics and computer science, and then worked for ten years as an engineer at Google building advertising technology.

I founded Wish to help the underserved who have been neglected by existing ecommerce offerings. This massive population of value-conscious consumers works hard to make a living, but still cannot afford more expensive or branded goods. My goal is to bring affordable goods and services to this underserved population. I also wanted to help merchants and manufacturers – many of which are small family businesses – find new customers around the world.

Our global marketplace is underpinned by data and technology across every aspect of our business. Half of our employees are engineers and data scientists. We built a platform – with the right algorithms, data science and machine-learning capabilities – that just gets better with time and usage.

We are going to continue leveraging our scale, data science, and technology capabilities, and the power of discovery-oriented shopping experiences to: (1) Create the best mobile shopping mall that drives value and accessibility for as many consumers around the world as possible, and (2) Enable brick and mortar stores, brands, merchants, and manufacturers to thrive in the highly competitive retail landscape by providing indispensable services to help grow and run their businesses and by delivering our massive base of value-oriented consumers.

As a company we are relentlessly focused on continuous improvement and measurable impact. We have a deeply ingrained culture of experimentation and testing that we combine with rigorous standards of measurement. Based on data, we will both double down and pull back on various initiatives as we continually pursue better performance and results.

The bold-faced language is what stands out to me. At its core, this is a data science / machine learning / tech company. While I may not always understand the markets they go after or the products they launch, I can very much get behind the idea that these will have been thoroughly vetted, vigorously tested and relentlessly optimized.

Unlike other colorful CEOs and visionaries dominating the headlines, this CEO and company seems to be quietly focused on execution. Engineers inherently think in terms of margin of safety. Each metric and target disclosed would have had to pass a withering level of scrutiny. My sense is that a software engineer / data scientist type is far more likely to sandbag his targets than to overstate them.

The company is personified by the CEO. Here he is in action at conferences and interviews:

· [2020] Discussing the IPO on CNBC and Bloomberg. Key quotes: “wouldn’t say we’re like dollar stores…order values probably much higher than dollar stores”; they transport goods in the underbellies of aircraft, which was impacted by COVID.

· [2017] Discussing the Lakers patch deal with NBA.com. Wish had reached out to Lakers and struck that deal within 6 weeks in 2017.

· [2017] Shoptalk presentation on the Failure of eCommerce. #1 Product failure in terms of finding and purchasing your product. #2 Demographic failure of people that have been left behind.

· [2016]Recode interview discussing their mission and addressing the four common criticisms. They were already on the path back then.

Within the letter and the Recode interview, there are also indications about his long-term aspirations with Wish in reaction to acquisition rumors at the time. The short answer is that I don’t think he’s interested in selling. I don’t think the marginal billion dollars is all that meaningful to him at this point. I think he’s looking to achieve something huge and world-changing, and he likes the hand that he’s been dealt.

In addition to his existing stock holdings, the CEO has a 7-year Performance Award based on hitting certain stock price targets up to 5x from IPO price that unlocks up to 5 tranches of RSUs.

This table caught my eye and raised a few thoughts for me:

• 10M shares at the IPO price is already worth $240M.

• If you value the received shares at the price targets, the package is worth ~$1.0B

• If you value the ~10M shares at the $138, the package is worth ~$1.4B

• When you consider the CEO already owns 134M shares, an additional 10M shares doesn’t really even move the needle for him. Why is this even here?

• Knowing what we know now about the CEO and his background, his motivations, and how he works, what would you estimate his confidence level is in hitting these targets? What is the probability that he does not hit these targets?

The CEO has mostly kept his shares. In June 2019, he did sell ~$17M in shares @ $12.17 back to the Company. Incidentally, it was reported in August 2019 that he had made a $15M Bel Air mansion purchase. The headline price seems high, but clicking through the pictures in the article, I found myself somewhat in awe by the amount of house he got for his money.

EMPLOYEES

The headcount metrics reflect the concentration in technology. Some key stats at IPO:

· 828 FTEs across 8 countries (primarily SF and Toronto)

· 417 FTEs (50%) in R&D. 32% hires from referrals. For reference, the share of employees in R&D is higher than what it was for Google at IPO. GOOG in June 2004 had 2,292 employees (705 R&D, 1,141 in S&M, 446 in G&A, prospectus GOOG pg 85).

· ~$3M revenue per employee. Facebook in 2011 leading up to its IPO had $4B revenue, 3,200 employees or $1.5M per employee (IPO at $38 in May 2012). Google had ~$2.3B in revenuein LTM June 2004, or ~$1M per employee, at IPO.

Based on the below table, there are approximately 75M common stock options and 50M RSUs that were outstanding leading up to the IPO. The value to all employees/management: $1.2B in options, $835M RSUs value as of 9/30/20 (F-40 of the prospectus).

However, the named executive officers (mostly the CEO) held ~44M options and ~19M RSUs from that pool. That leaves approximately 30M options and 30M RSUs for the rest of the employees, past and present. The company stopped granting options sometime between 2014 and 2017, so the options will be concentrated among the earliest employees. It’s thus likely that most of the ~800 employees have ~30M RSUs among them. Those 30M RSUs would be worth ~$720M at IPO, now <$400M, which means the average employee has ~$500k to $1M in equity value, at varying levels of vesting. Double those numbers if including the option pool too. After taxes, my guess is that the typical employee can perhaps afford a Bay Area down payment now, with likely a much smaller number who may be able to afford the house outright. It’s solid, but not really life changing money.

The Glassdoor reviews have been mixed (Jun 2020. Apr 2020) to poor (Aug 2020, Jan 2020). It doesn’t seem like a pleasant place to work: poor work-life balance, poor senior leadership, young employees, short-term metrics data-driven.

This may matter from an employee retention perspective for folks who may seek greener pastures and better working conditions. It’s not like companies aren’t willing to pay up for world-class data science and machine learning talent. It’s an area to keep an eye on. In my view though, it would be premature for someone to leave now.

WHAT’S THE CHATTER?

There isn’t that much out there on the interwebs. Here are the usual suspects:

· IPO blog posts. These Substacks have provided the best quality analyses so far. Both of these are negative, but they were both done in the lead up to the IPO. Napkin Math (a solid skeptical breakdown of the S-1), The Diff (raises interesting point about inevitable short selling report)

· Seeking Alpha. Recent articles are mixed to bearish (Apr 2021, Mar 2021), but the comments to these articles are mostly bullish pointing out asymmetric returns and comparisons to Pinduoduo. Key criticisms: margins challenged, concerned about customer loyalty, highly promotional business model, product quality, poor reliability and long shipping times. No clear plan to reach profitability. Low-cost competitors in emerging markets – MercadoLibre in LatAm, Allegor and Avito in Eastern Europe, Shopee and Lazada in SEA, Souq Cobone and Sukar in MENA, and Jumia/Konga/Alibaba in Africa. The regional low cost players are a fair point.

· YouTube: This one provides a comparison between Chinese companies Pinduoduo and Tiktok to Wish, starting with lower-income untapped region. Alex Moazed (Wish is a scam), though the cognitive dissonance on display in this video is amusing – his mind is blown by the reported numbers, but the only rationalization is that it must be a scam. Here’s another video outlining Wish as a Bullish opportunity.

· Value Investor Club. No writeup for the non-members yet.

· Reddit forums. WISH_STOCK. Nothing of note, though this type of company has a lot of ingredients for a meme stock. I would think it should resonate with this community.

SECRET POWERS

Wish provides a fascinating case study of Hamilton Helmer’s 7 Powers, the foundations of business strategy.

There are notable scale economies, network economies, and process power associated with their distribution and massive volumes. There are also, to a lesser degree, elements of cornered resource in their data science expertise, branding with their #1 app positioning, and even switching costs for sellers looking to drive as much volume with Wish.

What intrigues me the most about Wish is their counter-positioning. This is when “a newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.”

The advantage lies in being dismissed and disdained as a very small niche business, similar to how a dominant Blockbuster perceived Netflix, or how the investment management industry perceived Vanguard’s index funds, or how Google was ridiculed for years for overpaying for an unmonetizable video platform overflowing with low quality pirated user generated content in Youtube.

What better business is there than one in which no one else wants to compete with you?

As Peter Thiel put it, “Competition is for losers.” Thiel happened to invest in Wish around the time that article was written and when his Zero to One book was written.

But doesn’t Wish compete with Amazon and Alibaba and a host of others? Of course they do, but then again, perhaps not really.

Amazon, at the end of the day, is looking to sell more Prime subscriptions on the consumer side. Amazon is not likely to venture into geographies if they are unable to deploy the Prime playbook there. I don’t think Wish and Amazon are competing for the same user, even though their respective customer bases may sometimes purchase similar inventory. Wish’s target market is the non-Prime customer, anywhere in the world.

Alibaba could very well be the threat, but their superpower emanates from their dominance in China. The company doesn’t have a great track record in achieving a similar level of success in any of their efforts outside of China yet. While AliExpress may have enjoyed some success in certain geographies earlier on, I’m not sure about their ability to sustain that growth globally, particularly as the universe of addressable merchants expands outside of China. Alibaba also has a lot of competing priorities starting from the very top (Jack Ma, Ant IPO, defending their home turf), which may impact their ability to adapt and compete effectively in this niche.

Most large incumbents, at least in the U.S., are likely to acknowledge but ultimately dismiss or outright disdain the opportunity. There will certainly be pockets within the large players that grasp the potential, but will they be able to mobilize their resources and act the way Wish and their CEO singularly can? The irony is that one of the most compelling and practically inevitable global trends is also found to be repellent. There is an unwillingness to traffic in this quality tier of inventory, engage in this type of tacky social promotion, or pursue such a humble demographic. This cognitive bias is challenging to overcome, not just among potential direct competitors of Wish, but also potential investors in the company.

But the longer the intensity of competition stays relatively dormant, the more time the company has to build and gain share. The attitude and ignorance of the incumbents acts as a protective barrier. As such, there is limited incentive for the company to share more than is necessary to go about their business. They’ll continue to fine-tune and optimize and add value for a large, underserved audience until one day their dominance of this niche will be a fait accompli. It will then have been obvious in hindsight.

VALUATION THOUGHTS

Let’s examine what we need to believe in order for the CEO to hit his targets.

The company has shared the following guidance for Q1’21 and long-term targets:

Such a data driven company would put a lot of care into selecting highly achievable financial targets. What jumps out is the adjusted EBITDA margin of 20% to 30%, which seems high from current levels, but is in line with marketplace businesses.

Adjusted EBITDA is a non-GAAP metric, but in this case, it likely tracks net income very closely. I think the only meaningful difference at this point is adding back stock-based compensation. Since this is a capital light business (little D&A), they deliberately operate at a slight loss (no taxes), they have no debt (no interest expense), the rank and file employees generally don’t seem to be paid very highly (depresses stock-based compensation), this may be a rare case where the Non-GAAP metric actually tracks net income pretty well. Net income would likely line up closely to free cash flow (FCF) including stock-based compensation.

Back in their investment highlights, the company had called out their addressable market of mobile commerce as $2.4T by 2024.

To put that in context, Digital Commerce 360 lists the top global online marketplace by GMV in 2020, with growth of 40-60% for the US depending on whether you exclude Amazon and eBay. Note that the pandemic generally had a positive impact on growth.

1. Taobao (Alibaba): $609B

2. TMall (Alibaba): $593B

3. Amazon: $475B

4. JD.com: $405B

5. eBay: $100B

Wish’s current revenue run rate is ~$3B, which suggests they are currently generate ~$20B annual GMV (assuming 15% monetization). Is it possible for the company to carve out a $100B+ GMV business in the next 5-7 years, even in the shadow of giants?

It all comes down to what they can achieve around revenue growth and margin. There could be a wide wide range here when you factor in all of the earlier commentary and their historical trajectory. The 70% Q1 growth guidance benefits from a terrible Q1’20, so it will be interesting to see how the rest of 2021 plays out.

Below are some high-level sensitivity tables varying revenue growth and FCF margin 6 years out:

Key assumptions:

• Base year revenue of $3B (roughly the Q1’21 run rate)

• 6 year hold period

• Market cap based on 15x multiple on FCF (may be conservative for a high growth company)

• No adjustment for cash balance

• Share price based on 700M shares at exit, which implies ~15% dilution to account for the impact of stock-based compensation. There were 75M options and 30M RSUs outstanding at the end of 2020.

It turns out that the assumptions don’t have to be too aggressive to start seeing a multi-bagger outcome. The share price table also provides a rough approximation for the metrics needed in order to hit the share price targets in the CEO’s performance bonus package.

At the current ~$7.5B market cap, that would suggest the market thinks the company will have ~10% annualized growth and ~10% FCF margins. While they haven’t proven out their profitability yet, that profile still seems really conservative for a marketplaces business. It assumes that the gross margins will stay pressured with the shift to logistics, that the user growth story has already peaked, and the cost of customer acquisition remains elevated and uneconomic. It would be interesting to see what this business could do if management turned its focus toward driving profitability. The guidance of long-term 20-30% EBITDA margins is comparable to other more mature marketplace businesses. The simplest approach would be to reduce the $1.7B in marketing spend accordingly. If the business can do better than that, then the upside potential on this is frankly massive. I like the odds of that playing out.

RANGE OF OUTCOMES IN 5-7 YEARS

These are just my guesses.

Downside (i.e., holding the bag) [~20% probability]. It turns out that user growth flattens and the profitability isn’t there. Reasons could include an escalated and/or protracted China trade war, the business model just doesn’t work, increased competition, prolonged pandemic disruption, fraud, some other black swan event (e.g., suppose China were to invade Taiwan and disrupts foreign trade).

This business, however, remains a very capital light business. There are still fewer than 900 employees. Even in the worst case where the company has to sustain a period of time of zero revenues, they have the $2B cash cushion to survive for several years with their predominant expense being salaries.

Provided management does not start wasting large sums chasing vanity projects, they could likely still pivot to running this for cash flows and cutting marketing significantly. Recall that ~70% of their revenues are from existing buyers. Even assuming a significant revenue decay, that is still a very healthy cigar butt, as they could probably shave off ~$1B+ in marketing spend per year. A starting base of $2B existing revenue at 20-40% annual decay rates would result in $5B to $10B in cumulative revenues, or $2B to $4B at a 40% margin.

When you consider that their $2B cash balance represents ~$3+ per share, they have operated at effectively breakeven for the past 4 years, and their CEO is likely in it for the long haul, my sense is that the downside is relatively limited from here. Let's not forget that they're still growing for the time being. Even clawing back to the IPO price represents a double from here.

Call this an $8 per share outcome.

Case studies: GRPN, ZYNGA– disappointing long-term outcomes

Upside (i.e., holding the bagger) [~80% probability]. We land somewhere in CEO’s performance comp plan: $46 through $138, representing a ~4x to 11x+ return. Based on the earlier sensitivity table, I think this comes into play if Wish can achieve 20%+ annualized revenue growth during this time period. There is also a real possibility that this goes parabolic beyond that. It’s not an atypical outcome for commerce with meaningful TAM and line of sight to scale.

Case studies: AMZN, ETSY, MELI, PYPL, SE, SQ, SHOP. Even DLTR, DG, TJX, WMT in offline context. BABA, JD and PDD for China.

This will be a volatile ride. The challenging part will be holding through the volatility.

While a Groupon or Zynga outcome is possible, I believe this is low probability. At IPO, Groupon had a fundamentally different business model, relying on a huge workforce (10k+), while enduring a much more contentious SEC review due to some innovative non-GAAP accounting. Moreover, the founders had already cashed out close to $1B prior to the IPO.

Zynga operated in a Facebook game hits driven business (FarmVille and Words with Friends), and a far more competitive environment. But they were quite the player back then, representing 12% of Facebook’s revenue at the time of Facebook’s IPO. It was just tough to sustain that advantage.

Wish has carved out a niche for itself that happens to be incredibly massive and valuable. Their space is dismissed and disdained as the sketchy area dominated by Chinese sellers and dollar stores.

The attitude toward Chinese-based sellers and dollar stores is actually somewhat baffling. There seems to be a pervasive false equivalence that because the quality of the items being sold on the platform may be of suspect quality, then the company behind them must therefore be suspect too.

China, however, is the most competitive and unforgiving e-commerce arena in the world. Sellers that survive and thrive there must be doing something right. The Chinese e-commerce players Alibaba, JD and Pinduoduo are among the most valuable companies in the world.

The dollar store industry is a perfectly fine place to be, particularly in the US. Between the two leaders, Dollar General ($52B market cap) and Dollar Tree ($27B market cap), there are ~30k stores, ~$50B sales, ~5-10% net income margins, 20x PE. Even a smaller player like Five Below with 1k stores trades at $11B market cap on $2B in sales (that's sales, not GMV). Peruse their stock charts, and I'm sure you will have been more than satisfied with a dollar store stock performance outcome over the past 10 years.

But Wish isn’t a retail company. They have no store footprint. It’s an asset light model. It’s global, mobile, local and social. It’s “algorithmic commerce” as described by Scott Galloway, only instead of Walmart plus Tiktok building this eventually, it’s already happening at global scale and at a rapid clip with Wish.

CATALYSTS

This one has been volatile over the past few weeks, and it seems more likely for downward pressure to prevail in the near-term.

[Negative] The impending lock-up expiration may put downward pressure on the stock over the next few weeks. May 12th is their Q1 earnings announcement, and ~90% of the company’s shares will be available to trade a few days afterwards. This traditionally puts downward pressure on the stock, but I’m not sure who would really want to sell at these levels.

[Negative] The upcoming earnings call will be interesting. The key will be their outlook for Q2 and whatever commentary they provide for the rest of the year. In 2020, they had -8% revenue growth in Q1 and 67% growth in Q2. They had already indicated that Q2 will be a challenging comp before seeing Q3 and Q4 return to normalized growth. This was highlighted during the Q4’20 comments, which happened just two months ago. The language seemed to suggest that Q2 might be relatively flat year over year. The large tech names have generally delivered stellar Q1 results, but their share prices haven’t necessarily moved as dramatically. Against that backdrop, my sense is that an underwhelming Q2 outlook will cause the share price to dip further in the short-term. That could provide an attractive level to build the position.

[Negative] A short-selling report gets released per the blog post mentioned previously, uncovering some salacious detail about the inventory, the sellers, the company, or some other unknown. The company does cover a lot of volume without that many people, so it is very possible something will go overlooked on the customer or inventory front. Unflattering PR is going to be an ongoing cost of doing business though. At these depressed levels, I’m not sure if there is enough juice for a short seller to squeeze. The shares short on this does seem to be building up though.

[Positive] The company announces a stock buyback program. It seems like a logical thing to do, especially if the stock continues to trade at these levels. They could theoretically buy back their 46M IPO shares and still have ~$500M+ in IPO cash left over.

[Positive] They flesh out the management team. While the CEO seems to have done just fine getting to this point, imagine if the company were to add a seasoned executive in the mold of an Eric Schmidt or Sheryl Sandberg, someone who had the experience to grow the business, while lending the gravitas to further legitimize the company on the communications and investor relations front. It would also allow the CEO to focus on the technology and optimizing the business. Such an announcement could very quickly shift the perception of this company. Some more diversity in the management ranks could help too. Fortunately, the company already has two strong candidates on their board with Tilenius (ex Google and eBay) and Reses (ex Square and Yahoo).

[Positive] This one is admittedly a long way off, but Wish will get added to the S&P and FTSE indices sometime after 2027 (assuming they’re actually profitable and large enough then to warrant inclusion). S&P and FTSE adopted rules in 2017 that disallowed companies with dual-class share structures into their indices. After Wish Class B shares sunset to Class A in 2027, this constraint falls away and these indices would be required to buy shares. There was a similar dynamic with Tesla in late 2020 after they had achieved their second GAAP profitable quarter and were then eligible to be included in the S&P indices, which prompted a lot of automatic purchasing given their size.

[Positive] Wish has a lot of ingredients (their target demographic, their underdog story, the constrained float, an increasing number of shares short) that could potentially lead to a meme stock Reddit surge at some point. Hard to predict, but tough to dismiss that possibility.

Several of these could potentially get checked off during the earnings call on Wednesday.

SELL SCENARIOS

• Company misses their targets more than once. This would shatter my company-is-awesome-at-data-science thesis.

• Watch for deterioration in the metrics, which could include: (1) the revenue growth starting to flatten out (e.g., <25% revenue growth for 2 years running), (2) deterioration in cohort performance on either the CAC or LTV front, and (3) reduced evidence in operating leverage, represented by a deceleration in sales & marketing expense improvement, rising cost of goods (which would represent higher logistics costs), or rising capex % which would indicate a departure from their asset-light approach.

• Pay attention to their headcount growth and whether they need to invest in more customer care or content moderation.

• When the CEO or BOD starts to sell out, steps down, or otherwise indicate less confidence in the business. I would be surprised if this occurred in the near-term though.

• Some black swan negative event (e.g., security breach). Something that goes by uncaught that they overlook.

• If the CEO hits his comp targets (i.e., after the stock appreciates 10x+), reevaluate.

BOTTOM LINE

• Impressive data driven iterative product development. Feel confident in their ability to be nimble, launch, test and iterate and follow where the data points them to and what the customer needs are.

• Strongly counterpositioned to both capitalize on a massive opportunity while occupying a space that few want to compete in.

• Opportunity to buy in (<$8B market cap) at 2016-2017 price levels.

• Bet with the CEO (highly aligned incentives) to see if he hits his comp plan.

• Limited downside (frankly don’t see much downside from these levels with roughly breakeven FCF operations while supporting growth, plus the ~$2B cash and no debt)

• Hold for 5-7 years. Entry price significantly below the IPO price seems pretty enticing with very decent probability for multi-bagger outcome.

PLAYS TO CONSIDER:

Buy the stock. If you assume the CEO’s first $46 target, then whatever below that which feels comfortable. $15 and below seems like an attractive risk-reward entry point.

Sell cash-secured puts. I found many examples of structuring something where you either get an adjusted entry price at a 10-20% discount, or you get a 20%-30% yield on your cash.

Personally, I find it rare for so many elements to align where it makes sense to dust off the elephant gun.

Other References:

· IPO in December 2020 at $24/share (high end of $22-$24 range), raised $1.1B at $17B fully diluted valuation. Currently trading at $12.

· Wish filings and financial targets: 2020 10-K; Q4’20 report; IPO prospectus

· Commentary: How Wish passed $1B in rev by inverting Amazon’s strategy (Mar 2021); How Wish built a retail empire for shoppers to buy on the cheap under the nose of Amazon (Feb 2020, includes CEO quotes); Wish, the $10B company no one’s talking about (Apr 2018);

· What is it like to sell on Wish? Deliverr blog; CED Commerce: How to Sell on Wish.