1. Introduction

Many successful businesses are the result of solving important yet accepted problems. Oftentimes the solution is simple, however more complex problems tend to require more sophisticated solutions. GoodRx has chosen to tackle a key problem in one of the most convoluted, political and complicated industries out there - the US healthcare system.

I have spent a good part of this last month learning about the intricacies of the US healthcare system in order to write this deep-dive. From the point of view of a UK citizen, the US healthcare system comes across, for the most part, as overly complex and generally inefficient. And inefficiency creates opportunity.

• The US is the only OECD country without some form of universal health coverage, resulting in the US spending twice as much (per capita) than other OECD countries.

• Despite this higher spending, most data shows health outcomes in the U.S. to be worse than other OECD countries, even after adjusting for nuances like above-average obesity.

• A 2020 study by the Commonwealth Fund notes the U.S. has the highest rate of avoidable deaths in the world.

• The vast majority of americans (64%) will need to make the decision to risk their health by delaying/avoiding medical care because of the costs.

These serious systemic issues prompted lifelong friends, Doug Hirsch and Trevor Bezdek, to start GoodRx - a service offering affordable access to healthcare for all citizens. Since starting the company in 2011, they have gone on to help over 6 Million monthly users get access to affordable healthcare - saving a cumulative $25 billion on prescription costs (as of March 2021).

Lastly, taking into account the low penetration of GDRX (10%) and the fact that 70% of patients still don’t know that drug prices can vary by pharmacy - I believe GoodRx are still in their infancy as a company.

2. Thesis

• Addresses a huge inefficiency in the current medical market - drug affordability. The product helps regular people save an average of 70% off retail pharmacy cash prices. In turn, this helps people get access to medication that would otherwise be out of reach.

• Market leader in the space and is primed to take share in their primary markets.

• Addressable market penetration is currently low at about 3-5% but has the potential to increase dramatically over the coming decades.

• Re-investing heavily into growth - specifically advertising.

• Strong history of past growth, positive Free Cash Flow and an attractive balance sheet. These are all important to future growth as it enables the company to be able to conduct investments and M&A activity at will.

• Management have significant ‘skin in the game’ have have a proven track record of execution along with showing a real desire to give the consumer the best product possible.

• There are some risks such as Amazon entering the scene, along with the potential for substantial healthcare reform which, if it happens, could significantly reduce GoodRx’s value proposition.

3. Key terms

If you’re reading this from outside the US, some of the terminology throughout the article may be difficult to understand, so I’ve highlighted a few key terms.

Deductible: The amount you pay for covered health care services before your insurance plan starts to kick in. E.g. With a $2,000 deductible you pay the first $2,000 of covered services yourself.

Copayment: Defined as a fixed amount you pay for a covered healthcare service after you have paid your deductible. E.g. For a doctors office visit costing $100, you pay a fixed price of $20.

Coinsurance: Similar to copayment, but calculated as a percentage after your deductible has been paid.

EHR: Electronic health records - essentially a digital version of a patients medical history.

U&C prices: Usual and customary (U&C) prices reflect the costs of the drugs to the consumer at the retail level without the use of insurance.

PBM: Pharmacy Benefit Managers negotiate discounts and rebates with drug manufacturers with the goal of lowering the overall cost of prescription drugs for the general public. There are currently 66, with the top 3 controlling over 80% of the pharmacies.

Rx: Abbreviation for a prescription.

4. GDRX explained

4.1. The problem

As explained in the introduction, healthcare costs in the United States are the most expensive globally by almost 2x the OECD average. In reality, the current state of healthcare in the US means that people who don’t have access to affordable healthcare plans either delay treatment, or simply go untreated.

The state of the current system ultimately leads to the US having the highest rate of avoidable deaths - defined as “premature deaths from conditions that are considered preventable with timely access to effective and quality health care”.

These issues aren’t new. But 10 years ago, GoodRx was formed with the intention of reducing the scope of this problem by making healthcare more affordable through heavy discounts.

4.2. How do GoodRx solve the problem?

GoodRx solves this problem by essentially offering a coupon service where users can access cheaper medication. 

The company started out as a price comparison tool, enabling users to compare the price of prescription drugs between various locations. This still makes up the majority of their revenue.

The core business serves as the main on-boarding mechanism in order to make customers aware of the various other businesses GoodRx runs, such as Subscriptions, Telehealth, Marketplace and Pharmaceutical Manufacturer Solutions.

The basic GoodRx service gives consumers the ability to compare Rx (prescription) prices between a range of pharmacies. Using the app or online, GoodRx provides the user with a discount card to present at the pharmacy counter in order to receive significant discounts on regular prices.

4.3. So, how do they achieve these discounts?

Firstly, we need to understand one of the key features of the US healthcare system - a PBM (Pharmacy Benefit Manager).

Pharmacy Benefit Managers negotiate discounts and rebates with drug manufacturers with the goal of lowering the overall cost of prescription drugs for the general public.

Each PBM has a network of pharmacies with which they sign contracts to allow consumers with insurance to easily fill cheaper prescriptions at those locations. Most pharmacies are part of one or multiple PBM networks.

But why would Pharmacies want to lower their profit margin by selling drugs at a lower price? 

Well, In exchange for the discount, these pharmacies are hoping to build awareness, drive more foot-traffic to their store, and therefore make up the margin on in-store purchases. This model works well for bigger pharmacies selling other items such as food, however it’s not so great for the smaller independent pharmacies.

If an uninsured consumer chooses to purchase a drug using the GoodRx discount code, the pharmacy pays a fee to the PBM who provided that discount. Then, a portion of that fee is shared with GDRX, which allows GDRX to offer the discount service for free.

On average, the GoodRx fee works out at 14.4% of the Gross Merchandise Volume (total price the consumer pays). The reason this business model works for GoodRx is because if the end user pays the original price instead of finding a discount code, then the PBM earns $0. Therefore, it’s in the PBM’s best interest to work with GoodRx - a win-win for everybody involved.

• Consumers get cheaper drugs.

• Pharmacies recoup margin on footfall traffic.

• PBM’s increase their revenues.

• GoodRx, as the facilitator, gets a fee from very little operational overhead (high gross margin).

Because of the attractive economics of this business model, it’s no surprise that a large proportion of the PBM’s in the country have signed contracts with GoodRx.

And, just for context, there are currently 66 PBMs, with the three largest – Express Scripts, CVS Caremark, and OptumRx – controlling approximately 89% of the market and serving more than 270 million Americans. GoodRx has contracts with Express Scripts, OptumRx and over 10 more PBM’s.

• Over the company’s lifetime, the average discount offered to consumers has risen from 58% to 79% (as of Q2 2021).

• GDRX is accepted in over 70,000 pharmacies country-wide (over 85%).

4.4. Who is the consumer?

My logic going into this deep-dive was that the majority of GoodRx’s revenue mix would come from uninsured consumers rather than their insured counterparts. This turns out to be somewhat incorrect.

In actual fact, ~75% of the company’s monthly active users (MAUs) are insured.

So how can we break the customer base down?

1. The uninsured: Currently, 27.5 million americans go without health insurance (roughly 8% of the population). This category would be the main beneficiary of GoodRx. 

2. High deductible plans: Roughly 50% of americans are enrolled in ‘High Deductible Health Plans’, for which GoodRx will come in very useful as long as 

3. Expensive Copayment or Coinsurance plans: Once the deductible limit is met and patients start having to pay copay/coinsurance, it seems like GDRX prices are cheaper than copay/coinsurance roughly 40% of the time.

4.5. What is the value proposition?

There are two main value propositions for the GoodRx platform - giving consumers the ability to quickly and easily compare prices between pharmacies, and ultimately to help consumers save money on prescription costs.

Over and above these two value propositions, GDRX provides value in various other ways…

Consumers:

• Simple access to affordable healthcare

• Improves quality of care due to accessibility

• #1 downloaded medical app

• Over $25 billion in customer savings

Physicians:

• Increases medical adherence, improving health outcomes

• Happier customers

PBMs:

• Adds to profits

• Offers easy to use platform

Pharmacies:

• Increased footfall

• Better customer perception of pharmacies, as offering lowest price

Manufacturers:

• Encourages more patients to start, and stay, on their therapy

• Provides high-intent audience, enabling effective targeting to deliver higher ROI

5. GDRX other avenues

In addition to the core ‘coupon’ business, GoodRx operates other complimentary businesses with the aim to improve the overall healthcare experience. These include:

• Subscription services

• Telehealth

• Marketplace

• Pharmaceutical Manufacturer solutions

As you can see from the below graphs, the ‘other revenue’ segment of the business has been growing rapidly over recent years. As of FY2020 it makes up roughly 11% of total revenues, and has more than doubled since 2019.

5.1. Subscriptions

GoodRx charge $5.99 per month for individuals or $9.99 for groups as a subscription in addition to the core ‘coupon’ service. This gives added benefits - namely getting access to cheaper prices on over 1,000+ prescription drugs.

“Some pharmacies offered us even lower prices if we could create a membership program for people filling 2 or more prescriptions at a smaller group of pharmacies“

These prescription services are split into three main baskets:

1. Free prescription service

2. GoodRx Gold (2017)

3. Kroger Savings Plan (2018)

I’m not fully clear on how GoodRx Gold differentiates from the core service. However, from some digging, it seems that instead of GoodRx getting paid a fee by PBMs through the regular route, they instead negotiate prices with the Pharmacies directly and keep 100% of the subscription fees.

The company mainly enrolls people to the gold service organically, but also attempts to upsell users of the core discount service. Generally speaking, the more often you use GoodRx for your prescriptions the more likely it is you will get sufficient benefit from the subscription service. It seems prescription penetration currently sits at about 20% of the overall customer base (which is good), and has potential to increase over the coming years - probably growing at a quicker rate than the core business.

5.2. Telehealth

Telehealth, which is essentially a vertical integration on the existing GoodRx infrastructure, is an interesting area and one which seems to be expanding rapidly (somewhat boosted by the pandemic). It is also a ‘no-brainer’ extension to the core GoodRx product.

GoodRx purchased Heydoctor in 2019 and has since re-branded to ‘GoodRx Care, subsequently launching GoodRx Marketplace in 2020. You can think of this division as a similar model to Teladoc, probably the most popular Telehealth service.

The Telehealth division (GoodRx Care) in this instance acts as a sort-of marketing tool - seamlessly driving traffic to their core business and subscriptions via referrals from physicians. This strategy is extremely beneficial for GoodRx as it significantly lowers the Customer Acquisition Cost. Additionally the company can cross-advertise on both platforms, squeezing the most value out of their customer base as possible.

• Apparently >10% of GoodRx Care consults lead to a consumer using a GoodRx discount code at a pharmacy.

• Already competitive area

• Medical consultants keep the majority of fees under the GDRX telehealth model (lower margin business). Requires scale for profitability.

• Scale of their operation has improved dramatically since the takeover, however it seems unlikely that profitability of the operation will happen anytime soon.

If we look at Teladoc as a comparison within this sub-sector of the medical market, there are some big differences in scale between Teladoc’s offering and GoodRx’s offering.

Teladoc currently has over 50% market share and generate roughly $100 in revenue per visit, this is compared to the GoodRx telehealth solution generating about $40 in revenue per visit. In for GoodRx Care to get to Teladoc’s level of scale and profitability will be incredibly costly and time-consuming.

This doesn’t seem like a long-term profitable business-model on the surface, however building out the Telehealth business is a great on-ramp towards GoodRx marketplace, which is where the bulk of the profitability lies.  

5.3. GoodRx Marketplace

Essentially, GoodRx Marketplace is an aggregator of over 30 Telehealth providers (including Teladoc), covering over 150 conditions across the entire country.

GDRX generates referral fees for directing traffic to marketplace partners and by integrating electronic health record systems of partners (such as TDOC) to allow customers to utilize the prescription service if a prescription is written with the consultant.

I see this as more of a strategic play as it allows GDRX to move up the customer acquisition funnel to the point of prescription and simultaneously lower the CAC whilst driving higher penetration for the core prescription business.

By the time the S1 was issued, they saw more than 1M consumer visits and over 200,000 consults. Scaling quickly.

Telehealth is a small part of the business today, but has plenty of potential to scale over time.

5.4. Pharmaceutical Manufacturer Solutions

As well as offering discounts on generic drugs, they also aim to target manufacturers who spend a great deal on marketing branded medications directly to consumers. Consumer focused advertisements are growing fast - accounting for roughly 30% of overall ad spending (about $10B).

GoodRx are hoping to capture some of this market by partnering with drug manufacturers in order to advertise on the GoodRx Marketplace. 

6. Market context

6.1. Total addressable Market

I think it’s safe to assume GoodRx’s serviceable addressable market is much smaller than their estimated TAM of $800B.

Richard Chu does a great job of breaking this down, but essentially the breakdown is

• $18 Billion for prescription and subscription services

• $10 billion for the Pharma Manufacturer solutions segment

• $7.5 billion for the Telehealth segment

To reach a total Serviceable Addressable Market (SAM) of $35.5 Billion.

Market penetration is currently low at about 3%-5% of the overall addressable market. However, there is good scope to increase this important figure over the coming years.

One fairly obvious reason I can think of for the low penetration at this stage is the age-mix of GoodRx users and the differing habits between age groups. Basically, the older you get the more likely you will be to need to use GoodRx’s services. And GoodRx’s modern e-commerce-like solution is less likely to be utilised by the current older generation. As the older generations move on and the current, more tech-savvy, generations find the need to use GoodRx’s services more - the company will continue to grow.

For example, research shows smartphone penetration to be around 61% for the 65+ demographic. Therefore in several decades time, the GoodRx penetration figure is likely to rise substantially.

6.2. Competitive advantage

But where is the competitive advantage for GoodRx? What makes them unique?

1. High quality recurring revenue: In terms of the nature of the prescription business, a high proportion of ailments are chronic - therefore requiring regular medication in order to operate. This creates solid recurring revenue with low churn for GoodRx unless the patient happens to move to a different pharmacy where they don’t need GoodRx.

2. Lowest prices due to PBM relationships: GoodRx are head-and-shoulders above the competition when it comes to the relationship with the PBM’s. As mentioned earlier, GoodRx have contractual relationships with at least 12 of the top PBMs across the United states, with over 85% pharmacy penetration.

   What makes this even better is the fact that the company have a patent (expiring in 2034) which essentially enables GoodRx to be the only competitor allowed to sign contracts with multiple PBM’s. Therefore it’s almost impossible for other competitors to offer a consistently better service than GoodRx.

3. Watertight contracts: Similar to the above point, the contracts written up by the GoodRx team seem to be very forward-thinking and don’t allow for much flexibility on the PBM side.

   For example, the contracts stipulate that the PBM’s can’t terminate the contracts out of conveniency, they must auto-renew, and the PBM can’t go outside the GoodRx platform. Additionally, if the contract were to expire, GoodRx would continue to receive payments for several years after the termination. 

4. Purchasing power: Essentially, GoodRx is the aggregator of demand for the PBMs. If a PBM is able to negotiate more competitive discounts then they will most likely receive more of the GoodRx volume.

   As more and more PBMs onboard to the service, there is a battle to capture as much of the GoodRx volume as possible. This means the incentive to reduce prices perpetuates to every PBM, therefore GoodRx’s discount prices will continue to improve over time. 

5. High NPS score: It seems to be the case that everywhere I look online I see glowing reviews of the service. It’s hard not to like something that can cut the cost of your essential medication by 70% on average!

   They also report NPS scores of 86 among healthcare professionals and 90 among customers. These are great numbers, but it’s useful to remember these are ‘self reported’.

7. Strong Marketing/customer acquisition: One aspect GoodRx (and all other competitors) need to be cognizant of is marketing. It’s probably the most important aspect of acquiring customers. And seeing as roughly 50% of total costs are focused towards sales and marketing, this bodes well.  

6.3. Competition

There are a multitude of competitors GoodRx will need to contend with over the coming years, and they fit into three main buckets - Direct competitors (basically doing the same thing), large pharmacy chains (e.g. CVS) and Amazon.

Direct competitors include Blink Health, WellRx, Rx Saver, Inside Rx and many more. With Blink Health being probably the closest competitor with roughly half the reach at 35,000.

Other than that, GoodRx tend to remain either the No.1 or No.2 best price on the market. And, of course, the patent not allowing any competitor to be able to contract with more than 1 PBM means GoodRx will likely continue to pull away from the competition.

Pharmacy discount programs include companies like CVS and Walmart where they tend to offer fairly good drug prices for popular drugs. The reason being is because they operate at a big enough scale to afford to take a small hit on a ‘loss leader’. This gets people physically into their store where they will probably make strong markups on other purchases.

Lastly, Amazon have been in the news over the past year due to their new foray into the mail-order drug market. For me, this should be considered one of the larger risks. After buying PillPack in 2018, Amazon launched Amazon Pharmacy. It acts as a mail-order pharmacy, but prime members also get access to their discount programme (similar to GoodRx).

I believe Amazon are hoping to leverage their existing delivery infrastructure to eventually offer same-day delivery. However it’s not quite there yet, and probably won't be for quite some time. However, when we look at the likelihood of using the amazon discount card over the GoodRx discount card, it seems like GoodRx still wins in terms of price. Their multiple PBM relationships are simply too strong compared to Amazon’s one.

I can see Amazon successfully growing this business model - and there is a real chance customers will value the frictionless integrated experience over the GoodRx model and will therefore forgo a small price difference. However, the mail-order business is only young, and time will tell if they are successful.

You would think mail-order would take off during the pandemic, however the percentage of people using mail-order prescription services is roughly at pre-pandemic levels. This is mainly due to slow delivery times, the added value of a knowledgeable pharmacist, and patient wellbeing.

7. Managament & Culture

GoodRx is a story of three good friends - Doug Hirsch, Trevor Bezdek and Scott Marlette - who put their heads together in order to solve a core problem in the healthcare industry. 

The idea famously stemmed in 2011 from a breakfast the three friends would attend once every year where they would spend hours discussing various business ideas. After throwing out a tone of ideas, they landed on the GoodRx business-model.

Both Doug and Scott worked as early employees at Facebook.

7.1. Culture

Culture is an aspect of a company that is hard to accurately quantify. Though it’s as important to the success of a business as other aspects such as finances. At the end of the day, if company culture is strong and people want to wake up and work there, it’s a big plus in my books.

From reading interviews, the culture at GoodRx feels like one of entrepreneurship - i.e. not to be afraid to fail and ‘break things’ as long as the intention is there to fix the problem just as quickly. Being able to foster and maintain this entrepreneurial spirit inside an organisation with over 200 employees enables them to stay somewhat agile, which enables the company to react more quickly than their competitors.

Overall, from looking at the very positive Glassdoor reviews (98% approve of the CEO) and CEO interviews, it seem like the company have a fantastic culture which is conducive to a positive future.

7.2. Building a mission

From every interview and transcript I’ve digested, it’s clear that the founders are really passionate about solving the transparency and affordability problems in healthcare. As a result, they’re very customer and product focused, which explains why they didn’t just stop at Rx drugs; they find new problems and build products to address them, or find better ways to address the same problem and tweak the product. 

7.3. Skin in the game

Skin in the game is absolutely present at GoodRx.

For one, the company is founder-led which has a multitude of effects.

1. Passion - the ability to get excited about the work you’re doing.

2. Obsession - manifests in pure dedication in solving some of the hardest problems.

3. Owners mindset - This permeates throughout the business, encouraging employees to take risks and make hard decisions.

Secondly, the ownership within the business indicates a strong level of ‘personal stake’ in the success of the business. The share structure is semi-confusing with shares split into class A and class B - class A being worth 1 vote per share and class B being worth two. The below image really goes to show that most of the decisions will be made by 4 main groups of investors - one of which being the founders (‘Idea Men’).

7.4. Valuable board members

Lastly, it’s useful to take a look at the composition of the board members to see if there is anyone particularly influential working alongside GoodRx.

The majority of the board is made up of investors from the various investor groups above, but there are several board members who stick out.

1. Agnes Rey-Giraud joined the board in 2016 and previously spent 12 years as an executive at Express Scripts, which is one of the GDRX’s most important PBM partners.

2. Jacqueline Kosecoff also joined in 2016, and was previously the CEO of OptumRx, which is another important PBM partner. Express Scripts and OptumRx have a combined PBM market share of nearly 50%, which makes these two directors invaluable, in my view.

3. Gregory Mondre is on the board of Expedia

4. Julie Bradley was previously the CFO of Tripadvisor and currently on the board of Wayfair (Expedia, Tripadvisor, and Wayfair all lean heavily on digital advertising, much like GDRX, and these directors likely provide valuable insight there).

8. Bull Case

1. A real problem with a real solution.

2. Ability to scale massively over time as demographics evolve.

3. Great optionality makes for a sticky product for patients and physicians.

4. Good track record with consistent growth.

5. Zero marginal cost of supply, so scaling is key. Only limited by demand.

6. Smart marketing.

7. Monopoly on PBM contracts.

9. Bear Case

1. Healthcare reform - GoodRx shouldn’t have to exist. 

2. PBM reliance - if one of the big PBM’s leave, it could have major negative effects on GDRX’s bottom-line.

3. Data privacy - Need to be very careful when handling patient data.

4. Amazon entering the picture.

5. Pharmacies hate GDRX because it hurts their margins.

6. Highly shorted: almost 28% of the float is short as of early 2021.

10. Financials

10.1. Income Statement

Revenue growth has been strong over the past several years, with a Compound Annual Growth Rate (CAGR) of 50% since 2016. In addition to this, y/y revenue for Q2 has increased 43%. These numbers are primarily driven by the strong growth seen in the Monthly Active Consumers and Subscription plans - which have grown 36% and 86% respectively.

Gross margin sits at roughly 95% which is a symptom of the capital-light business model they operate. Net margins hover around the mid-teens, with the most recent quarter coming in at 17%. And adjusted EBITDA margins sit at 30%, a decline from 40% the year prior. This is mainly due to an increase in R&D and G&A spending.

As discussed earlier, Sales and Marketing expenses make up 50% of the company's total costs, which is crucial in order to continue to grow and maintain their leading position. Compared to other competitors, GoodRx has a significant advantage in the amount of cash available to spend on these expenses.

Subscription transactions revenue grew 32% y/y/ to $144.9M driven mainly by an increase in users, but partially offset by the acquisition of Scriptcycle. Then if we take a look at ‘other revenues’ (including telehealth, subscription and pharmaceutical manufacturer)  we can see much more accelerated growth. With Q2 revenues growing 136% y/y and 21% since Q1 2021.

10.2. Balance sheet

Before the company IPOd in late 2020, they had approximately $700 million of first lien debt on the balance sheet. “A first lien is the first to be paid when a borrower defaults and the property or asset was used as collateral for the debt. A first lien is paid before all other liens.” This is obviously not a great situation to be in as it diminishes the companies ability to incur additional debt, make other payments, make investments, do M&A type activity etc.

However, the IPO raised approximately $900 million - offsetting the total debt load. They finished 2020 with negative debt of $300 million, which is a combination of $667M in debt and $968M in cash and cash equivalents.

The first lien debt is to be deployed slowly over the coming years, so it is likely GoodRx will utilise this excess cash balance to invest in the business.

10.3. Cash Flow

GoodRx are unique in the sense that the business-model requires relatively low levels of capital expenditure in order to grow. Therefore the company has consistently generated positive free cash flow from operations.

The fact that they operate ad a 95% gross margin goes a long way to help with their cash position. In addition, they have negotiated an 8 month payback period on marketing which further contributes to the companies high margins.

10.4. Valuation

On the whole, it’s tricky to pinpoint GoodRx down in terms of relative valuation due to the fact that most of their competitors are private businesses. 

That being said, trading at a multiple of ~28 EV/Rev seems to match up with the premium deserved from being a high-quality company with strong recurring revenues whilst growing rapidly and being a clear market leader. The business model semi-resembles a SaaS business model where margins tend to be high and revenue is reliable due to the subscription nature. Again, factoring in the quality of the contracts signed offers the company fairly predictable longevity.

All of the above combined with the optionality in its ‘other’ areas which are growing much faster than the core business, i would argue, justify the valuation.

11. Conclusion

Overall, GoodRx is a unique business run by unique leaders operating in an industry begging for disruption.

Healthcare is an issue at the core of the American system, and GoodRx are on a mission to help improve the system for those who would otherwise not be able to afford it. I think the overall industry needs a big change, however the likelihood of that happening anytime soon is next to nil, as the current way of doing things is tightly woven into the fabric of the American economy. Therefore GoodRx are nicely poised to continue to find a way to make this system work for the benefit of the consumers.

GoodRx might even be a solid hedge against inflation. As inflation continues over the coming years, we will all be worse off - meaning the GoodRx service will be in higher demand. 

The mixture of a strong moat, optionality, driven leadership, reliable revenue and high margins is rare to find outside of the SaaS world. Coupled with their proven track record in delivering shareholder value, and the fact that the healthcare system is in the process of modernising - GoodRx could be one of the best bets in this segment over the next decade.

Cheers,

Innovestor

Cybersecurity is not a simple industry to analyse for a generalist like myself, which is why this piece has taken me slightly longer than usual.

For the next deep-dive I would like to look at a less well known company. I’m open to suggestions, so if you have an idea message me at innovestor1@gmail.com, in the comments, or by twitter DM.

1. Introduction

2. Thesis

3. Key Terminology

4. History

5. What is Crowdstrike and how does it work?

6. Industry & competition

7. Management & Culture

8. Bull case

9. Bear case

10. Financials

11. Valuation

12. Final thoughts

1. Introduction

With the rise of the internet in its many forms over the past two decades, we have seen more and more vulnerabilities arise. To be frank, the early internet wasn’t built with the intention to connect the entire world. The first instance of the internet was more intended for sharing between military and academic networks. As the internet grew in reach and scale, as did the vulnerabilities.

By mid-way through the 2000’s it was clear that legacy solutions to combating intrusive malware was insufficient compared to the rate at which it was being produced. In essence, legacy cybersecurity was reactive rather than proactive. Therefore, the attackers were always two steps ahead.

Oftentimes, it takes something to go wrong before we feel the need to address the problem. The preventative nature of security goes somewhat against human psychology. In business, this phenomenon manifests in companies' reluctance to invest sufficient capital into protecting themselves from cyber threats.

With an increase in attacks over the years, the business world is beginning to take the matter more seriously. Sensitive data-leaks can bring a business to its knees.

That’s where Crowdstrike comes in. 

2. Thesis

In a world becoming increasingly reliant on digital solutions to digital problems, the Cybersecurity industry will become more and more important. In fact, cybersecurity will be essential. Businesses operating without a top cybersecurity solution will suffer.

Crowdstrike, with their best-in-class, innovative, cybersecurity solution are well positioned within a fast growing and absolutely necessary industry. Their desirable modular product suite combined with their current state of ‘hypergrowth’ sets them up to be one of the most influential Endpoint Protection Cybersecurity companies over the coming 3-5 years.

Even considering the currently lofty valuation, Crowdstrike are in-line with many of the top SaaS and high-growth peers - this is taking into account that most other businesses aren’t growing their baseline revenue at the rates of Crowdstrike.

Crowdstrike are in the perfect position to capitalize on an industry crying out for disruption, leveraging their first-mover advantage, network effects and strong management.

3. Key terminology

Before we get into the meat of the article I think it’s worthwhile outlining some of the key terms as, most likely, you will be approaching this company from a similar starting point to myself.

3.1. Endpoint

Any physical device that can be connected to a network. E.g. Laptops, desktops, mobile phones, tablets, servers, and virtual environments can all be considered endpoints.

Endpoints started off being relatively few and far between (e.g. personal computers). However as technology has developed, the variety of endpoints has continued to climb. Therefore, endpoint security is becoming more and more valuable. 

3.2. Malware & Virus

Malware is a catch-all term for any type of malicious software, regardless of how it works, its intent, or how it’s distributed. A virus is a specific type of malware that self-replicates by inserting its code into other programs. 

Each type of virus has hundreds and thousands of variations and iterations, thereby making it hard to find each new instance.

The virus, at its core, executes a process (e.g. opening a program, closing a program, sending an email). These processes result in patterns which CrowdStrike systems can locate, identify as an attack, and nullify.

Interestingly, as well as having many variations, viruses can access your system in many different ways - e.g. social engineering, phishing, spear phishing and many more. The social engineering aspect is possibly the most interesting/vulnerable aspect. As with many other things, human nature remains the fundamental weakness.

3.3. IOC vs IOA

An IoC (Indicator of compromise) is a post-infection indicator. This means after a virus has been installed into a target system, the antivirus program scans files and documents for known virus signatures (like we do with the PCR tests and Covid-19) and then quarantines the files and deletes them.

You may have seen this before with programs like McCafee, where they scan and incubate. 

That's not what CrowdStrike specializes in. CrowdStrike focuses on IoA (indicators of Attack). IoA scans for suspicious processes that are started in the background by malicious files. Simply put, you can think of IoC as a ‘reactive’ method of protection whereas IOAs is a ‘preventative’ method of protection - stopping the virus before it can reach do anything harmful.

4. History

• In 1987 McAfee launched its first antivirus solution which was followed by Symantec’s antivirus solution in 1991.

• by 2007, roughly 5.5 million malware samples were identified in that year alone.

• By 2013 400,000 new malware samples were being reported every day. From this point onwards, it was clear something within the industry needed to change. Cybersecurity needed to become preventative rather than reactive.

• Several years later, in 2011, George Kurtz (the CTO of Mcafee at the time) pitched the idea of CrowdStrike to ‘Warburg Pincus’ (a private equity firm) on a Saturday morning via Skype. They instantly gave him $25M in seed money, and by the sounds of it were willing to give him as much as he needed. This small anecdote speaks volumes of the conviction the private equity firm had in George (we’ll cover this in more detail later). 

• George previously established Foundstone, a security firm that was eventually bought by McAfee in 2004. He has previously held key positions in the cybersecurity area at Ernst & Young and PriceWaterhouseCooper. He graduated from Seton Hall University with a degreein Accounting. As of April 2020, George owned 22.4 percent of Crowdstrike.

“My light-bulb moment for CrowdStrike happened when I was on a plane. I noticed a passenger take out his laptop and turn it on. McAfee software popped up and started to scan the man's machine. The guy was waiting for 15 minutes. He was waiting and waiting and I was just sitting there, the CTO of the company that makes the technology. I realized there must be a better solution.

That's when Dmitri Alperovitch, who was the vice president of threat research at McAfee at the time, and Gregg Marston and I decided to build a security company entirely on the cloud. CrowdStrike became the first native cloud security solution, which means that it's lightweight and nimble and doesn't slow down the user's machine.”

• With the help from his two co-founders, Dmitri Alperovitch & Gregg Marston, they built the company into one of the fastest growing and most innovative cybersecurity companies in the world.

5. What is Crowdstrike and how does it work?

5.1. At a glance

CrowdStrike is a cloud-based antivirus company with the aim of stopping the cyber attack before it can execute on the target device (or ‘endpoint’). In terms of scale, and where they want to eventually reach, they make comparisons to some of the other big cloud players - such as Salesforce, Servicenow and Workday. These are ambitious, but seemingly achievable targets.

5.2. Core Product

Crowdstrike’s core product revolves around the Falcon platform, which supports 19 cloud modules using a SaaS (Software as a Service) model.

For context, the pace of innovation over the past decade has been impressive, starting out with 10 modules and adding almost 1 new module per year since then.

The company’s open cloud architecture allows third parties (along with Crowdstrike themselves) to build and deploy new cloud modules in order to provide end users with unique functionality - supporting the individual needs of companies. This is a far cry from the incumbent solutions which are slow-moving and lack flexibility.

5.3. Why CrowdStrike’s solution is better than legacy IT Cybersecurity

Typically, legacy IT infrastructure does not scale well as the number of endpoints (users, phones, laptops etc.) scales up. Typically, the more endpoints there are, the more a company must spend to secure them.

New threats also means new solutions need to be installed on EVERY end-point - thereby bloating up the system. A real life example of this many of us can relate to is the difference in speed between a new work laptop and an old one. The work PC starts off quick and responsive, however as more and more malware protection is added on by your organisation over the years, the slower it gets. CrowdStrike solves this problem.

CrowdStrike is Cloud-Native, which means the product is scalable, adaptable, and benefits from network effects.

Additionally, and possibly the most ‘next-gen’ aspect of the product is the use of Artificial Intelligence and Machine Learning. With each new ‘attack’ on the system, the AI/ML algorithm uses this data to helps to strengthen the overall network by feeding that information back into the system, helping it to learn. This new method is classed as ‘Next Gen Anti-Virus’ (NGAV).

So, put simply, the more customers Crowdstrike have - the better the end product is due to the addition of data points it has to draw from. This is know as ‘network effects’ and is extremely powerful.

One slight downside of Crowdstrike from an investor’s point of view is the complexity of the business. Without a background in IT or Cyber, this company is tricky to fully understand. This, in my opinion, makes building conviction hard. 

That being said, once you can begin to understand the core business, it’s easy to see why the business model is effective and disruptive. And that mainly boils down to the laser-focus on the experience of the end user.

5.4. Pricing

There are four main pricing options on the Crowdstrike platform - Falcon Pro, Falcon Enterprise, Falcon Premium and Falcon Complete.

“some of the legacy vendors in this space had hundreds of thousands of enterprise customers. The key to our rapidly expanding customer base is that we are winning customers of all sizes. From a one-person shop all the way to the largest companies in the world, we can sell into any vertical, geography or any level of technical sophistication. Essentially, we can sell to almost anyone.”

This indicates the pricing structure is working.

In comparison to other offerings, Crowstrike comes at somewhat of a premium. However, one could argue they have the superior product. The question is, will the buyers recognise the importance of having the best protection in this day and age?

One breach for a company nowadays could be catastrophic.

With the increase in high-profile security breaches over the past couple of years, I believe consumers and enterprises will com to realise this fact.

In addition to the modular option pricing (above) Crowdstrike also offers incident response and forensic investigatory services, technical assessment and strategic advisory services, as well as training to assist organizations that have experienced a breach or are assessing their security posture and ability to respond to breaches. These are listed as professional services and make up roughly 7% of total revenues (down from ~30% 5 years ago) and is a much lower margin business (35% gross margin compared to the the 76% gross margin on the subscription business).

That being said, these professional services are a great onboarding tool, as when customers encounter problems and begin to trust that Crowdstrike knows what they are talking about - then upselling modular assistance is made 10X easier.

As an example...

From the recent annual report - “After experiencing the benefits of our platform firsthand, many of our incident response customers become subscription customers. Among organizations who first became a customer after February 1, 2019, for each $1.00 spent by those customers on their initial engagement for our incident response or proactive services, as of January 31, 2021, we derived an average of $5.51 in ARR from those subscription contracts.”

5.5. Why is Crowdstrike Unique?

Crowdstrike is a pioneer of technologies and new ways of tackling problems within the cybersecurity industry. Their product is unique in several different ways - and here’s why.

1. Single lightweight agent: To simplify, in order for an antivirus system to work on your computer/device, you need to install what is called an ‘agent’. This ‘agent’ can be thought of simply as a programme on your PC.

Typically, for the ‘old-gen’ cybersecurity companies they would install several ‘agents’, all with different uses. The downside would be increased programmes running on your PC, therefore slowing it down significantly. 

In comparison, Crowdstrike is able to solve this problem by installing one single ‘agent’ which does all the work locally on your device, then streams data back to the cloud-based Falcon platform for real-time decision making.

2. Artificial Intelligence & Machine Learning: Essentially, Crowdstrike’s use of machine learning via a distributed cloud architecture means that if one person experience a specific data-breach/attack, the AI/ML system will ‘learn’ - therefore protecting everyone else on the network from the same attack.

“CrowdStrike Threat Graph is the brains behind the Falcon endpoint protection platform. Threat Graph predicts and prevents modern threats in real time through the industry's most comprehensive sets of endpoint telemetry, threat intelligence and AI-powered analytics.”

With AI, a typical method of ‘training’ is to feed it other examples of known ‘attacks’ so the AI has a better knowledge of what it looks like. Just like us Humans learn by input and confirmation over the duration of our lives, computer AI systems learn by recognising patterns in data.

A great, simple, example of this principle is the story of teaching AI systems what animals look like. To us, it’s easy to identify a dog or a cat and the obvious distinction between the two. However, this kind of image recognition is far harder for computers. In order to learn - an AI system must learn by looking at other pictures of dogs and cats.

So, if the AI sees a pattern, it can correlate that pattern with a ‘learned’ virus/breech.

This model, which uses real-life examples to train the system, has the ability to scale-up by using the cloud.

3. Cloud architecture: As mentioned above, the nature of Crowdstrike’s cloud-based architecture offers many advantages to both the end user and the company.

Once the lightweight agent is on the end-user’s system, the cloud-based system can update modules in real-time. Whereas non-cloud-based models would require the user to upload each new module to their system - taking significant time and effort. This makes selling the platform easy.

Adding to this, the cloud infrastructure is fairly ‘lean’ in that costs are significantly reduced without the need for complex physical IT infrastructure and the various costs associated with that.

5.6. Modules - a key driver of success

As mentioned briefly earlier, one of the key drivers of Crowdstrike’s success is the constant addition of modules.

This can be shown below from the table below, highlighting as the number of modules increased from 2017 (assuming roughly 15 modules) to 2021 (19 modules) - the number of subscribers with over 4 or more modules increased from 0% to 66% as of Q2 2022. 

The plan seems to be to keep integrating additional modules (organically or via acquisition) whilst increasing the ease of discoverability for end users to find and try these new modules via the Crowdstrike store.

“We launched the CrowdStrike Store, the first open cloud-based application PaaS for cybersecurity, which provides an ecosystem of trusted partners and applications for our customers. In the future we plan to continue investing in the CrowdStrike Store to empower our partners by making it easier to build applications and to enable our customers to more easily discover, try, and purchase additional cloud modules from both trusted partners and us.”

Additionally to the table above, the Q2 2022 results show 53% of subscribers have more than 5 modules and 29% of subscribers have more than 6 modules.

The beauty of this model is that as crowdstrike continues to grow and focuses on getting their subscribers signed up to as many modules as possible, the margin will increase due to the higher-nature margin of each additional module. This business model works well in cybersecurity, because (generally) cybersecurity solutions are very sticky - traditionally due to the high switching costs.

There is, however, a fine balance between focusing on increasing the number of modules per subscriber and getting new customers through the door, which is something management has mentioned in the annual reports.

That being said, in the most recent call George Kurz CEO cited an increase in new customers signing up to multiple modules - “this new CrowdStrike customer was eager to transform the security posture and adopted 11 Falcon modules, including Falcon Complete, Discover, Spotlight, Falcon X Recon, Cloud Workload Protection, and Falcon Zero Trust to proactively secure and fully manage their workstations, cloud workloads, and identity layer, as well as provide visibility into their IT assets and vulnerabilities.”

Summary

To summarize this section, it’s clear that the advantage Crowdstrike has over the incumbent Cybersecurity players is the cloud architecture which combines with the single light agent and constantly evolving AI/ML algorithms. This combination allows the sales process to happen seamlessly, whilst also providing better proactive protection for the end user.

A study by Gartner showed that almost half of the enterprises surveyed indicated that they want to consolidate their security vendors in the next 2-3 years.

6. Cybersecurity - trend or necessity?

With the digital age we’re currently living in, the core services’ a business needs inevitably changes. For example, and it’s not apples for apples, but every business nowadays needs someone (or a team) to look after the social media aspect - this did not exist 15-20 years ago. Similarly, with the increased use of ‘digital’, every company needs to protect themselves from malicious cyber attacks. Simply, if you don’t have all your bases covered with cyber security, then the business will suffer. Therefore, Cyber is an absolute must in this day and age.

6.1. The industry

According to the most recent investor presentation, the total addressable market sits at $36.5B for 2021 with the potential to increase to $43.6B by 2023. Future growth in this total addressable market is likely to be fueled by emerging areas such as cloud, IoT and home office/remote working solutions.

For me, this TAM can be broken down into three overarching drivers…

1. An increase in cyber attacks - over the past 10 years, large-scale cyber attacks have increased dramatically. These examples from Wolf Of Harcourt’s article on Cybersecurity show how common the issue is becoming.

• In 2020, a Twitter breach targeted 130 accounts, including those of past presidents and Elon Musk, resulted in attackers swindling $121,000 in Bitcoin through nearly 300 transactions. (CNBC)

• In 2020, Marriott disclosed a security breach impacted data of more than 5.2 million hotel guests. (Marriott)

• A ransomware attack in early 2020 on the New Orleans city government cost the city upwards of $7 million. (SC Magazine)

• A ransomware attack in early 2020 on the New Orleans city government cost the city upwards of $7 million. (SC Magazine)

• In February 2020, a ransomware attack cost Denmark-based company ISS upwards of $50 million. (GlobeNewswire)

2. Increasing digitisation - The emergence of various technological innovations such as IoT, cloud and 5G has magnified connectivity within our modern world. We rely on these technologies along with the underlying data now more than ever.

3. Growing awareness for cloud-based cyber adoption - Relating somewhat back to point 1, many of the current large companies are not equipped for a serious cyber attack. In addition, according to Accenture’s 2021 report 50% of firms lack appropriate security management systems.

From looking at several different sources, I’m beginning to think the outlined total addressable market from Crowdstrike is looking rather conservative. With an estimate from GrandView Research of $167.13B in 2020 with an 8 year CAGR of 10.9% to become a $382.4B industry by 2028.

Additionally, Gartner estimates $150 Billion in 2021 with a 12.4% CAGR over the next 5 years - making it a $250B industry.

A combination of the above drivers have started to move the needle on more of a macro level - prompting both governments and enterprises alike to start thinking more seriously about their security infrastructure.

For example, earlier this year Joe Biden announced an executive order with the aim of improving the cybersecurity of the US which insisted on moving to Zero Trust architecture.

Examples like the above create significant monetization opportunities for cybersecurity providers, like Crowdstrike.

6.2. Growing to fill the TAM

It’s all well and good having a nice big TAM (total addressable market), however if there is no sign the company has any intention of growing into the TAM then it doesn’t mean much.

So, what do Crowdstrike have planned in order to expand into the broader TAM?

Acquisitions

The most obvious solution to overcome the slowdown of organic growth (coming from the place of a healthy balance sheet) is to acquire companies that fit the brief.

It’s going to be a real question-mark as to whether they can move beyond their core competency successfully. Many businesses struggle. It takes extra resources and solving problems in a whole new area.

I believe Crowdstrike understands the need to acquire in order to grow. They have shown this over the past year with several acquisitions:

• Preempt Security for $90M (sept 2020) - real time access control and threat prevention

• Humio for $400M (March 2021) - cloud-based data logging company

I would expect to see more of this over the coming years.

Other short-to-medium term growth strategies outlined in the annual report include:

• Grow customer base by replacing legacy and other endpoint security products

• Upselling/penetrating existing customers

• Leveraging the Falcon platform to enter into new markets

• Broadening into new customer segments

• Extending the Falcon platform and Ecosystem

• Broadening reach into the U.S. Federal Government Vertical

• Expanding into new international territories

6.3. The Competition

Cybersecurity is a cutthroat business with a fast-changing technical environment.

Some key endpoint competitors include SentinelOne, VMware, Trend Micro, Fortinet and Carbon Black - just to name a few. They also compete with antivirus solution providers such as McAfee, Kaspersky, Microsoft, and others, as well as network security companies such as Palo Alto Networks and FireEye.

The above ‘Magic Quadrants’ graph from Gartner outlines the main competitive landscape within the Cybersecurity industry, focusing on ‘completeness of vision’ and ‘ability to execute’. From it, we can clearly see the velocity with which Crowdstrike has risen to be a market leader over the past few years in a still VERY crowded market.

Despite the fierce competition within the market, Crowdstrike have been eating up market share over the past couple of years. According to research, the company increased their market-share by about 99% whilst the incumbent top 3 solutions share of the market decreased in 2018/19.

This is all in the context of being one of the more expensive solutions in the market alongside the majority of payments being up-front, which further goes to demonstrate the company’s pricing power.

CrowdStrike was the first to identify and handle the growing security demands of the cloud age, thus it benefited from a first-mover advantage. At the moment, it records 3 trillion endpoint-related events every week in real-time.

One thing you may notice from the above graphic is the closeness in competitive nature between Microsoft and Crowdstrike. At first glance it may seem like Crowdstrike could be up against stiff competition, however George Kurtz disagrees.

Speaking about Microsoft and the risk of having the same Operating System and Security System - “And, you know, there has been a lot of talk, again, at the audit committee around risk in a monoculture. And customers are becoming more and more uncomfortable with putting their eggs in one basket. So, you know, I think we have a great opportunity there.”

In relation to rate of growth - from a quick glance we can see that they must be doing something right. They are growing at orders of magnitude compared to their established competition. This is somewhat to be expected with growth companies compared to established competitors, but it is definitely something to look out for.

Lastly, a good sign of competitiveness within an industry is when rival CEO’s mention your company as a threat. For example, Palo Alto Network CEO mentioned Crowdstrike in a recent conference call - “Don't forget, in each of those areas, we are dealing with a extremely competitive situation. In the case of XDR, we deal with dedicated salespeople. And CrowdStrike, they outflank us 8:1 on the number of salespeople. So, we have to look hard at how much investment we want to make on the sales side. We do get leverage from the Palo Alto salespeople, eventually end up with hand to hand combat.”

6.4. Crowdstrike vs SentinelOne

As a relative beginner researching the space, it’s difficult to find many noteworthy differences between the two companies other than the obvious scale which likely means a higher quality of data and therefore a superior end-product for Crowdstrike.

Both operate within the same market with similar products, operating a similar cloud-based  platform approach to security with similar architecture. It’s likely that SentinelOne are in a similar position to that of Crowdstrike when they IPO’d.

The question is, can SentinelOne stock follow a similar playbook to Crowdstrike considering the metrics (below) look similar?

That being said, Crowdstrike’s numbers looks better in basically every way according to these graphs, and significantly better a few. For example, FCF margin and operating margin are worrying signs for $S when you compare the two.

These initial numbers don’t look great for SentinelOne.

The thing is, in order to compete within this already crowded market, SentinelOne will need to invest heavily into growth activities which will further emphasise their margin issue. It will likely look (and currently does look) like the plan is to lower prices in order to attract more customers.

Quote from random reddit user - “Both vendors were the top 2 that we POCed last summer. You really can't go wrong with either but CS right now has the most polish, and they are rocking the world. They have a new cloud security product just added, dark web monitoring, and a few more all in the same platform. You wont be disappointed how easy it is to use either. S1 might have a little more power if you are a scripter, but CS is just easier to use.”

Another quote (below) is from a question in the Crowdstrike earnings call asking about SentinelOne and market share.

“There's a lot of noise, but I think you have to look at the numbers that we put up on the board. And, you know, one quarter of our net new ARR is probably 94% of their total ARR. So, you know, when we think about this, it's a big market.”

The problem is, burning cash as such a rapid rate is obviously not a good place to be for any company. I can easily see the next several years looking hard for the stock as they will need to continue to push prices lower, diminishing their pricing power and needing to be financed externally.

I personally don’t see another way SentinelOne can compete with other leading cybersecurity companies. The market is ridiculously competitive which basically means losses are a certainty over the next 2-3 years at least.

Probably a good company, but I am holding off investing for the time being until I see they are moving in the right direction.

7. Management/Culture

One thing I’m aiming to do a more comprehensive job of in these deep-dives is looking into management and really getting an idea as to my perception of them. This takes time and is a far more subjective process than the majority of a deep-dive.

As with many companies, the CEO is a crucial piece to the puzzle. In this case it’s especially true with Crowdstrike’s CEO and founder, George Kurtz.

To start, lets look at the glassdoor ratings where we can see George Kurtz rates highly - with an approval score of 97%. In addition 82% of the 215 reviewers would recommend to a friend.

These glassdoor ratings are fairly complementary, and there are enough submissions (215) for me to take it seriously.

One of the reasons I like to look at Glassdoor reviews, is because (typically) people will be more inclined to leave reviews on a site due to negative experiences. Therefore, finding CEO’s with exemplary scores tends to be a good indication of competent management & culture.

7.1. Hiring mentality

From my readings, George tries to foster a culture of strong work ethic in a fast-paced environment. This quote from a ‘foundation capital’ interview highlights the mentality of hunger and grit that he likes to see in his employees.

“When it comes to hiring a go-to-market team, George looks for someone with a combination of hunger, grit, and book smarts. His go-to question in an interview is “What drives you more, the will to win or the hatred to lose?” In his experience, it’s usually the people who hate to lose who are often the most driven. And while this drive is extremely important to success, it is equally as important that a hire is a team player and strong cultural fit. As George puts it, “you need to want to collectively win with the team.”

This obsession with hiring employees who are the ‘right fit’ for the company is almost certainly a large contributing factor to Crowdstrike’s success so far.

He even compares hiring to be as important as financials, which is a refreshing take.

“When it comes to hiring, a focus on finding the best is better than worrying about building fancy offices. I followed this formula when I founded CrowdStrike in 2011. This is why I've always focused on hiring individuals based on performance as opposed to location.”

7.2. Building a mission

George realizes the importance of everyone in the company being 100% focused on the mission. If there is no ‘north star’ as a reference point, it’s easy to get lost in a sea of uncertainty.

He explains that for CrowdStrike, he didn’t want a static mission statement but rather a culture where employees could be passionate about the work of stopping “bad guys.”  He writes…

“When you have passion, mission and purpose, you have limitless boundaries that unlock immense value to you, your shareholders and most importantly, your customers.

My journey into entrepreneurship wasn’t exactly planned and it hasn’t always been easy, but my advice is simple: Education and evolution are critical, always hire the best, and remain steadfast in believing in the change you and your team can deliver.”

In addition, the ability to focus on long-term goals rather than short-term targets is something investors love to see. The founding story is a testament to this. Back in 2011 when cloud-based cybersecurity wasn’t talked about by anyone, George Kurtz saw what it could be and didn’t stop until it became a reality.

Naturally, initial customers were skeptical. However, persistence and small steady strides towards a long-term goal saw customer’s opinions dramatically change over time. Now Crowdstrike operates the security for 63 of the fortune 100 companies, 234 of the fortune 500 companies, and 14 of the top 20 banks.

7.3. Skin in the game

According to Gurufocus, George Kurtz owns almost 45% of the business.

Equally compelling is the sizable ownership stakes from upper-management and the board of directors. To me, this indicates a management team and board of directors with significant skin in the game.

7.4. Fierce competitive nature

Crowdstrike wouldn’t have gotten very far in this industry without keeping an eye closely on the competition. This attitude tends to manifest in the management team - comparing Crowdstrike to the competition in almost every earnings call. A quick ‘Ctrl + F’ of ‘McAfee’ or ‘Microsoft’ usually brings up several results.

Here’s an example from the most recent earnings call.

“To further demonstrate my point, I'd like to share a recent customer win with a Fortune 500 company that was using Microsoft's legacy security products that failed to rise to the challenges of today's adversaries and ended up unnecessarily costing them millions of dollars.

This company experienced a long and difficult deployment process, particularly in low bandwidth environments where endpoint performance was critical. Notably frustrated, this company began to evaluate alternatives when it was unfortunately hit by ransomware that encrypted their primary and backup data, causing weeks of business disruption and a financial impact estimated to be in the tens to hundreds of millions of dollars. This is when they turned to CrowdStrike.”

And another example…

“But there's a lot of companies out there, big and small, and we still think we've got a lot of runway and still continue the migration of share from Symantec and McAfee to CrowdStrike.”

Adding to this, Crowdstrike have set up a page on their website outlining 10 reasons why Crowdstrike is a better product than SentinelOne. Here’s an example.

SentinelOne do exactly the same on their site.

It seems petty from both companies, but goes to highlight the competitive nature of the industry in which they both operate.

It’s still relatively early days for SentielOne, and pretty much day 1 in their life as a public company - so there is still a long way to go. I could easily see $S being a serious competitor to Crowdstike in the coming 5 years if they execute well.

7.5. Personell

George Kurtz is the company's founder and CEO. He was CTO of McAfee before starting CrowdStrike. His history in the industry is rich, having published a well-renound book on Cybersecurity called ‘Hacking Exposed’ and starting a company called Foundstone which was bought by McAfee in 2004.

In February 2020, Michael Sentonas was appointed CTO of Crowdstrike. He was formerly the company's Vice President of Technology Strategy. Prior to joining CrowdStrike, he served as McAfee's Chief Technology Officer – Security Connected and Chief Technology and Strategy Officer.

Lastly, Colin Black joined the business in 2015 and worked his way to become COO in 2017. Before joining CrowdStrike, he was CIO of Kratos Defense and Security Solutions, Inc. and Cymer & Mindspeed Technologies, Inc.

8. Bull

1. Sector tailwinds - Cloud as an industry is growing rapidly - with key drivers being secular tailwinds such as digital transformation and an increase in security breaches.

• This has led to two things happening - an increase in the number of cloud-native applications available due to better efficiency and scaleability, and the diminishing effectiveness of legacy antivirus companies compared to next gen companies like crowdstrike.

2. Durable economic moat - Manifesting in three main ways: a superior product with first-mover advantage and an overall sticky platform.

- Superior product:

• Efficiency - cloud-based, integrated platform meets enterprise demand for efficient consolidation of security solutions. Based on Gartner’s recent market report, most enterprises now own more than 75 security solutions, with almost half of them indicating a desire to consolidate security vendors in the next 2-3 years

• Strong endpoint performance - Falcon automatically organises data that is stored locally or streamed onto the Threat Graph, hence lessening the burden on client endpoints, compared to rivals whose on-premise approach means that clients can only manually clear data from endpoints through queries. 

• Diversification - modular-based architecture where additional solutions can be seamlessly added, enables greater personalisation to cater to diverse needs of enterprises. This makes it easy for CRWD to acquire customers of any size and expand across verticals, geographies and technical sophistication.

- First mover advantage:

• Timining looks to be key in this market. Due to the relitively early start Crowdstrike had against many of their competitors, the company have been able to utilise the flywheel effect of having more data to feed into the AI system.

• This means, because of the first mover advantage, crowdstrike are way ahead of the rest of the pack.

- Sticky platform:

• Similar to above, as customers continue to grow the product only improves. 

• The modular nature of the platform allows easy onboarding and easy upselling. Over time this leads to increased switching costs for the end user.

3. Scalability

It's a scalable solution that gains with the network effect and copying that network effect in an instant is very difficult. 

4. Constant innovation

I could talk about this point for days, but constant innovation is crucial if the aim is to remain a market leader.

This point especially applies to the cybersecurity industry where the core business model is keeping up with (or being one step ahead of) attackers. The attackers are constantly finding new innovative ways to get around Crowdstrike’s system.

Part of the strategy to be on top of the changes within the industry is to make strategic acquisitions.

Peempt (Sept 2020) - Keeping up with the need for better protection against identity security threats.

Humio (Mar 2021) - Enhancing the detection platform.

5. High Margin model - The simple strategy of ‘land and expand’, I.e. to gain an initial subscription customer with the goal of upselling modules at a much higher margin in the future is likely to be effective. This will continue to drive the Average Revenue Per User (ARPU).

9. Bear

1. Will the moat be there in 5 years time?

One way to measure the likelihood of a durable moat in any particular industry is to look at the number of new entrants in the last decade. Industries consisting of companies with strong moats tend to only have several main players or have consolidated to several main players.

E.g. the CPU/GPU market consolidated to NVDIA, AMD and Intel with almost no new entrants over the past decade. This indicates a strong moat.

If we then look at the TV/Film industry which is rapidly changing and evolving, there have been lots of new entrants - showing that it’s not hard to knock the market leader off the top spot (i.e. weak moat).

Cybersecurity is more similar to the entertainment industry than the CPU/GPU industry in this regard. There were countless past leaders over the last decade - e.g. Symantec, Mcafee and Palo Alto Networks. None lasted.

Because of this, it’s looking likely that within the next 5-10 years we might see a new leader. Time will tell.

2. Unprofitable on GAAP basis

CrowdStrike's top-line growth is amazing, but the company is still unprofitable under GAAP. Its net loss increased in fiscal 2020, decreased in fiscal 2021, then almost tripled year over year to $142.4 million in the first half of 2022. This growing deficit may be ascribed to the firm's recent acquisition of Humio, a cloud-based data logging company, its high stock-based compensation expenditures (which devoured 20% of its sales in the first half of the year), and escalating R&D and marketing expenses.

3. Share dilution

CrowdStrike's reliance on stock incentives has increased the number of outstanding shares since its IPO, and continuous dilution may keep its values from dropping. On the other hand, their non-GAAP earnings continue to improve. The company reached non-GAAP profitability in FY2021 and aims to raise non-GAAP net income by 64 percent to 86 percent this year.

4. Stiff competition

The cybersecurity industry is crowded in nature with a host of well established, well funded legacy companies which could limit the growth potential for a company like Crowdstrike, even with their strong value proposition.

To counter this point, beyond their main market in the US, CRWD has steadily expanded into differing industries and geographies, all of which increase the potential TAM. For example, in April’s FY21 analyst call, management estimated the Total Addressable Market (TAM) to be $43.6 B in FY23.

5. If Falcon platform is breached, it could be catastrophic

Crowdstrike take a lot of pride in their Falcon platform, having built up a level of trust and relationship with some of the worlds top companies. If they were to experience any sort of breach, this would put their whole system under question.

6. Looked at in detail by many analysts

Not necessarily a bad thing, but due to the company’s recent success they have caught the attention of most analysts. This leads to major sensitivity in share price if they don’t meet/exceed expectations almost every quarter.

10. Financials

Before we get into the meat of the financials, lets take a look at a few key metrics which give a good indication of performance. Bare in mind, most of these metrics are from the investor presentation and quarterly earnings call - so possibly cherry-picked by the company.

1. Subscription growth has increased dramatically over the past year, with Q2 2022 seeing an 81% increase Y/Y. And between 2020 and 2021 subscribers grew 82% from 5,431 to 9,896. Crowdstrike is well and truly in hyper-growth mode, having added a record 1,660 new subscription customers in the last quarter.

2. ARR (Annual Recurring Revenue) is increasing rapidly. Current ARR sits at $1.34 billion, having added a record $151 million in the last quarter. This is an increase of 70% y/y.

Both of these metrics go to illustrate the speed at which Crowdstrike is growing as a company. But not only that, it demonstrates that Crowdstrike is attracting the right type of customer. I.e. having 63 of the fortune 100 companies as customers is a big deal - and ‘validates’ the service to the remaining 37. Similarly, for 14 of the top 20 banks to use crowdstrike goes to show how effective the product really is.

3. Strong gross margins. A key aspect to the business model is the constant addition and upselling of modules to existing customers. The theory behind this strategy is that for every module added to that one customer, the unit gross margin increases dramatically. The below graph implies Crowdstrike have been successful in this endeavour over the past 4 years, with gross margin rising from 36% in FY17 to 76% in FY21.

Another statistic backing up the above graph as well as emphasizing the product’s stickiness, is the chart below. It shows that more and more customers are using more and more modules. 66% using 4 or more, 53% using 5 or more and 29% using 6 or more are impressive numbers.

4. Operating leverage is at an inflection point. What is operating leverage? Operating leverage, put simply, is the comparison between the core operating costs which can’t be avoided if they want to grow (Sales & Marketing, Research & development and General and Administrative). We essentially want these costs to be as small a percentage of total revenue as possible. The aim is to get operating leverage to a point where we can generate positive operating margin (see chart below).

Now we have some of the key metrics out of the way, lets get into the other financial highlights.

10.1. Income statement

The past 3-4 years have seen Crowdstrike grow in many different ways. One look at the income statement (below) will give you a good idea how well the company has come on in such a short period of time. 

• Revenues have been growing at an average rate of 102% over the past 4-5 years.

• Gross margins have increased from 35% to 73%

• Operating margins have improved from -171% to -10.2%

• FCF has been positive the past two years, with 2021 seeing massive growth to $292M

For growth companies, I like to look at revenues as a proxy for the company’s success. Basically, if more people are willing to pay more money every year then the company are achieving some sort of product-market-fit. Crowdstrike are obviously achieving this from looking at the table above.

Taking a look at the revenue mix we can see that since 2017 the subscription revenue as a percentage of overall revenue has increased dramatically from 71% to 92%. This fact is good news for Crowdstrike as the subscription revenue is the substantially higher margin business.

10.2. Free cash flow

Free cash flow is separate from revenues in that only accounts for ‘cash’. 

“Free cash flow is the money left over after a company has met its operating and capital expenditure requirements and it can be the best way to differentiate between a good investment and a bad one.”

The reason it is important to investors is because it goes a long way to show how much actual cash the company has at their disposal. And as we know, cash is king.

Ideally we want to be seeing cash flows from operations (money coming in from business day-to-day operations) rise significantly over time. We also  want to see cash flows from financing (issuing shares etc.) and cash flows from investing (sale of investments etc.) remain relatively stable.

Crowdstrike look like they are moving more-or-less in the right direction with cash flows from operating activities increasing steadily over time.

Adding to this, as seen in the income statement section, the free cash flow margins are up to 33.4%. The cash position is looking strong.

10.3. Balance sheet

In addition to the above strong-looking financials, Crowdstrike also seem to have a healthy balance sheet with one of the drivers being the very successful $6.7B IPO in 2019.

The company previously had no long-term debt until 2021 when it spiked at $738M in order to contribute towards the $400M acquisition of Humio earlier this year. Despite this, the balance sheet remains strong with a current ratio (current assets/current liabilities) of 1.98.

10.4. Target operating model

Crowdstrike’s management have laid out their ideal future operating model. It’s useful to track in order to benchmark the quarters/years to see if the company are moving in the right direction.

By these benchmarks Crowdstrike are looking fairly successful. They are pretty much meeting the gross margin, R&D, G&A and FCF margins. Not bad if this is the long-term goal.

These numbers are maluable and likely to change over time.

11. Valuation

Crowdstrike has been on somewhat of a run since it’s initial offering in June 2019, being up over X%. If you had placed $10,000 in crowdstrike on it’s IPO date, you would currently have upwards of $42,000. This increase somewhat reflects the stocks relative performance over the time period - beating estimate after estimate.

Now, when we use multiples to compare between businesses - crowdstrike, along with almost every other growth company ever, looks expensive. This is mainly due to the nature and popularity of the SaaS business models (i.e. high margins w/ recurring revenues). It’s desirable and highly profitable. 

If we look at a collection of top SaaS companies, we can see that crowdstrike is up there with some high-quality businesses. A hefty price, regardless.

And looking at EV/FCF and EV/Gross profit basis, the company begins to look more reasonable.

Next, if we cast our minds back to earlier in the deep-dive where I mentioned that crowdstrike is comparing themselves to a small handful of cloud-native services, lets take a look at the relative valuation. At first glance it’s clear to see an obvious gap in multiples, this is mainly due to the stage of growth these companies are currently in. CRWD is in their hypergrowth stage. I would class the others as mature-growth.

Basically CRWD will look expensive at these levels. However, the key difference is the stage of growth these companies are in. Crowdstrike is in hypergrowth mode. 50-60% rev growth compared to 15-20% rev growth for the industry standard companies.

12. Final thoughts

All things considering, I have come away form this deep-dive really liking Crowdstrike as a business. Their subscription business and overall strategy has the potential to be highly profitable over the coming years.

Taking into account the imminent and very real threat of the other strong players within the industry like Microsoft and SentinelOne, Crowdstrike have proven a durable moat which should see them cement their first-mover-advantage.

Strong management/culture, powerful industry tailwinds, an astute strategy for growth and consistent innovation all work in crowdstrike’s favor - offering significant potential for future success.

Valuation can’t be ignored in this situation - and as much as I think there is potential for real upside, the risk of significant downside is also there.

Therefore, my approach to investing into the Cybersecurity industry is to take a broad basket approach for the time being - either taking small stakes in the main players, or following an ETF such as $CIBR, $BUG, $IHAK or $HACK.

Cheers,

Innovestor

1. Intro

Tencent are one of the worlds most recognisable brands, yet most of the world have no idea what Tencent even is - such is the insularity of the Chinese market.

China (along with Tencent) are at the center of the news at the moment - and not in a good way. We’re seeing more and more frequently how decisions made at the very peak of the Chinese government are impacting the share-price of these tech-focused conglomerates.

In this lengthly deep-dive, I aim to answer the question of whether Tencent makes a good investment over the next 5-10 years. I touch on the various and interwoven business models at play and try to understand the context within the current market.

In addition, I will attempt to walk you through a simple valuation model to try to value the company over the next 5 years.

2. Thesis

I’ll keep the thesis short and snappy.

Tencent, although facing significant short-term instability alongside a myriad of longer-term risks, are a company whose fundamental businesses (along with the investment portfolio) are undervalued by the market.

These facts will solidify the company’s future success:

1. A proven track record of growth.

2. A resilient and well diversified business model.

3. Evidence of strong cash-flow generation.

4. The scale of WeChat is a nearly impenetrable moat.

5. Recurring revenue streams in each of their business segments.

6. Strong management and culture.

7. World-class investment portfolio.

3. How Tencent got here...

I’ll keep the background as short as possible. But it’s important to understand how the company managed to get to where they are today, and the context surrounding their rise to power.

Tencent was founded by ‘Pony’ Ma who’s first success was QQ - a social network which took off in early-internet China.

In many ways, the building blocks of Tencent (QQ and WeChat) were a case of ‘right time, right place’. However two aspects of the company’s early business model distinguished them from the pack.

3.1 The initial success of QQ

Firstly, rather than relying on advertising for the majority of the revenue, QQ helped to pioneer “Value added services”.

Users could purchase virtual goods like customisable avatars and gifts as status symbols. The success of this model was thought to be directly related to the fact that under communism, Chinese people had been ‘dull and collective’ in their personal representation. QQ therefore enabled a representation of one’s self in a way that was never before possible.

Secondly, with the addition of each new product, Tencent have never truly been starting from scratch - the company would carry its enormous and growing user-base from one venture to the next until it had near monopoly-level control over the world’s largest market.

Then in 2011 the company launched what would be their most successful ever product - an application known in English as WeChat (Weixin in China), which integrated with QQ.

WeChat continued to grow dramatically with the, now commonplace, WeChat Pay and Mini programs - which allows users to install other apps within the app.

In 2021, you can think of WeChat to be about as close to a ‘super-app’ as it gets. This is down to the fact that Chinese life is essentially entirely operated from inside the app. You have the ability to shop, pay, rent, run a business, game, consume media, make doctors appointments and much, much more.

This useful info-graphic from Vinyard Holding’s article on Tencent, nicely outlines just how all-encompassing the app actually is.

“Texting has always been quite pricey in China, so unlike in the US – where large telecoms bundled texting with other phone services – WeChat was able to quickly fill the instant messaging gap and hit critical mass. Many Chinese adopters skipped immediately to smartphones, leapfrogging personal computers entirely.”

3.2 Mobile Stats

• Roughly 50% of all online purchases in China are made via mobile, as opposed to the 30% in the US.

• Before COVID-19, China was already a digital leader in consumer-facing areas, accounting for 45 percent of global e-commerce transactions while mobile payments penetration was three times higher than that of the US.

• Over 1.2B users spend over 4 hours a day (on average) on the WeChat app in china. That’s more than US users spend on all social media combined.

4. What they do and how they make money

So, now we have the background out of the way, I want to answer the next question - “What does Tencent actually do, and how do they make money?”...

This question is not a simple one to answer, mainly due to the fact that Tencent is a vast and sprawling business, covering a plethora of different industries and countries - with their fingers in almost every pie you could possibly think of. 

But let's start from the center and work outwards.

In the context of China, Tencent are one of three Chinese internet giants, along with Bidu and Alibaba.

Operating in Shenzhen (HongKong) the company operates as a sort-of mirror to silicon valley, which is famous for intense work hours, a deep-rooted culture of competition, and a reputation for thinking outside the box.

The core of Tencent’s business model, as outlined in the background section, relies on their Super-App - ‘WeChat’. Stemming from this are (give or take) 6 core business divisions which, on their own, easily compete with industry leaders in their respective fields (as we can see from the image below).

1. Communication and Social

2. Online games

3. Digital Content

4. Online Advertising

5. Fintech

6. Cloud and other business services

Here are several examples of the sheer scale of Tencent’s individual divisions: 

• Tencent’s Digital payments division is almost on par with PayPal. 

• The subscription revenue is close to that of Netflix. 

• They make more from games than Sony or Nintendo. 

• WeGame is significantly larger than Steam. 

• Also they own 100% of Riot Games (creators of Leauge of Legends), 5% of Activision Blizzard, 40% of Epic games - just to name a few.

4.1 Why is Tencent so dominant?

The Chinese economy is inherently different from the US, though the differences may seem counter-intuitive. For example, if we look at the US, the technology ecosystem is filled with competition - we have multiple leading companies for almost every industry. 

Whereas in China, it seems to be the case that Tencent are one of only several dominant companies, with competition being more concentrated to less than a handful across all industries.

This goes against our intuition due to the fact that China have a much larger population with a far greater diversification of languages, cultures, regions and not to forget the sheer size. You would therefore think these differences would result in a far greater diversity of options for consumers.

The distinction lies in the fact that the Chinese government is willing to give Chinese companies the freedom to operate as they see fit as long as the result is beneficial for the Chinese government. This has led to the existence of near-monopolies/duopolies with the clear examples being Tencent, Bidu, and Alibaba.

The elevation by the CCP (Chinese Communist Party) of these domestic Chinese companies serves 3 main purposes for the state…

1. Brand - Putting these companies on a pedestal serves to elevate the image of Chinese entrepreneurship, and therefore the Chinese ‘brand’ as a whole. This is thought to make China look like a more prosperous society from the outside.

2. Ensuring domestic success - the success of domestic companies comes at the expense of foreign ones. To the very limited extent that Western companies succeed in China, they do so with the express approval and financial benefit of a Chinese counterpart. It is even a legal requirement that foreign firms must parter with a local one.

3. Territorial Power - The fact that these Chinese companies have become so overbearingly large with stakes in multiple global companies serves a slightly more malicious purpose - global dominance. With some level of power outside of mainland China, these Chinese companies will have the ability to impose their rules and regulations. One possible example of this would be the ability to collect data from EU/US citizens in companies Tencent has minority/majority stakes in - i.e. Snapchat, Riot, Reddit, Epic Games etc.

In the following sub-sections I will try to give my insight into each of the core divisions Tencent operates within. Focusing on:

• WeChat

• Gaming

• Media

• Fintech

• Cloud

• Investment Portfolio

4.2. WeChat & Social Networks

As discussed before, WeChat serves as the core of tencent’s business and is arguably the company’s most substantial moat.

From leveraging the original userbase on QQ in the realms of social and gaming (and then WeChat), Tencent have created a platform where Chinese people rely on the app to carry out the majority of their every-day tasks. In other words, if Tencent were to vanish tomorrow - Chinese life fall apart.

WeChat is essentially the super app for china. It’s genuinely hard to operate in modern China without using the WeChat platform. This is the real kicker in my opinion. It is what will enable Tencent to weather almost any storm. 

As a gatekeeper to the market, WeChat is able to set prices, copy & kill competitors, and be selective in what they show. An example of this is the fact that when companies outside of China attempt to enter the Chinese market, they end up either partnering with Tencent or dying a death.

Outside of the main functionality of the app, WeChat acts as sort of an enabler for Tencent to enter into each of their other industry segments - for example, payments and gaming. This type of thing has been mentioned many times before, but the flywheel effect here is significant. I.e. when merchants join the platform to access the customer base, it adds more reasons for new users to join - all while WeChat/Tencent take a small slice of the transaction value. Once the flywheel momentum starts, it’s hard to stop.

And yet, this app is only a relatively small aspect of the wider business model.

4.2.1. WeChat Mini-Programs

A vital aspect to understand about WeChat is the mini-programs, as this is where a large amount of the value really lies.

Mini-programs are essentially mini-apps inside of Wechat, which have several distinct properties:

1. Can be developed rapidly due to lower coding requirements. 

2. They are accessible because of not needing to download or install.

3. Most every-day tasks can be carried out using these mini-programs.

Here are some statistics to outline the impact mini-programs have on the Tencent business model:

• There are 3.2M mini chat programs

• 410M Daily Active Users (DAUs)

• 1.2B Monthly Active Users (MAUs)

• Almost all users are between 25 and 35, so good pricing power.

• 88% of American companies use ‘WeCom’ to communicate with employees in china

• 87% of consumers in China use ‘WeChat Pay’ for online payments

• “36.2% of all time spent on apps in China are spent on Tencent apps, and 11% of all online advertising revenue is spent on Tencent adverts. This suggests not only does Tencent have the market dominance on both the advertiser and the consumer sides, but that there is also decent room for monetisation.”

More than just being a useful tool for supply-side merchants to connect with their customer-base, these mini-programs offer easy, flexible, direct avenues, which users can share within the app.

The product locks merchants and customers into the WeChat platform, lowering the long-term customer acquisition cost for merchants and improves experience for customers - a win win.

In China, WeChat is dominant. It’s possibly the most overpowered acquisition funnel to get people to use their other businesses.

Three of the four largest holdings - Meituan Dianping, JD.com, and Pinduoduo - are Chinese ecommerce businesses that run on top of WeChat. Tencent uses data from WeChat to source investments, and then provides preferential placement to its investees’ Official Accounts and Mini Programs within WeChat.

No one else has the transaction data or the ability to boost a company’s distribution the way that Tencent does with WeChat. This will continue to be an advantage - in just three years, there are over 1 million WeChat Mini Programs. Tencent can cherry pick the best, invest, and practically guarantee their success.

Here is a super valuable thread from JoshuaTai who nicely outlines each of the uses of WeChat 

4.3. Gaming

As mentioned earlier, although not considered a gaming company per se, Tencent’s online gaming segment did $6.65B in Q2 revenue (increase of 12%), which is bigger than any other gaming company on the planet. It owns Riot Games, which makes League of Legends, the most popular esports title in the world by over 4x (as judged by Twitch streams) and 40% of Epic Games, which makes Fortnite (350 million players). 

The below graphic by Granite Bay Capital serves to highlight the sheer reach of Tencent’s gaming dominance. They are connected throughout most of the gaming industry in some way or another.

4.3.1. Gaming Strategy

In the push for global gaming dominance, Tencent’s approach seems to be multi-pronged:

1. Increase mergers & acquisitions in overseas developers, like Riot Games and SuperCell.

2. Develop games internally (like Honour of Kings) to be published overseas. And also licence these games to key distribution partners (such as SEA Ltd).

3. License other IP assets at their disposal to develop new games for global mobile market (Call of Duty Mobile, PUBG Mobile)

Gaming has always been a big deal in China with, one could argue, more brand loyalty attached than in the west. Gaming is also far more embedded in the culture, partially due to the type of games played.

In the west, early gaming was more along the lines of plug and play shoot-em-ups etc, whereas the far east were playing more Massive Multiplayer Online Role Playing Games (MMORPGs) - the most popular of which probably being World of Warcraft. These types of games lent themselves to Chinese culture as it enabled a sense of individuality via customization. These games tended not to have an end, therefore building up very sticky customers over a long period of time.

In addition to gaming being an integral part of the Chinese culture, the gaming business is great for flywheel effects. As shown by the image below, the on-ramp of gaming leads to many other avenues where monetisation is possible.

Therefore, owning the games is key to owning the flywheel.

All that being said, gaming is a hard business. On the positive side of the spectrum - franchise games have brilliant unit economics, loyal customers, low capital expenditure requirements, regular streams of income, and strong pricing power. However, the downside is that successful games are almost impossible to produce on a reliable basis. This makes it hard to re-invest capital. It is also why gaming Intellectual Property is becoming so valuable.

In the context of Tencent’s overall gaming strategy, their past actions in terms of investments and choice of partners has lead to a dominant position within the gaming market. They are the largest shareholders in Riot Games, Bluehole, Supercell, Activision Blizzard and Epic Games.

Epic Game’s Unreal Engine is one of the two major competing games engines that underpin the development of almost every major game and 3d/graphic-based application worldwide. Their 40% stake in Epic games was possibly one of the best investments the company has ever made in this sense.

4.3.2. Competition

It’s clear gaming competition within China is beginning to heat up. Competitors like Alibaba, NetEase & Bytedance are all heavily allocating capital towards their own gaming efforts. Each has released well received games in 2021.

Smaller gaming studios are popping up all over the place, too. And although this may not seem like a massive threat on the surface, it only takes one viral game to knock the current no.1 off the top spot. We have seen this with titles like Rocket League, who have come from humble beginnings to being one of the most played games worldwide. 

This article goes into detail on Tencent’s increased investment in gaming.

4.3.3. Investments

A running theme throughout this deep-dive will be the high praise I give towards the capital allocation of management. Some of the investments made over the past decade have been nothing short of inspired.

With regards to the gaming portfolio, Tencent has made some impactful investments into gaming studios. They are the largest shareholders in Riot Games, Bluehole, Supercell, Activision Blizzard and Epic Games. As mentioned earlier, Epic Games is probably the most noteworthy investment here, however there is a large amount of strong IP and valuable assets within each company.

4.3.4. E-Sports

As talked about in great depth in my Enthusiast Gaming deep-dive, I see e-Sports as a huge growth opportunity within the gaming landscape. In this particular instance, Tencent’s dominant position within the wider Chinese E-Sports industry shows just how big of an opportunity this is.

To boil it down, the whole industry uses Tencent’s platforms, investments, and infrastructure (livestreaming/distribution/marketing etc). The Chinese E-sports ecosystem is nuanced but also nearly impossible for eSports professionals to opt out of participating in Tencent eSports.

They essentially have a monopoly in this department.

4.3.5. Potential risk

As I mentioned earlier, a large risk within the gaming realm is the possibility of another gaming studio producing a massively popular game that reaches new heights. As gaming is the one of the main on-ramps to Tencent’s overall platform (and it is a large source of revenue) the company will see any competitors as a threat.

“Recently, Genshin Impact (GI) – a AAA, free-to-play mobile game – launched, hitting roughly $400 million revenue in two months (on a budget of ~$100 million) and winning Best Game 2020 awards from both Apple and Google.”

The biggest takeaway from this development was the fact that these smaller gaming studios no longer NEED Tencent to be able to pull-off a big revenue generating game.

Circumventing the Tencent ecosystem, GI-creators miHoYo marketed via a range of other channels (Twitch, YouTube, Reddit, Discord, etc). They also set the first well-received example of a truly open-world, console-like experience on mobile. 

The implications of miHoYo’s game are – in summary – that mobile-first gaming is huge and can compete with console in quality; that the Chinese studio competition is fierce and impending for East and West developers alike; and that the free-to-play model is likely the future.

4.3.6. Looking forwards

If we are to predict what is next for Tencent within the gaming industry, they will firstly need to strengthen their gaming ecosystem over time. This could materialise in partnering with companies like Nintendo, maintaining the dominance of WeChat, or investing in companies like VSPN (the leading esports solutions provider in Asia) where these markets are set to grow over the next decade.

This raises the question of international expansion, which has never been an easy task for Chinese companies. However, Tencent are in a good position with their globally diversified investment portfolio.

4.4. Media

Leaving gaming out of the equation for one second, one could make an argument that Tencent is one of the most influential media companies in the world at the moment. That being said, competition is rife in this sector and has been heating up over the past two years with the rise of Bytedance and TikTok.

Because our customer attention is zero-sum (i.e. there is only so much time in the day someone can look at their phone), all of these companies are fighting tooth-and-nail for the most attention possible - and this is true for all forms of entertainment.

In online TV, Tencent (394 million monthly active users) competes with Alibaba’s Youku (394 million) and Baidu’s iQiyi (348 million).

In short form videos, Bytedance owns the market with Douyin/TikTok, but Kuaishou is a close second. This is an incredibly important battleground.

The purchasing power of these users will likely grow over time.

4.4.1. Livestream

In July 2019, Tencent won a lawsuit giving them game copyrights in third-party live broadcast. This gave them major control over the game broadcast market. Currently, this “Twitch-for-Asia” market is dominated by Douyu and Huya (in which Tencent is the largest shareholder), who together have an 80% share of the market. Kuaishou has 18.5% and Bilibili has 17.1%, both are partially owned by Tencent, too. 

For this reason, both Douyin and Kuaishou are moving heavily into livestream, longer form video and eCommerce. Kuaishou has 300 million daily active users, of which 170 million watch livestream and 100 users engage in livestream e-commerce each day. 

4.4.2. Music

Lastly, music is another industry in which Tencent dominates. Tencent Music Entertainment (TME) is the largest music platform in China with a market cap of $30B.

The competitive advantage here is similar to that of Spotify - where they have spent vast sums acquiring music licenses and exclusive rights. Netease Music is their only real serious competitor.

• They are now looking to expand into livestreaming, online karaoke, podcasting, and offline performances.

• They have developed an advertising arm of the business, which is growing at 100% y/y.

• They expect podcasting users to double by 2021 end.

Paid subscriber growth within music leaves plenty of room for improvement. Currently only 9% of users are paid subscribers, whereas Spotify boasts around 45%.

4.5. Fintech

Fintech is a real potential area for growth. It has been one of the fastest growing industries over the past 50 years - and with the recent tech revolution, this industry can be expected to continue its fast-paced growth.

At it’s core, the Chinese payment system is majority app-driven - mainly due to the fact that cheap mobile devices came about in a relatively short period of time. This enabled leapfrogging of the western technology development road-map.

One obvious thing is the difference between Revenue for both companies. The business models are fundamentally different and speak to the regulatory oversight of the CCP. Fin-techs in China are there (in the eyes of the government) to serve the Chinese people. Hence, they have less room to monetize than their Western counterparts. This principle carries over into WeChat advertising relative to Facebook’s, Alibaba’s GMV relative to Amazon’s, and more. (less opportunity to generate rev, but much larger base).

Both Alibaba and Tencent are investing aggressively in these thematic industries. Given their size and complexity, it is impossible to say who has the advantage here. Both Tencent and Alibaba have incredibly holistic views of the consumer through their myriad offerings and products. This data allows them to track consumer lending, offering variable loan rates and product prices to different buyers.

4.6. Cloud

Early stages to say the least.

Cloud adoption in China (let alone the rest of Greater Asia), is still in the bottom left of its S-curve. It is conservatively predicted to grow around 28% annually to 2023, with historical growth rates shown in Figure 29.

Hurdles for cloud mainly fall into 3 categories:

1. distrust of cloud due to historical leaked data scandals

2. a mentality that is  used to cheap labour and software piracy subsidising costs

3. yet-unmet expectations around customisation of cloud offerings

The trends are there to get businesses in China to begin to use the cloud: A younger workforce, COVID-19, big tech’s push to cloud, a 5G roll-out, geopolitical sovereignty, and the CCP-mandated 5-Year-Plan.

So where does Tencent fit into this? Roughly speaking, Alibaba has 40% market share in China, and Tencent and Huawei vie for second with both hovering around the 16% mark. Tencent doesn’t disclose their cloud growth beyond lumping it with the rest of “FinTech and Business Services” which grew ~26% year-on-year through 2020. Qualitatively, EqualOcean’s comparison below highlights some of the differences between AliCloud and Tencent Cloud.

4.7. Oh, and how they make the rest of their money…

Possibly the most exciting aspect of the business, and why I believe the company is still somewhat undervalued from an investment standpoint, is the scale and depth of the investment portfolio.

PackyM has done a fantastic service by compiling a super-list of the main Tencent investment portfolio holdings, which we can assume is more-or-less accurate. Even if just to give us a ball-park figure, it’s an incredibly useful tool.

Taking a quick glance down the list of businesses - most are household names. Here are just a few you may have heard of, split by sectors.

E-commerce

• JD (18%)

• Afterpay (5%)

• Pinduoduo (17%)

Finance

• WeBank (30%)

• Futu (30%)

• Nubank (10%)

Gaming

• Riot Games (100%)

• Supercell (81%)

• Epic Games (40%)

• Activision Blizzard (5%)

• Ubisoft (5%)

• Roblox 1.3%

Other

• Discord (2%)

• Universal Music Group (10%)

• Spotify (6.8%)

• Tencent Music (58%)

• SEA (26%)

• SNAP (12%)

• Reddit (5%)

• Tesla (5%)

• Nio (15%)

In my opinion, the skill within the management team to deploy cash is second-to-none. Two of Pony Ma’s top executives are ex-Goldman Sachs bankers, which makes sense.

“Our M&A strategy has always been trying to invest in up and coming companies which have a great management, who have innovative products, and at the same time, they have synergies with our existing platforms. We now have more than 700 companies.”

The investment portfolio in context

To give some context - if we were to try to calculate the intrinsic value of Tencent’s operational divisions (which I will do in the valuation section below), the value comes out somewhere between $500Billion-$700Billion depending on your level of optimism. Let’s be on the safe side and say $550Billion, which is already 91% of their $600B market cap. 

Importantly, this is NOT including the additional investment portfolio.

When adding the value of the investment portfolio to the estimated value of the operating business, we come to a value roughly 33% above the the current market cap.

Over and above the obvious value in being vastly diversified within some of the most exciting up-and-coming businesses in the world, the investment portfolio serves as a sort-of risk management tool in order to pursue the goal of increasing international dominance.

In China, some of Tencent’s largest and most important investments are in E-Commerce, with the plan of increasing the amount of investment going into smart retail due to the success of the WeChat Mini-Programs.

The international portfolio is more diversified. With gaming by far the largest slice of the pie (with some big names mentioned earlier in the article).

Outside of typical foreign territories such as Singapore and Indonesia, Tencent are beginning to invest in companies building similar super-apps to WeChat - such as SEA and Gojek.

To summarise their investment portfolio - it’s complicated, wide-reaching, large and risky. Tencent invest in almost every up-and-coming company out there, which results in heaps of potential future opportunity, alongside some short term volatility.

I believe the investment portfolio is one of the many gems within Tencent’s overall business and should not be overlooked.

4.8. To summarize

The ‘what they do’ section here is understandably massive. Tencent are a vast and sprawling company with their fingers in many different pies. But the main takeaway is this. Tencent are dominant in almost every industry they operate within. If they can continue to hold off competition within each of these industries, there is no reason why they can’t remain number 1.

5. The crackdown - what’s happening and why?

Now that we understand what they do (as well as is humanly possible), let's figure out what is happening with Tencent within the context of China right now - and try to figure out whether the recent pullback is justified and will be sustained

Quick summary before jumping into the detail:

1. China announced a 6 month rectification plan for big tech and internet companies, including turning education businesses into non profits. These education businesses were big ad spenders for Tencent, so will have some material impact on the revenue figures.

2. Tencent uses some questionable tactics such as link-blocking competitors on their platforms. This has been called into question by the regulators.

3. Regulatory pressure on WeChat Pay. Tencent's WeChat Pay holds a near-duopoly in China's online payments market with Ant Group's Alipay. However, the Chinese government wants to regulate both platforms more tightly as financial institutions -- which could cripple their ability to disrupt traditional state-run banks.

4. Banning the merger of Huya and DouYu (provide videogame live-streaming services akin to Twitch in the U.S.). The merger would have created a great promotional platform for its top games and expanded its streaming video presence beyond Tencent Video. Unfortunately, the market regulators blocked the deal, claiming the deal would monopolize the esports streaming market - which it would.

5. No more exclusive music for Tencent Music. On July 24, the market regulators forced Tencent Music, which controls over 80% of China's streaming music market, to give up all of its exclusive music licensing rights. Tencent spun off Tencent Music in an IPO in late 2018, but it remains the company's biggest stakeholder.

6. The gaming business is coming under fire, with the government looking to restrict the amount of playing time minors can have on a daily basis. Could definitely impact revenue.

As most will be aware, the current state of Chinese stocks is a concerning matter for anyone with any amount of capital invested.  I won’t spend too much time on this section, however I will try to outline the main point of what is causing the ‘nose-dive’ in the price of Chinese stocks and, more importantly, why.

5.1. The what...

China’s goals over the past several decades are clear - to become the largest global economic force. An interesting distinction about China, compared to most of the rest of the world, is that they are not a fully capitalist society. At least not as far as we understand it in the west.

Slowly, over time, the Chinese Communist Party has been trying to introduce different aspects of capitalism into the economy. One example of this was the establishment of the Chinese stock exchange. This re-opened in the 1990s and since then, the government has been slowly adding more capitalism-type investment vehicles to be utilized by chinese companies.

That being said, China would also be considered to be ruled by an authoritarian government/political-body. This can be a real problem for any capitalist-type business operating within China, as the ruling body (in this case the CCP) don’t like giving up their power.

As an example, the government has made a habit of making ambitious economic/political plans to allow more private investment and freedom to Chinese companies, only to backtrack shortly afterwards when they try to take back the power they have given up due to problems arising.

This has manifested in a recent backslides, in which they have dramatically increased the oversight applied to prominent Chinese technology companies who are currently listed on the stock exchange and plan to be listed on the stock exchange in the near future.

5.2. The why

So why does this matter? And what does this have to do with Chinese stocks in general tanking? 

The first thing to take into consideration is the fact that the Chinese stock exchange was considered by the world at large to be only on a provisional basis. It can be treated as somewhat of an experiment by the Chinese government - dipping their toes into new waters. There were, and still are, big question marks around whether the CCP will really allow for these capitalist-style financial vehicles to operate in the way they were intended.

The market opportunity in China is massive, with the world’s largest middle class, littered with huge monetisation opportunities - but none of that matters if the Chinese government will continue to interfere/ban certain businesses to operate.

The general consensus with investors in Chinese companies is that as long as the government remains relatively hands-off, they are willing to invest. However, with this recent backtrack and outright interference in some of the major Chinese players, the Chinese government has scared many foreign investors out of the country - tanking the share price.

Adding to this - it’s important to note that the motivation behind these anti-capitalist policies and regulations isn’t simply to break up the monopolistic companies like Tencent and Alibaba for the greater good of the economy. It seems more like a knee-jerk reaction to the idea that power is being taken away from the CCP. When it’s boiled down, the CCP want to remain the most powerful entity in China, and are therefore willing to do whatever they can to achieve that goal. 

All this being said, I have estimated the current damage to Tencent on these crackdowns on their core revenue to be somewhere between $3B - $6B (or between 4% and 6% of annual revenues). I would therefore argue that the recent pullback of +20% seems somewhat overdramatic. However, it’s difficult to know to what extent this crackdown will continue and for how long.

6. The opportunity

The chinese middle class is huge. Over the past several decades, the growth of the Chinese middle-class has been nothing short of exceptional. Over the next ten years, the middle class in China and the rest of Asia (areas which Tencent are targeting in particular) are projected to continue growing rapidly. For example by 2035 China will have a larger middle class than USA + Europe combined. They are targeting 35k USD per capita.

China hasn't had a recession in 40 years. The regulators do their jobs and regulate. For example, the recent crackdown on the ANT IPO, where they were lending ~10k to students through a quick 2 minute form and charging 20% interest. China is good at shutting these type of things down, whereas in the US there seems to be much more leniency for this kind of activity. This proactive behavior creates short term pain but long term stability.

6.1. Where do I see the future growth?

Much of Tencent’s future growth relies on the continued flywheel that is WeChat and the various ancillary services surrounding that. The more Tencent are able to focus on expected growth industries, such as cloud and gaming - the better chance of continuing their substantial growth trajectory.

Some tailwinds for growth include…

Industry specific tailwinds

• High base rates case for gaming-industry growth. Roughly 15% per year is the base estimate which, given Tencent’s position in the market, they will likely smash.

• 5G being rolled out worldwide would provide tailwinds with many of their indirect investments.

• Rising chinese consumer spending as the economy continues to develop.

• Several areas of Tencent’s focus - e.g. cloud & SaaS are severely undervalued in terms of use-cases. This is a significant area to increase monetisation.

Country-specific

• Between 2010 and 2018, the Chinese GDP per capital has grown at roughly a 7% CAGR (compound annual growth rate). The forecast between 2019 and 2026 comes in at roughly 7.5%. Very few other markets are growing at these rates. 

Lastly, with the ever-increasing push into

 overseas markets, and into a more investment-centric model, I expect markets in India and Southeast Asia to underpin a chunk of growth going forward. These two countries are somewhat similar to China a couple of decades ago, and while Tencent focuses on the move to B2B within China, they will look to repeat much of their B2C growth within these markets.

7. Tencent and the Metaverse

I talk about the metaverse a lot - so here’s a brief thread I did a while back outlining my thoughts on what the metaverse is and how it might shape-out over the next 10 - 20 years.

Of all the super-apps out there, WeChat, one could argue, is the closest thing we have to a metaverse-like platform - even if this platform mainly exists in the 2D realm. Users can shop, pay, play games, send gifts, personalise products amongst many other things - all without leaving the app.

This opportunity to be a metaverse-like platform is likely to represent an incomprehensible about of wealth-creation over the next 10-20 years as technology develops. And Tencent, who have strategically invested in many metaverse areas of focus (e.g. Epic Games), are in a leading position to capitalise on this opportunity.

7.1. The building blocks

We don’t really know what kind of ‘platform’ the metaverse will end up being built on eventually. It could be Epic’s Unreal Engine, Nvidia’s Omniverse platform, or both, or neither. Most likely, and this is actually one of the core definitions of the metaverse, is that the platforms will be interchangeable and connected. In other words, there will be no singular platform.

Tencent’s 40% investment in Epic Games is the best opportunity (in my opinion) the company has to be able to capitalise on the potential metaverse adoption. More than likely, most applications (games, AR, VR etc) will use either Unity or Unreal Engine to build the metaverse. The Unreal Engine is the platform, Fortnite is Content. It owns 1.5% of Roblox, which has 164 million users and is played by half of people under age 16 in the United States.

Here’s a detailed thread on EPIC.

Another important piece to the puzzle is Snapchat. As Tencent are Snapchat’s largest shareholder at ~12%. I think snap are an important piece in the metaverse jigsaw puzzle - bridging the gap between the physical and the digital worlds.

7.2. Audio

Audio is beginning to make a resurgence with podcasts beginning to become the norm and daily listening times increasing. Therefore I see audio becoming a more integral part of our everyday lives.

Tencent has a 9% stake in spotify, who are best placed to capitalize on the audio opportunity. The company currently has 

Spotify, of which Tencent owns 9%, is best positioned to capture that earshare. Spotify currently has 365 million monthly active users and are rapidly experimenting with different types of long-form spoken-word content. Sleepwell Capital is a great resource for all things spotify.

I believe audio will nicely fill the gap in the metaverse where people are not able to fully immerse in the digital world - offering an extra on-ramp. Additionally, audio really enhances the immersive experience that the metaverse is looking to achieve.

There is much more to be said on the relationship Tencent has with the metaverse - check out Packy McCormick’s essay on this subject.

8. The Bull & Bear Case

8.1. Bull

#1 - WeChat which is a nearly impenetrable moat that Tencent will enjoy for at least another decade or two. WeChat users spent $115 billionthrough mini programs in 2019 and exact figures weren’t disclosed in Tencent’s 2020 annual report but I did find that in their report that annual transaction volume from Mini programs doubled in 2020.

All of this is important because while WeChat is a dominant force, user growth has been slowing given that it already penetrates nearly all of China and so it’ll be important for Tencent to continue monetizing on its users to propel further growth.

In order to not be too repetitive, I won’t touch upon gaming and Tencent’s investment portfolio. 2nd most valuable brand in china and the 7th most valuable in the world.

#2 - Resilient with strong Moat. The abnormally large scale allows Tencent to leverage scale benefits across all verticles. Integral to the Chinese consumer. Integral to most businesses in china as a point of sale, distribution channel, advertising medium and providing cloud and data infrastructure. Also integral to the asian gaming market.

Not dependent on any one supplier. Multiple successful business arms. Low marginal cost. Low to no Customer Acquisition Cost. The more they grow, the better the unit economics become. Low debt and low capital requirements. All of these factors contribute to the company’s overall resilience. 

#3 - Strong Management & Culture. Tencent is still led by the core team who founded it. Great working environment with a 4.3 star rating on glassdoor. Of Tencent’s founding five, two are still executives (Pony Ma, CEO and Xu Chenye, CIO). The other three are on the advisory board. Most of the rest of the executive body have been with the company since around 2005.

#4 - Live Streaming. Tencent owns a dominant 37% and 38% stake in China’s largest gaming streaming sites named Huya and Douyu and has been pushing for the two companies to merge. Unfortunately for tencent, this did not pass due to monopolistic concerns, however this segment remains a huge growth opportunity which serves as a nice compliment to their gaming segment.

#5 - Fintech and business services. This is the fastest growing segment of Tencent’s business (40% for Q2 y/y). Tencent has been able to take considerable share away from Alipay through Tenpay (equivalent of Paypal or Venmo) which currently accounts for about 39% of transactions - up from about 10% in 2014.

Regarding the cloud, Tencent holds the 3rd place spot in terms of market share and given that the overall industry grew by 62% in Q4 2020, I’m sure Tencent will be putting a lot of effort into this business segment.

#5 - The investment portfolio. This is possibly one of the best aspects of owning Tencent, and is a smart move on the company's behalf. Creating and developing their own products would be very inefficient. The company’s best minds should be focusing on building a company that is set up to catch the next big growth wave.

Investment in some of their best bets vs ownership is smart (especially within the context of the metaverse). It will likely be wide-reaching, and we don’t know who the various winners will be. But it most likely wont be one sigle entity.

To avoid repetition - I will simply list the rest.

#6 Reasonable valuation

#7 Strong fundamentals

#8 Multiple industry tailwinds

#9 Leader in almost all areas of operations

8.2. Bear

#1 - Regulatory risk. Unlike Jack Ma who notoriously spoke out against the party and caused many issues for Alibaba, Tencent is known to have a very strong relationship with the government. That being said, the CCP can at any time change its policies that can hurt Tencent’s business (and have done so over the past several months).

This is an ongoing risk and probably one of the largest short-term drivers of the stock price. We simply don’t know how long this will last, or how much damage will be done.

#2 - International political unrest. It’s a real risk that China grows way too powerful that countries will work to limit its power, such as making Tencent sell off its US holdings if an anti-China US president came to power. What should be noted though is that Tencent’s business mostly resides in China (97%), so there would be notable but minimal impact

#3 - WeChat growth is slowing and competition is heating up. As WeChat have grown to be the single largest messaging/social/business platform in all of China, user growth has inevitably began to slow. And the new kid on the block looking to eat up some of this market share is ByteDance which is the company behind Douyin / Tiktok.

TikTok has over 689 million monthly active users while Douyin has over 600 million, and as we’ve seen with WeChat, once you have the users, your opportunities to create additional businesses are endless

#4 - Tencent trades in the US as a Level 1 ADR. Level 1 ADRs trade on OTC markets and don’t need to abide by GAAP accounting which result in less reliability and transparency when it comes to reporting the numbers. 

I find it unlikely that Tencent would commit serious fraud with their accounting, but it;s something to be aware of. There was also some talk about the US delisting Chinese ADRs so again, this is another risk.

Alternative options, as discussed in the financial section below, are to invest in Naspers or Prosus.

#5 - Lacking in one single vision/goal/focus. One could argue Tencent has lost focus and drive - the company is too far-reaching and therefore lacks the direction needed to succeed long-term. It could be compared to an investment fund - not to say this is necessarily a bad thing.

# 6 - Competition in all areas. As mentioned earlier, competition is heating up in many of the areas they operate within. They face a behemoth of a general competitor in Alibaba, an investment competitor in Softbank, an emerging wave of entertainment competitors such as Bilibili, NetEase and Bytedance, and increasing anti monopoly regulation.

#7 - Culture of Short-termism. There are several accounts knocking about that due to the sheer scale and desire to grow year on year, some members of management have been known to focus more on the short-term goals than is healthy.

In a nutshell, and this is something that happens to companies when they get too big, is that they lose the ability to innovate effectively - so they just copy ideas and acquire (look at Facebook).

9. Financials

I’m going to briefly go over the headline financial figures for Tencent before doing a much more thorough job at a discounted cash flow valuation in the next section as I believe that is far more important.

Tencent have a good financial history, with little debt and strong historical revenue growth. The company are highly profitable with an adjusted EBITDA of around 40%. They have roughly as much cash as they do debt.

No marginal cost for most products. Similar to the US technology gians, the more Tencent grows, the better their unit economics become. They have the leeway to be able to invest in companies/projects with poor unit economics which can be subsidesed through cash from the company’s core operations.

You may want to see a larger cash position, but Tencent is generating so much in free cash flow that it really doesn’t matter over the short-to-medium term. 

9.1. Cash Flow

The cash flow statement is extremely strong. But what is really impressive is the way in which Tencent re-invest back into its businesses using cash generated from the core operating businesses. This is what’s leading to its fast, sustained, compounding growth.

If we run a quick eye over the cash flow statement, we can see the substantial cash from operations coming into the business. At the same time, we can also see a significant, and almost precise, outflow of cash towards investing activities. This is cash coming straight in and heading straight out the door. In other words, they are utilising every bit of cash-flow they make in order to invest and compound at a greater rate. Exactly what we want to see to indicate longevity. 

9.2. Summary of financial position

• Highly profitable, adjusted EBITDA around 40%

• Roughly as much cash as debt. 

• Generating large amounts of free cash flow.

• Not necessarily cheap, but could now be a good time to purchase?

• The way in which they reinvest capital back into its business from its core operating businesses is what’s leading to it’s long lasting growth and compounding.

  • Cash generated from operations was 29B, and 28B reinvested back into the business. 

9.3. Valuation

I’m going to try to keep this aspect as simple and as easy to follow as possible.

Generally speaking I find complex valuation models make things less clear rather than more clear. I’ll take you through my thought process step-by-step and provide the spreadsheet so you can play with the numbers and follow along.

ACCESS SPREADSHEET

Step 1 - get the numbers

Step 1 is to gather the historical financial data for the company over the past 5 years. I realise we’re half way through 2021, however I’m going to use the annual figures from 2015 to 2020, as it keeps the process simple (ish).

This step is actually harder than it sounds as Tencent doesn’t report in USD - therefore I will have to use a third party provider (y-charts or TIKR) to grab the numbers. 

Step 2 - Make basic assumptions

We’re going to make some minor assumptions based on the historical figures in order to forecast growth over the next 5 years (2021 - 2025). Assumptions made here include:

• Conservative estimate of revenue growth @ 15% per year (even though average revenue growth over past 5 years is ~37%).

• Using historical average EBIT margin of 31%.

• Using historical FCF as a % of EBIT in order to calculate the future Free Cash Flow (see formulas in spreadsheet if confusing)

  • For example, if we know that historically (on average) the Free Cash Flow figure is 1.25x the EBIT number, we can multiply any future EBIT number by 1.25x to get the estimated cash flow.

Step 3 - Which method of earnings do we use?

Now that we have all of the numbers and forecasts, the next thing we need to decide is which method of earnings to use to calculate a fair value for Tencent - the options being ‘Net Income’ or EBIT. 

In this case we’re going to use EBIT due to the fact that Net Income includes some investment gains that we want to exclude for the moment.

Even though the investment gains are technically ‘real’ and of material value, it’s simply too volatile to be able to predict moving forwards. Therefore we will bolt-on the equity investments at the end of the valuation.

We will also be using the Free Cash Flow number which has averaged at roughly 125% of EBIT.

Step 4 - Finding the intrinsic value

In order to find the intrinsic value of the operating business, we need to add together the discounted terminal value and the sum of the discounted free cash flows.

• In order to get these terminal values, I will need to come up with a terminal value multiple. I have chosen a TV multiple of 20 to be on the safe side. The reason being is that the EV/EBIT multiple has been trending downwards over the past 5 years, so I can see this pattern continuing. Equally a fair value would probably be anywhere between 20 to 30.

• Once we have calculated the terminal value (formula in spreadsheet) we then discount this terminal value figure by the discount rate of 15% (formula in spreadsheet), which gives us the discounted terminal value.

• We then sum the discounted FCF values and add them to the discounted terminal value to get to the intrinsic value of the operating business. Which equals to roughly $536 Billion. 

Step 5 - Adding the investment portfolio

Next, we want to find the total estimated fair value of Tencent, including their investment portfolio arm - which is the intrinsic value (which we just calculated) + the estimated value of the investment portfolio.

PackyM’s spreadsheet shows the current portfolio to be worth roughly $320B, but I’ve discounted it by 20% to account for some volatility.

Therefore, the total estimated value of Tencent in 5 years is $785B, which (dividing by the outstanding shares) makes a share price of $81. The margin of safety is roughly 22% from the current price, as well as an IRR of roughly 22%. 

On the basis of some fairly conservative estimates, the current price looks extremely attractive to me. I have also added a bull and a bear case in the spreadsheet.

9.4. Relative valuation

On a relative basis, Tencent are coming back to a level that looks more appealing. Especially considering the underlying business hasn’t changed much, regardless of the Chinese crackdown.

The below graph compares the EV/Sales ratio between some of the major Chinese companies. It’s a good way of showing the general market trend. Though appearing attractive at the moment, it’s difficult to say how long or how deep this shakeout of Chinese stocks will/can continue.

This valuation matrix below, from factset, gives a great indication of the relative underlying fundamental performance of Tencent compared to both their Chinese and Western counterparts.

Amongst the chinese group, Tencent lead the way in terms of profitability numbers. They lead the pack in net margin, EBITDA margin and FCF yield. However their revenue growth numbers look decidedly average.

I would argue that the below table, which shows solid fundamentals, justifies the relative premium in comparison to their Chinese counterparts in the chart above.

9.5. Buy Tencent at a discount?

While researching, I kept coming across Naspers and Prosus as potential alternatives to investing in Tencent at a ‘discount’. Lets find out what all this means…

What is Naspers?

Naspers took the decision to buy a 46.5% stake of Tencent in 2001. The ownership stake was diluted when Tencent decided to ipo. The total cost basis of that Tencent investment was 32 million dollars back then, which has turned into over $200B today as Tencent has become one of the most dominant internet giants not only in china but globally.

That is a CAGR of approximately 55%, which is insane. As a result of this Investment, Naspers market cap has grown to the point of dominating the South African stock exchange. Even today, Naspers accounts for 22% of the South African index.

However, this poses a problem. since many institutional investors in South Africa are forced to sell out of the Naspers investment in order to reduce the concentration risk in their portfolio. The sustained selling of the stock along with the limited float resulted in a reduction in the price of Naspers shares.

In order to address this discount, Naspers management decided to organize a spin-off in the form of ‘Prosus’.

Prosus

September 2019 saw Naspers list Prosus on the Amsterdam Stock Exchange. With the idea that the formation of Prosus would give the company more liquidity from a new diverse base of investors.

The new listing would reduce the problem that Naspers had where they were dominating the entire South African index. This spin-off would be allocated the entire Tencent stake and other investments that Naspers previously controlled.

The listing was a massive success - with the initial listing price prediction of 58.7 euros Prosus exceed this, shooting up to a range of around 76 euros.

So, If you’re looking at Prosus or Naspers, you’re not really looking at an investment in Tencent, but more the capability of the management team to manage the capital. Most likely, Naspers and Prosus will never sell their stake in Tencent.

My opinion is that if you are looking to invest in Tencent, don’t over-complicate it. Unless you are truly knowledgeable about the management of either Naspers or Prosus, don’t in what is essentially a derivative of a derivative. There are plenty of risks to already consider with owning Tencent without adding an extra layer of complexity.

10. Conclusion

I’ll keep this conclusion short, mainly because the article ended up being so long. However, I think the opportunity present here is great.

I believe Tencent has pretty-much everything we’re looking for in a good investment opportunity - resilient business, strong investment portfolio with an eye towards the future, huge growth tailwinds in multiple industries, dominant in almost every area of operation, impenetrable moat and ‘metaverse-ready’ (amongst other things).

All risks considered, the company is trading at a relatively reasonable valuation level. I strongly believe the potential upside here far outweighs the risk.

For full disclosure, I have already initiated a 3% portfolio position in Tencent at an initial cost basis of ~$59, with the aim of gradually adding over the coming years. This is a good practice for any investment in order to manage risk, but in this case I wan’t to manage the downside as much as possible.

Cheers,

Innovestor

Some thanks:

1. Special thanks to both of Pacy McCormick’s Tencent articles (One, and two) where he goes into great depth on the history aspect and has done some amazing ground-work on the investment portfolio analysis.

2. Special thanks to Vineyard Holdings article who goes into vast detail on Tencent, and moreso within the context of China.

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My aim with these deep-dives is to make the research process of investing in individual stocks more accessible. Enjoy!

Contents:

1. Thesis

2. Key takeaways

3. Business model

4. Market opportunity

5. Growth plan

6. Acquisitions/partnerships

7. Bull & Bear

8. Management

9. Financials

10. Conclusion

1. Thesis

Enthusiast Gaming is an opportunity to capitalize on a combination of a rapidly growing market (esports/gaming) with a ‘direction agnostic’ position within that market. I.e. not reliant on taking a bet on any particular game/trend/franchise to play out (e.g. Roblox/Fortnite/CoD).

The thesis here is to bet on the gaming industry in general, and the immense untapped value that a highly engaged group of 300M GenZ’s and Millenials will have in the near future. As advertisers and marketing managers come to recognise the potential for community, the average revenue per user will grow substantially (prediction of $3 but possibly way higher).

Along with this, gaming is the next social hangout space for young people, and 70% of GenZ’s attribute gaming as a large expression of their personality.

Gaming will continue to evolve rapidly over the coming years - EGLX are in the best position to monetise the community of gamers around the globe.

2. Key Takeaways

• Platform with global reach of over 300m gamers every month

• Building social network (platform) for gamers, capitalizing on social revolution and changes in how Gen Z and millennials consume content

• Q1 2021 Revenue was $30.0 million, a 321% increase vs Q1 2020 revenue of $7.1 million.

• Gross profit was $5.9 million, an increase of 80% vs Q1 2020 gross profit of $3.3 million.

• Net loss was $13.6 million.

• Robust first-person data-set of highly lucrative demographic (GenZ/Millenials/GenA). Engaged, loyal communities of gamers.

• Undervalued compared to industry peers.

• Great exposure to the huge and fast-growing video game market through Esports, entertainment and media.

• Insider ownership of 30%.

• The company is beginning the monetization phase of its business strategy.

3. Business Model Overview

Enthusiast gaming is a business model that, on the surface, isn’t the most straightforward. They are neither a games developer, distributor, or anything directly related to the titles themselves. Those roles within the industry are competed by companies like Activision (ATVI), Electronic Arts (EA), Roblox (RBLX), Unity (U) and Take-Two (TTWO) amongst others, who are all extremely good at what they do.

Enthusiast Gaming’s area of competence is around the community. They have spent time and money building a community of engaged gamers with the option to tap into directly at any time. I’ll go onto explain why this is valuable later on in the article, however for the time being here’s their mission statement.

Mission – “building a world of communities where video gamers connect and engage”.

In essence, Enthusiast Gaming is building the world’s largest platform of communities for gamers and eSports fans. The company owns a platform with over 100 websites over 20M youtube subscribers, 7 pro E-Sports teams, over 550 influencers, subscription sites, events and more. Part of this includes the ownership of Luminosity Gaming,  which is one of the bigger E-Sports organizations in the world. Also, they have close to 30 events (b2b & b2c) around the world – including the largest mobile gaming event in Europe and the largest gaming expo in Canada.

The sheer size of the user-base of 300M monthly active users worldwide is arguably the company’s most compelling competitive advantage. This alone gives them the ability to communicate with over 300M game enthusiasts each and every month, which makes EGLX the largest gaming network in both North America and the UK.

“We feel no-one is as obsessively focused on the fan experience as we are. The thing that makes us so different to anyone else in the space is that we are not trying to dominate a vertical; we are not trying to just be an eSports organization, a collection of websites, or a tournament organizer - we want to build value right across the fan experience. If you are a super-keen EPIC Games’ Fortnite player who has logged-off, the beauty of this gaming phenomenon is that you are not then ‘done’ – you go to Twitch where – obviously! - we want you watching our Fortnite streamers Muselk and Fresh, when you go to YouTube, we want you to go to the biggest Fortnite YouTube channel in the world – our channel, BCC Gaming, if you want to see what EPIC Gaming is up to next, we want you to then come to one of our events and see their booth up-close. It is all highly integrated – and hopefully a lot of fun also!” - Adrian Montgomery (CEO)

3.1. So, how do they make money?

As with many business models, the answer is advertising.

Enthusiast Gaming don’t own any large games like CoD or streaming platforms like twitch. However, they do have a base of over 300M engaged monthly active users with which they can present adverts to. Combine this with the possibility for influencer marketing and you have a powerful route directly to these lucrative age groups.

Companies like Facebook and Google are already dominating the advertising space with their ad platforms, however advertising is evolving. Influencer marketing is becoming one of the most effective forms of advertisements - and Enthusiast are in a great position to capitalise.

The level of content and reach within the gaming industry gives Enthusiast Gaming the opportunity to partner with large companies like Samsung who will be able to more effectively target ads.

3.2. Understanding the model

The idea of gaming is a different experience for different people… Some might complete the story-mode, maybe play online - but then once you turn it off, you forget about it. The other type of gamer would be playing in a similar way, with the big difference being the involvement and consumption of content around the game. For example, youtube videos, forums, podcasts, attending events etc.

In order to understand the business model, lets try to put ourselves in the shoes of a typical gamer. I’ll use myself as an example. Once I’m done playing I might…

• Try to find news about future games/updates to games that are coming up.

• Join a forum to discuss the game with other fans.

• Subscribe to a youtube channel to watch live-streams or to find tips/tricks/engage in comments.

• Look at twitch or youtube to follow a particular e-sports team

• Attend virtual event (previously live events) – and connect with other fans at these events.

The fact Enthusiast Gaming has curated an eco-system creates a flywheel effect where the more people involved in every aspect of the ecosystem (websites, YouTube channels, e-sports team, influencers, experiences), the more value is created for users – therefore attracting more users and fueling the flywheel. This eco-system around the game itself the the portion of the gaming experience EGLX are aiming to control.

3.3. The core pillars of Enthusiast

If we zoom out slightly to try and distinguish some core pillars of the business model, it breaks down into three main sections - Media, Events and E-Sports.

3.3.1. Media (95% of rev for most recent quarter)

The media aspect, which makes up roughly 95% of the most recent revenue stream, is a crucial part of Enthusiast Gaming’s business. As shown in the image above, this consists of over 100 active sites, over 1000 youtube channels with over 3.2B views every month and a bunch of high-profile influencers within the industry.

The company sees their assets (luminosity gaming, influencers etc.) as “content factories” - keeping fans engaged.

The crucial point here is the fact that EGLX owns this entire audience. This means they have direct access - a trait which brands value immensely. Subsequently allowing Enthusiast to charge a premium for advertising real-estate.

Interestingly, the amount of focus EGLX has put on the media aspect to date has been relatively low compared to the anticipated focus moving forwards. The plan is to move focus towards direct advertising rather than programmatic advertising (difference explained here), which will require a big boost in the number of sales team-members. We are already starting to see this.

3.3.2. Events

Secondly, events within the gaming sector are crucial to building the community. It’s a chance to bring together a community of like-minded individuals.

Pre-covid, EGLX have been doing a good job at putting on large events for the gaming community. Their flagship event is the EGLX event (above), however they do other events/conferences such as ‘pocket gamer connects’.

3.3.3. E-Sports

As I have discussed in previous articles, the rise of E-Sports is a phenomenon in-and-of-itself. It is essentially a subset of the overall gaming industry (as demonstrated below), where elite gamers are able to compete against the best in the world.

E-Sports has been growing at ludicrous rates over the past several years. The industry is now at a point where viewership figures are beginning to overtake traditional sports.

(Below source: business insider)

• “A 2020 report by Limelight Networks found that gamers ages 18 to 25 spend significantly more time each week watching other people play video games online (4 hours, 7 minutes) than they spend watching traditional sports on TV (2 hours, 36 minutes) or online (2 hours, 34 minutes).”

• “As competitive video games continue to integrate into popular culture, global investors, brands, media outlets, and consumers are all paying attention. Total esports viewership is expected to grow at a 9% compound annual growth rate (CAGR) between 2019 and 2023, up from 454 million in 2019 to 646 million in 2023, per Insider Intelligence estimates. That puts the esports audience on pace to nearly double over a six-year period, as the 2017 audience stood at 335 million.”

With regards to Enthusiast Gaming, the company own one of the bigger e-sports organisations in the world called Luminosity gaming which they acquired in 2019 for $1.5M in cash, 7.5M shares of GameCo and a promissory note worth $2M.

The franchise has over 50 content creators and key influencers, over 100M fans and 6 pro e-sports teams. Tyler “Ninja” Blevins, one of the most famous gamers in the world, was a member of Luminosity Gaming earlier in his career (and I believe is still under contract with the franchise).

• E-Sports thriving during the pandemic.

• Luminosity currently ranks 42nd in terms of revenue generation. Lots of room to improve here.

• E-sports makes up 6.5% of total revenue.

3.4 Revenue streams

The CEO, Adrian Montgomery recently said in an interview when asked about the strategy behind revenue generation at EGLX - “We aggregate the largest fanbase possible, and turn that fanbase into a customer base.”

Simple.

Now if we delve slightly deeper into this statement, we can begin to see why this strategy (within the context of the gaming industry) will be so lucrative in the future.

“They” (Gen Z & Millenials) “are the world’s most lucrative demographic because they have a lot of purchasing power. They don’t have their money sucked away by these things called children and mortgages. If you are a company, you are no doubt trying to get them into your world at a very early point in their buying lifecycle. What people don’t really understand is that any traditional sports would kill for the demographics of an eSports fan - they are a little bit older than you think – typically being in their 20’s; they have more disposable income than other traditional sports fan but then, they are elusive - they just don’t consume content the way I did in 20 years ago!” Adrian Montgomery - CEO

“Gen Z are the most lucrative demographic, but also the most elusive.” Some statistics to illustrate this point…

• Almost none watch linear TV.

• Gen Z spend almost 4.5 hours a day on social media, while Millennials estimate they spend an average of around 3.8 hours.

• Gen Z are more likely to have watched social media videos in the last week than TV series. 70% of Gen Zs say they consume social media videos. That’s an increase from 66% who reported watching social media videos in the last week back in June 2020. This means that for this group, social media video viewing now eclipses TV series viewing, with 66% reporting that they watched TV series in the last week.

• Instagram, TikTok, and Snapchat are in their top 10 sources for video content - but cable isn’t. Just 15% report watching cable weekly or more.

• The majority are using social media while they’re watching TV. Over half (57%) of Gen Z use social media while they’re watching TV. The fragmented attention is real. That’s compared to 51% of Millennials who say the same, so in case you were wondering if older consumers were more engaged viewers, they are but barely.

• Gen Z makes more mobile purchases. Compared to millennials, Gen Z is twice as likely to purchase something on their mobile device.

Taking all this into account, Gen Z are fickle, hard to reach, elusive, but also a goldmine for advertisers. Being able to communicate through gaming is the key to unlock this demographic. Therefore creating an incredible opportunity to monetize through ad-sense, and you can command significant advertising rates because of this. It’s all made possible due to the fact that the platform is wholly owned by EGLX.

So, if we then look at how this breaks down in reality - there are 4 main methods of generating revenue, and more to come.

1. Ad sales: Strong base to sell ads and to monetize. Viewers come back 25ish times per month – compared to IGN/Gamestop = 5/6 times per month. Twich = 5/6 times per month.

2. Subscription: Opportunity to sell subscriptions to a percentage of these 300M base. E.g. sims resource subscription service – 137,000 people pay $4 per month for VIP content. Recurring high margin rev stream.

3. Sponsorship of E-Sports teams: All the big brands want to get into gaming at the moment.

4. Appreciation in value of e-sports teams: One way trend for all sports.

   *Future - marketplace/platform for gamers.*

The beauty with this business model is the fact it’s agnostic to specific games or directions of travel within the industry. It’s not like Activision who’s future performance directly relates to the success of their handful of franchises. If gaming wins - EGLX wins. Therefore it’s great overall exposure to the e-sports sector.

There are no other companies/products with this array of assets. The aim is to own all communities, and have as many touchpoints as possible with GenZs.

4. Market Opportunity

• According to YouTube, viewers watched an approximately 50 billion hours of Gaming Video Content on its platform in 2018, doubling to approximately 100 billion in 2020.

• The number of gaming-related tweets increased from approximately 218 million in 2017 to over 2 billion in 2020, according to Twitter.

I won’t talk for too long about the gaming industry, as I have been over it several times in the past - mainly in my Activision Blizzard deep-dive. I would also recommend reading a collection of essays by the 10th man, who has gone into great detail on the industry.

“I had just read an article about eSports, and one of my guys phoned me and said “You know how you were interested in eSports? Well, these guys are coming in – do you want to come on the site tour?”. Well, it turned out we had this opportunity to host the biggest eSports event in the world – the DOTA 2 International run by Valve – that was coming out of Seattle for the first time.  I came down and met these three guys, who were acting as if they were in charge of FIFA or the SuperBowl or something! “Take that down, move that, block that off, our crew needs this...”. I was getting a little frustrated and keen to try to put them in their place, saying ‘Hey, so what exactly is the prize purse for this little rinky-dink tournament right? “$33 million dollars (USD)”. Oh my god! So, I went back at the end of the site tour and said, alright, there is clearly something here!” Adrian Montgomery - CEO

Gaming, as you are probably aware, is one of the fastest growing industries at the current time and is expected to continue its spectacular growth trajectory over the coming years.

Gaming is the most powerful form of entertainment – twice as big as the movie industry and the music industry combined. Online viewership has far more views than any traditional sports.

• Growth at 35% p.a.

• Prior to COVID, studies were already showed that over 90% of all children in America were gaming in some capacity.

• Hollywood $40B industry, gaming $150B and growing

• Layer on the 25% of the audience which are GenZ’s. 75% of which think gaming is a core personal expression.

“According to Newzoo, the industry is expected to grow to USD$218 billion by 2023. The proliferation of high speed internet, accessible technology, and publishers using enhanced live operations and other tools have further accelerated the gaming market. Gaming has amassed a diverse audience who rely on the industry as a form of entertainment and social connection. Increasingly, younger generations are immersing themselves in gaming ecosystems and now choose gaming as their primary form of entertainment. Today, there are 2.7 billion global gamers, who engage with interactive entertainment using three platforms: console, PC and mobile, according to Newzoo.5 It is expected that gamers will surpass 3 billion by 2023 as smartphone penetration increases globally.”

The idea of gamers as kids in their parents basements, barely affording rent is a thing of the past. The average age of an esports fan is 22. The purchasing power of this audience is therefore rapidly increasing - and will continue to do so over the coming years.

4.1. Positioning within the gaming market

You have the $200B gaming industry consisting of large publishers like Activision Blizzard, Take-Two and RIOT that make the games. Facebook, Amazon and Google are competing to become the broadcaster for the content. That leaves Enthusiast Gaming with a lot of freedom to consolidate the fan experience.

There are 2.5B Gen Z’s in the world – 70% of whom say that gaming is a core part of their identity as human beings. They are consuming content and playing video games at record levels. In addition, you could argue gaming is also the new social network. Gaming is how people interact with eachother and, one day, might be the most common method of interaction.

(Ardian Montgomery) - “Gaming to them is what music was to the rest of us. It’s the way they express themselves to the outside world, which is extremely powerful. So to be able to speak to billions of Gen Z’s through a shared love (gaming) is a powerful engaged relationship. With this highly engaged relationship comes more data and better understanding of their wants/needs.”

“When you have that large community to draw upon – when you give that young person who loves video games an extra hour in the day, they’ll spend that in some way somehow in the video games ecosystem.”

4.2. Stats & vision

• On the influencer side, No.1 on twitch in terms of viewership. Nearly double anyone else. (March 2021 40M hours watched compared to No.2 with ~25M hours).

• On the Youtube side, EGLX currently reach about 25% of all Youtube gaming (over 3M views per month).

• On the website side, the company has spent 4-5 years acquiring all of these websites – leaving not much left for competition to replicate the model. Therefore going to be hard for a fortune 500 company to replicate from scratch.

Big companies like Microsoft and Facebook are obsessing over video gaming and content communities. The power of communities, the sharing of content, the creating of content and the fact people aren’t passively sitting in front of traditional media. People are flocking to communities and that’s why Microsoft and Facebook are focused on this area. The CEO of Microsoft said something very impactful - “we’re going to transition from being about media consumption to content creation – and building communities around that creation of content”. EGLX are onto something big here.

4.3. COVID

Covid spiked traffic to EGLX’s various touchpoints. Over 25% across the board and over 40% on some sites.

• Content views gone up by around 25%

• Page views up.

• Time on site up.

• The challenge is that advertising rates were down at the beginning of Covid but have since picked up.

5. Growth plan

The majority of past growth has stemmed from a strategy primarily based on strategic mergers and acquisitions. This will continue to be a growth lever moving forwards.

In addition to strategic M&As, Enthusiast Gaming believes they have a clear path towards increasing monetisation within the gaming ecosystem. These strategies include…

• Optimising CPM

• Increasing direct sales

• growing the subscriber base

• and licencing content

The company has a 4 stage plan to increase ARPU from $0.40 to $3.00 by 2023.

Stage 1 involves building scale by acquiring assets within gaming/content creation.

Stage 2 involves concentrating on increasing the ARPU number by focusing on direct advertising. This will involve the company increasing their sales team.

Stage 3 involves working on other forms of revenue generation within the company by focusing on increasing subscription revenues and licencing deals.

Stage 4 involves leveraging first party data (eg. acquisition of tabwire) to enhance gamer experience. EGLX are looking towards e-commerce and the creation of a social platform.

‘Platform’ is the key word here and is arguably the end goal for the company - i.e. to create a platform for gaming entertainment worldwide… To be the no.1 source of gaming content/entertainment.

“What is next is for us to sell our content using elements such as subscriptions. We believe we can take a userbase and turn it into a marketplace. Why can’t we have an App Store? Can we connect these communities and people together and make a social media network of our own even – that is all ahead of us. I always tell my team, while we are building a company called Enthusiast Gaming, we are also helping to build an industry – and the rules are being written as we speak. Adrian Montgomery - CEO

Ideas are to…

• Become a subscription content platform similar to Roku – offering advertisers direct access to a highly engaged audience.

• Could become a marketplace for gamers – making use of the 300M ‘walled garden’.

5.1. Advertising

“According to eMarketer, consumers in the U.S. spent an average of 181 minutes accessing digital media in 2010. In 2020, this figure increased to 470 minutes a day, representing 160% growth. Due to, among other things, the shift in media consumption from traditional to digital and increased time consumers are spending online, advertisers have adjusted the way in which they allocate their advertising budgets. According to eMarketer, USD$90 billion was spent globally on digital advertising in 2012. This spend increased to USD$378 billion in 2020, representing growth of 319%. Digital advertising is expected to grow to USD$646 billion by 2024.” - Management Discussion

Until recently, Chief Marketing Officers tended to ‘age discriminate’. This manifested itself in dismissive behaviour towards e-sports as a vehicle for advertising - mainly due to the demographic being seen as too ‘young’ or ‘niche’. Now, all brands want/need to be involved in e-sports. We are beginning to see all the big brands clamoring to get their name involved within the industry.

"Enthusiast Gaming is already partnering with the likes of Gillette, Proctor and Gamble, GoDaddy, and Pizza Hut. However, Adrian was clear that other brands need to realize that gaming is not a hobby for many millions – billions of people.

“eSports is more than a hobby for gamers - it’s a way of life. It’s their identity, it’s their social network, and it’s their method of expression. eSports and gaming is going to continue to skyrocket, and people are realizing how pervasive it is in people’s lives. What I’ve seen change this year - and I can tell you which is one of the most exciting things for our industry today - is that most marketing directors now know if you need to communicate with young people, you simply must have a video game strategy. eSports has made quantum leaps during the recent pandemic.” - Excerpt from interview with Adrian Montgomery.

The industry as a whole is estimated to be growing at roughly 35% per year. This presents massive opportunity for brands looking to get in early and cement themselves within the community.

Take Red Bull for example. With an early vision of esports marketing, the company is now synonymous with various top players - Ninja for example.

5.2. ARPU

Relating directly to advertising, ARPU (average Revenue Per User) is the low hanging fruit the company can currently focus on in order to really grow top-line revenue in the short-term. ARPU currently currently sits at $0.4 but with some minor changes of emphasis, it is predicted to jump to $3 by 2023 - however I can see it going much higher.

ARPU is higher in the US than anywhere else because the sheer value of the Youtube and Web eyeballs in America is significantly higher than anywhere else.

5.3. Advertising/Sales team

Another aspect of the growth and increasing ARPU is the increase in the sales team to better penetrate the direct advertising market.

They have the potential to quickly unlock some of the ARPU through direct ads. These direct ads are more likely to be exclusive/targeted and much better value for the brand/advertiser as EGLX know exactly their target audience (70% Gen Z & Millenials). These brand partners are willing to pay a premium for this added precision with the advertising model.

The brands want access to Enthusiast’s youtube audience, web audience, but most importantly the influencers. This combination of youtube, web and influencers is something that no-one in the market is delivering at the moment and really moves the needle on sales for brands.

Once they have the advertising, sales and subscription sales sorted, they can then evolve to a marketplace for gamers – leveraging their 300M walled garden of engaged gamers. (Stage 4)  

“So now that we have an opportunity and so for the present time despite all the success that we've had recently with direct sales we're probably only selling two percent of our inventory directly to the customer, but when you sell directly to the customer you're almost at a minimum 10x in your cpms. So every incremental two percent three percent shift of inventory from programmatic to direct has an outsized impact on margin. And so when we look at all of the things in front of us we think we can dramatically increase our gross margin like we did before with enthusiasts.

How complex and expensive is it to switch from programmatic to direct is it just a matter of hiring the sales people.”

Programmatic advertising on it’s own was probably at around $0.5c per user, and this was fairly bottom-of-the-barrel, low effort, easy to scale stuff – whereas if you layer in the data and the sales team and the subscriptions and the e-commerce, that’s when you could potentially go $5-$10 per user. So that’s where the focus is at the moment – building and scaling up the sales team in order to be able to implement this change from programmatic advertising to direct.

For an indication of this, in Jan 2020 the company had about 2 salespeople – now they have over 40. The intention is clear.

Much of the $120M in revenue from the previous years was due to programmatic ads. This change is the tip of the Iceberg.

5.4. CAC - Customer Acquisition Cost

One relatively hidden benefit of Enthusiast Gaming’s business model is the very low (allegedly $0) CAC. This is also arguably their deepest moat.

“The thing that blows people away – and is routed in our content and approach – is when I tell them we don’t spend a single cent in acquiring or keeping that traffic coming back. They won’t believe it. Building a world-class business routed in user-generated content is definitely a very hard thing to do – and when you succeed it is a very hard thing to explain! There is a lot of art as to how it’s curated, how its presented, but when you can do it well, the sky is the limit for you in terms of possibilities.” - Adrian Montgomery

Silicon Valley tend to ask the question “is your CAC lower than your LTV?”

All this growth in ARPU with $0 CAC (due to owning both the traffic and data) will lead to outsized margin increases over time. The moat is that there isn’t anyone else in the industry with an audience as large and highly-engaged as EGLX. The company don’t spend money to drive traffic to their sites – the traffic comes organically. Therefore it is virtually impossible to replicate an audience as large and as loyal. Those 300M people consume over 4.5B views per month.

5.5. Content licencing (Roku/Samsung)

The play for the longer-term is to begin to licence some of the content and sell to companies like Samsung and Roku, which will have an immediate effect on the bottom line. (Stage 3)

“The Company is pursuing opportunities to license its library of content and owned & operated brands to distributors. Enthusiast Gaming already has established partnerships with TikTok, Samsung, and Snapchat.”

5.6. Downsides of growth

In terms of profitability, EGLX are still several years off – they are actively investing in growth as they see this as a huge potential opportunity. Everything is being ploughed back into the ability for the company to grow.

“The alchemy of running a ‘user generated content’ business is that it’s very hard to do and it's almost harder to explain, and the moment you lose that authentic and genuine edge the whole thing falls apart. Activision as an example – people wouldn't flock to Activision fan communities if they knew big brother was owning them and moderating them right and selling selling the data. We are focused on growth and uh but we could be profitable tomorrow if we so choose.” - Adrian Montgomery CEO

Growing and scaling as a business is hard. Short term profitability usually needs to be overlooked in favour of long-term gains.

6. Acquisitions/partnerships

Acquisitions and partnerships are a key aspect of the growth strategy. In this section I will very briefly touch on some of the acquisitions/partnerships Enthusiast gaming have made over the recent past.

So far, we’re looking at 16 acquisitions in the past 4 years.

In addition to the various acquisitions over the past several years (above), the company owns 6 e-sports teams including (Vancouver Titans - Overwatch, Seattle Surge - CoD, Luminosity - Fortnite, and Luminosity - Valorant)

Some of the most notable recent acquisitions include…

• Omnia Media - “Omnia owns content brands that matter to fans who love gaming and pop culture including BBC Gaming, Arcade Cloud and Wisecrack.”

  Enthusiast Gaming has announced the launch of BCC Gaming, its first free, ad-supported streaming channel, which is available on Samsung TV Plus, Samsung’s free Smart TV video service, in the US.

  This licensing and distribution activity is the latest result of Enthusiast Gaming’s recent acquisition of Omnia Media, which extends the company from one that was previously focused on online esports and gaming communities to one that produces and distributes premium, original content.

• Icy Veins - acquisition of Vedatis, which owns Icy Veins — a platform dedicated to guides for Activision Blizzard games including Hearthstone, World of Warcraft, and Overwatch — for €7M EUR ($8.51M USD).

  Enthusiast Gaming expects the acquisition “to be accretive to Enthusiast Gaming’s revenue and margins and demonstrates opportunity for increased monetization through the company’s proprietary flywheel, which includes YouTube channels, subscriptions, content licensing, and e-commerce.” 

• Tabstats - A step in the direction of increased social interaction on the platform. “GenZ and Millennial audiences have been moving away from traditional social networks and turning to gaming as an alternative,” commented Adrian Montgomery, CEO of Enthusiast Gaming. “Project GG addresses these trends and will allow gamers to register their unique gaming profiles, compare stats, develop meaningful connections, and share content and ideas.” He continued, “Tabwire marks an important milestone for Enthusiast Gaming to be able to bring Project GG to market later this year. It will provide us with essential data capabilities to deliver our customers a complete social offering with a more targeted, integrated and personalized experience for today’s gamer. This is a meaningful next step towards becoming a technology-powered, media, esports and entertainment company.”

6.1. Collab with Coldplay

Coldplay are a historically innovative music act. One of the, if not the, first bands to licence their music to iTunes. That deal was done directly with Steve Jobs by licencing ‘viva la vida’ for an iTunes commercial and ended up winning a grammy.

EGLX have a content creator in Luminosity called ZHU, who is one of the leading EDM DJ’s. The idea is for ZHU to remix ‘Higher Power’ by Coldplay.

EGLX created an event showcasing the remix, along with a performance from Coldplay. Really interesting cultural crossover between mainstream music and gaming.

“Coldplay are timeless, cross-generational musicians, and we look forward to serving as a bridge between them and our global gaming audience. While this is the first collaboration of its kind for us and in the gaming space, our platform provides immense opportunity for similar experiences in the future.”

EGLX are taking over the world – and it’s not just in video gaming. The interesting thing here is the intersection between music & gaming, fashion & gaming, lifestyle & gaming etc.

Adrian Montgomery goes on to make some really interesting points about attracting the entrenched investors who may not be keeping up with pop-culture. This collab with Coldplay is something that may spark their attention. EGLX will be doing more with Coldplay and other mediums of entertainment outside gaming.

6.2. Torstar JV

More recently EGLX form a Joint Venture with Torstar to launch an online news channel - creating an original news platform and community named AFK.

"AFK is a new brand that brings insight and community to issues that matter to gamers in a tone and format that feels familiar to them, such as short-form video content and message boards on digital-first platforms."

• Gen-Z focus: short vids + digital first approach

• Content creation seems a big focus here

This one is particularly interesting to me as EGLX seems to really be putting together the beginnings of a ‘platform-like’ experience.

7. Bull & Bear Case

7.1. Bull

1. Global Reach of engaged audience members (300M)

2. Capitalizing on revolution in how GenZ and Millenials spend social time. Creating the beginnings of a gaming-orientated social network.

3. Strong monetisation strategy with strong present and future revenue streams.

4. Multiple growth opportunities with significant upside potential.

5. Optionality. Direct and varied touchpoints with young people (Media, esports, gaming, music).

   • Sports betting market will be a big industry that EGLX are looking to get in on.

   • Social network primarily for gamers.

   • Content licencing with Roku/Samsung – licencing some of the content and selling it, which will have an immediate effect on the bottom line. Basically just live broadcast directly to ROKU which will increase viewership.

6. EGLX owns their audience, and therefore (and arguably more importantly) owns the data.

   • Monetising data is key. Enthusiast owns all of their users data along with the direct traffic which will be extremely valuable moving forwards. This puts them in a good position to sell user data and use it as a freemium model – i.e. people can access content for free with the assumption of being able to use their data. This will be valuable because it’s a very niche and very targeted audience meaning they can sell the advertising space/data at a significant premium.

7. Undervalued compared to industry peers.

8. Great overall exposure to gaming sector - game/trend agnostic.

7.2. Bear

1. Overly reliant on one source of revenue.

2. Competition

   • There is potential for large companies to come in and buy up a large portion of the gaming real-estate. However, EGLX currently one of the only companies doing what they are doing

     I would argue there are very few companies who will be able to generate the same level of reach in an organic way.

3. Profitability still a long way off.

   • Definitely one of the most concerning aspects of the company is the profitability. At current levels it’s not sustainable. That being said, in my opinion there is a clear plan to achieve profitability over the next few years. It will be really important as an investor to keep an eye on key metrics in order to ascertain whether the company are on track to achieve their goals.

4. Short interest.

   • As shown by the chart below, short interest for Enthusiast Gaming over the past several months (and well before that) has fluctuated wildly - ranging from 5% to over 50%.

5. Share dilution

   • In order to grow, Enthusiast Gaming need cash. Therefore it’s entirely likely the company will continue to issue shares in order to raise capital in the short term. That being said, they have ample working capital to meet the expected need for cash over the next 12 months.

     Definitely something to keep an eye on moving forwards.

8. Management

One of the key factors when analyzing a company - especially a ‘growth company’ - is the competency of management. There are several different things I would like to see when assessing the management team.

• Transparency

• Inside ownership

• Long-term orientated

• Experienced within the industry

• Passionate

• Strategic acquisitions

• General impression from interviews

Before outlining some of the key executives at EGLX, it’s worth noting the glassdoor score of 41% score for management. This isn’t great - I would ideally like to see a much, much higher score.

From looking at some of the comments it’s clear to see employees leaving poor reviews are generally referring to ‘growing pains’ due to the company growing so fast.

Management consist of a healthy mixture of gaming enthusiasts and industry veterans, for example Menashe Kestenbaum (founder) alongside individuals who have previously worked in sports entertainment and media - an industry sharing similarities with Enthusiast Gaming’s goals.

Additionally there is a significant portion of insider ownership, currently sitting at 30%.

ADRIAN MONTGOMERY

CHIEF EXECUTIVE OFFICER

“Vast experience in media, sports and entertainment, finance and industrial services. Most recently, he served as President and CEO of Aquilini Sports and Entertainment (Vancouver Canucks), one of Canada’s premier sports and entertainment organizations. He is the former president of Tuckamore Capital Management, a conglomerate with over $700 million of annual revenue, and was also the former CEO of QM Environmental, one of Canada’s largest contracting companies.”

This crossover from traditional sports to e-sports is a large positive for me.

Additionally, he comes across extremely well in all interviews and talks I’ve seen online.

MENASHE KESTENBAUM

PRESIDENT

“Menashe began his career in video games when he was 13, writing for IGN where he eventually became a community leader. After studying and lecturing in the Institute of Advanced Talmudic Law in Jerusalem for eight years, he returned to his passion for the video game industry and launched his first gaming blog, “Nintendo Enthusiast”, in 2011. In 2014, he returned to Toronto and incorporated Enthusiast. He has personally owned and operated gaming websites to a readership of over 2 million gamers, and has led Enthusiast and grown a writing and community staff team of over 84 people.”

ALEX MACDONALD

CHIEF FINANCIAL OFFICER

Was the CFO of Aquilini GameCo Inc., and led the 2019 mergers and acquisitions between Aquilini GameCo, Enthusiast Gaming Properties, Luminosity Gaming, and J55 Capital.

Prior to this he was the CFO of TSXV listed Peeks Social Ltd. (previously Keek Inc.) from 2014-2018.

9. Financials

9.1. Q1 2021 highlights

We’re almost at the announcement of Q2 earnings, so I won’t go into too much depth on the Q1 performance, although there are some interesting stats.

• Revenue was $30.0 million, a 321% increase vs Q1 2020 revenue of $7.1 million.

• Gross profit was $5.9 million, an increase of 80% vs Q1 2020 gross profit of $3.3 million.

• Net loss and comprehensive loss was $13.6 million, resulting in a net loss and comprehensive loss per share, basic and diluted, of $0.12.

• Direct advertising sales of $2.2 million, compared to $60 thousand in the same period last year.

• Paid subscribers grew 49% over the past 12 months to 137,000 paid subscribers as of March 31, 2021.

• 9.9 billion total views across written and video content.

• Strengthened balance sheet by approximately $50 million with the combination of a bought deal financing for gross proceeds of $42.5 million and the reduction of indebtedness through the conversion of outstanding debentures of approximately $9 million.

9.2. Revenue/profitability

Revenue for Enthusiast Gaming has grown considerably over the past several years. Mainly driven by the pandemic bringing more attention to gaming, and more specifically e-sports.

We don’t have years and years of financial data to look back on, however if we look at some y/y comparisons the growth of these numbers speak for themselves.

• Q1 2021 Revenue was $30.0 million, a 321% increase vs Q1 2020 revenue of $7.1 million.

• Gross profit was $5.9 million, an increase of 80% vs Q1 2020 gross profit of $3.3 million.

• Net loss was $13.6 million.

These gains in top-line growth were mainly driven by Covid and the uptake in gaming/esports. This led to direct advertising sales of $2.2 million, compared to $60 thousand in the same period last year, an increase in paid subscribers by 49% over the year to 137,000 paid subscribers as of March 31 2021, and finally an impressive total viewership number of 9.9 billion across all content.

Above we can see how Covid has impacted the revenue generation of Enthusiast Gaming and the gaming industry in general. However, it’s important to note the surprisingly low levels of profitability (or even losses) which are being sustained.

A gross margin on a TTM basis (Trailing Twelve Months) of 27.38% along with an operating margin and net profit margin of -34.39% and -46.01% respectively is less than ideal. However, management have long-term profitability planned for further down the line. As stated in several interviews with the CEO, if the company wanted to become profitable in the next quarter, they could. However growth is the key factor which is currently overriding the need to take profits.

“I think that we can similarly vault the gross margin up going forward and the reason is because as menasha had alluded to, historically we'd only ever sold our ads programmatically and we didn't have a direct sales function and we were selling for the most commoditized cost per thousands that we could that are out there because we were building the audience first.

I would say there isn’t really much use is comparing gross profit, operating profit and net profit with gaming industry counterparts due to the fact EGLX are purposefully operating at a loss for the time being as part of the long-term strategy.

I like this long-term thinking from management.

9.3. Revenue mix

As discussed earlier, the revenue is split between 3 main pillars - Media/content, E-sports & entertainment, and Subscriptions.

1. Media and content - mainly consists of advertising revenue on web and video platforms, and content licensing revenue. Video platform relates to the newly acquired Omnia. The increase in media and content revenue in Q1 2021 is mainly due to the acquisition of Omnia. Q1 2021 media and content revenue attributable to Omnia is $20.7 million. Q1 2021 media and content revenue excluding Omnia is $6.3 million, which increased $2.9 million compared to $3.4 million in Q1 2020, which is still an increase of 85%.

2. Esports and entertainment - Esports revenue relates to management services of other esports entities, sponsorships, prize money, merchandise sales, and other esports related sources. Entertainment revenue mainly relates to Pocket Gamer Connects mobile gaming events which occur throughout each year and the EGLX event which occurs in Q4 of each year. The decrease in esports and entertainment revenue was a direct result of Covid 19 and the inability to host an in-person event.

3. Subscriptions - revenue generated from paid subscribers to various offerings within the ecosystem. The increase between 2020 and 2021 is mainly due to to an increase in paid subscribers on ‘The Sims Resource’. EGLX had approximately 92,000 paid subscribers as at March 31 2020, increasing to 137,000 paid subscribers as at March 31 2021.

9.4. Balance Sheet

• Current assets = $43.7M

• Total Asssets = $236.2M

• Current liabilities = $22M

• Total liabilities = $53.5M

The balance sheet looks relatively strong here. The company’s total assets easily cover the current & total liabilities which allows the company to pursue the strategy of growth via acquisitions. The one negative is the fact that current assets does not cover the total liabilities. This ratio of 0.81 has improved since March 2020 where the current assets/total liability ratio sat at 0.35. Ideally I would like to see an increase to above 1.0.

As of 31st March 2021, the company’s cash position is relatively strong, although not entirely positive. The company have working capital of $21,642,243, which will be used to finance operations, growth, and mergers and acquisitions over the next 12 months.

$5 million of cash is expected to be required in the next 12 months, for which management believes that the existing working capital is sufficient. If more working capital is needed, the Company has revolving credit facilities of $14 million available to draw upon.

9.5. Cash flow

“During the three months ended March 31, 2021, the Company incurred a net loss and comprehensive loss of $13,565,128 (March 31, 2020 – $5,364,312) and, as of that date, the Company had accumulated a deficit of $111,802,958 (December 31, 2020 – $98,285,532) and negative cash flows from operations of $7,287,680 (March 31, 2020 – $4,930,645).”

It is uncertain as to when or whether the company can maintain positive cash flows from operation. The Company has not yet realized profitable operations and has mainly relied on non-operational sources of financing to fund operations.

It is entirely likely the company will continue to finance the company’s operations, growth and M&A through financing activities for the near future.

The below chart outlines the split of cash inflows/outflows. At some point down the line I would like to see this change to positive cash flows from operations and lower cash flows from financing.

9.6. Valuation

Valuation in this context is difficult - mainly due to the fact Enthusiast Gaming is growing at such rapid rates. However to inform the relative valuation of EGLX, investors should pay attention to key metrics such as user growth and ARPU.

EGLX is currently trading at a $594M market cap and a $587M Enterprise value. With TTM annual revenue at $73.6m, it puts the company at an EV/Sales ratio of 7.981. For a growth stock within the gaming industry - this seems reasonable.

And if we look in comparison to some other companies operating in the gaming industry, even though these companies are not ‘like-for-like’ they all can be classed as ‘entertainment companies operating within the gaming sector’.

One company I would have liked to compare it to is Skillz, who’s EV/Rev did not show up on Y-Charts. Theirs stands at roughly 20X.

In addition, if we look at where the company is planning on heading in the near future and beyond (an increase in ARPU to $3 by 2023), they are set to significantly increase revenue (750%). And then taking into account the potential increase in MAU’s, the ARPU figure of $3 could in-fact be fairly conservative.

*Firstly, Thanks for making it this far. If you would like to help support my writing, feel free to buy me a coffee by clicking on the link below.*

Buy me a coffee

10. Conclusion

Enthusiast Gaming are a fascinating company operating in a rapidly evolving industry.

If the company are able to execute in their goal of creating an engaged community of over 300M monthly active users, then there will be significant scope to increase monetization and become a very profitable company.

There are still major obstacles to overcome with regards to growth - i.e. executing on the four-step plan they have in place. However, if EG can successfully cultivate a community of lucrative gamers, then the sky is the limit.

If you wan’t to get exposure to the gaming industry, EGLX are one of the only publicly traded options in the gaming space.

• The company interact with over 300M gaming enthusiasts/fans every month.

• 43% of every American male visits one of EGLX’s properties every month.

• Gaming communities are going to become increasingly more valuable.

• EGLX are possibly the only vertically integrated gaming company in the world right now.

When investing, we are more-or-less looking for monopolies. So then we have to ask ourselves the question - “Can Enthusiast Gaming’s core business be easily replicated at a similar scale?” - and I think the answer is no, at least not easily and not without compromising the authenticity required for success.

To conclude, I believe Enthusiast Gaming is a great way to gain exposure to the evolving Gaming/Esports industy. Valuation is hard at these early stages of development, although I believe there will be significant upside if they can meet/beat ARPU and user-growth expectations.

The opportunity is not without risks (mainly financials). However, my confidence in the gaming sector combined with the vision of EGLX so far has led me to begin a speculative position.

I will be keeping a close eye on this one for the upcoming quarters.

Cheers,

Innovestor.

Alongside being one of the most dominant publishers on earth with a rich library of intellectual property at their disposal, Activision Blizzard have positioned themselves in a way to be able to effectively capitalise on the upcoming tailwinds within the industry.

Gaming is slowly but steadily creeping its way towards being the new ‘third place’ - with millions of users playing games simply to meet with friends. In addition to this, the upcoming boom of e-sports will take competitive gaming to another level - pumping billions of dollars into the industry.

With a management team and CEO proving their willingness to innovate and change along with the industry over the past 3 decades, I am confident the next 10 years will be just as fruitful as the last 10. This will only be the case if they can position themselves effectively over the next 1-2 years.

In this deep-dive I will be taking a look at Activision Blizzard’s business, the gaming industry and how the company has managed to adapt and change with the agility of a company a fraction of their size.

Short history

Activision Blizzard is an interesting company with a fascinating origin story which you can read here for a detailed background and here for a more personal look at the CEO. In summary, Bobby Kotick (CEO of Activision) has been at the helm for over 30 years having joined the company in 1990 and becoming the CEO the year after.

Activision struggled after the 1983 video game crash, where it changed its name to Mediagenic in an attempt to move into business software for the Mac. That failed, spurring Bobby to round up a bunch of investors to buy the ‘Activision’ name and its assets out of bankruptcy for $500k.

By 1995, Kotick had achieved the promise he made to the investors: that he would give them four years of 50% growth in revenues while remaining break-even. After reaching this initial goal, Kotick then set course on achieving the second promise he made to the investors: to develop high-demand games and make the company profitable.

Shortly after this, Bobby spearheaded various successful strategic acquisitions - leading the company to major success over the following 3 decades. Three of the main developments over recent years include:

• Infinity Ward Purchase in 2003 for $5M. The global gaming franchise is now worth billions in revenue on an annual basis.

• The merger with Blizzard in 2008. Blizzard owns some of the most valuable and popular gaming IP on the planet - inluding Diablo, Starcraft, and Overwatch.

• Acquisition of London-based ‘King’ in 2016 for $5.9B (The $5.9 billion price Activision is paying, at $18/share, is well below the 2014 IPO price of $22.50 a share). King make mobile gaming titles such as Candy Crush.

The business

The composition of ATVI’s business has changed over the years with several large acquisitions. The company is made up of three primary aspects - ‘Activision Puiblishing Inc.’, ‘Blizzard Entertainment Inc.’ and ‘King Digital Entertainment’. Activision produces titles like Call of Duty, Blizzard Entertainment produces titles such as Diablo, Starcraft, World of Warcraft and Overwatch. And ‘King Digital Entertainment’ is a mobile development/publishing team with the most famous title being Candy Crush.

In terms of revenues, we don’t know the exact details of the splits - however the estimate is that a large chunk (~70%) comes from just a handful of the titles.

Activition

• Activision’s main goal is releasing annual Call of Duty titles on various consoles and PC to achieve what is essentially recurring revenue.

• Currently the 3rd best selling video game franchise of all time with roughly 400M copies sold - behind Mario (805M) and Tetris (495M).

• Call of Duty is almost certainly the company’s most valuable piece of Intellectual Property.

• In late 2019 Activision made the decision to bring the Call of Duty franchise over to mobile - which increased the MAU (monthly active users) by 93M almost overnight.

• The introduction of the free-to-play Battle Royale element to Call of Duty (Warzone) was released on March 10th 2020 just before the pandemic and has been a roaring succcess.

“Because of it, during the second quarter of 2020, the hours played increased eight fold year on year. On PC, the hours played were double Black Ops 4, showing Activision that free to play is the right direction for a battle royale game, especially when plenty of great free to play BRs exist, such as Fortnite and Apex Legends. Revenue also hit a new record, increasing by five from last year due to the game’s battle passes, Call Of Duty points, premium store purchases etc.”

• Recently launched Call of Duty League (E-Sports) showing the value of owning your own IP. Comparing this to the termination of the destiny contract with Bungie in 2019 which negatively impacted the MAU - showing the opposite side of IP ownership.

• ‘Free to play’ models and E-sports will likely be a go-to business model moving forwards.

Blizzard

Blizzard has a handful of very successful IP’s for which they create new content - though not on a yearly basis like Call of Duty - these include Diablo, Overwatch, StarCraft, and World of Warcraft (possibly the most popular PC title worldwide).

• The majority of revenue here comes from the monthly/yearly subscriptions from WoW for which Blizzard produce regular updates.

• As mentioned above, the major difference between Activision and Blizzard titles is the frequency of releases - Blizzard being the less frequent, with bigger spikes in revenue.

• The margins on subscriptions for WoW are significantly higher than other areas of the business - making WoW one of the most profitable divisions.

• Overwatch was a relatively new addition which has since subdued in terms of revenues and viewing figures - however with the introduction of the Overwatch e-sports leagues and the upcoming release of Overwatch 2, this could change.

King

The acquisition of King Entertainment in 2016 was a huge deal for ATVI as it allowed the company to add ‘mobile gaming’ to their armory.

Bobby Kotick - “We see great opportunities to create new ways for audiences to experience their favorite franchises, from Candy Crush to World of Warcraft to Call of Duty and more, across mobile devices, consoles and personal computers”

One of King’s main titles, Candy Crush, is responsible for the lions share of the company’s revenue. Monthly Active Users fell by almost 40% in the first three years after the acquisition whilst revenue increased. This suggests the on-boarding of the Activision Blizzard strategy - to increase focus on the top performing franchises.

Strategy

ATVI’s strategy is to increase reach and engagement by reinvesting into existing franchises and adding new ones where appropriate. We have seen this recently with the renewed focus on Call of Duty - focusing on the free to play aspect along with e-sports.

Taking notes from Disney, the strategy of monetising across all mediums of entertainment is a proven strategy - and one that keeps users engaged.

Free-to-play

The free-to-play format has been around for several years now, with EPIC leading the way in the implementation of their immensely popular titles such as Fortnite and Rocket League. These titles have pioneered a whole new norm in the gaming industry.

In 2018, Fortnite made $2.4 Billion in revenue — the most annual revenue for any game in the history of the gaming industry, a record which is yet to be broken. Despite this fact, Fortnite accounted only for 2.2% of the gaming industry’s 2018 annual global revenue, which stood at $109 Billion.

In March 2020, ATVI entered the ‘free-to-play’ chat with Call of Duty: ‘Warzone’ - a Battle-Royale style model with revenue solely coming from in-game purchases.

“While ATVI does not breakdown in-game bookings revenue by segment, they noted in Q2 2020 that Call of Duty in-game net bookings more than doubled quarter over quarter and were around five times higher than a year ago. In Q3 2020, they noted that in-game bookings revenue was four times higher than a year earlier.”

Typically, game development teams work on a seasonal basis - with games being worked on throughout the year to be released before Christmas, therefore seeing big spikes in revenue in Q4 depending on how many copies have been sold. With this new model, ATVI were able to show quarterly revenues of over $1.9B for the first time in the company’s history outside of a seasonally strong Q4. There were some obvious tailwinds in the form of the global pandemic, however this increase in revenue was not driven by title sales, but rather in-game purchases - which is significant.

E-Sports

Among other initiatives such as TV/Entertainment and consumer products, Activision has been keeping a close eye on the e-sports industry which has been going from strength-to-strength over the past couple of years.

The company focus on two main opportunities within the esports realm - Overwatch League and Call of Duty League.

Overwatch League was launched in 2018 and was the first city-based esports league. The general structure is similar to that of a standard sports league - with city-based teams competing against each-other. Activision Blizzard have allowed entrepreneurs to run these teams as businesses, allowing the owners to share profits as the league grows. Another important distinction compared to other e-sports leagues is the fact that Blizzard operates and organises the whole thing - taking full control of their IP.

The Call of Duty league is more recent having kicked-off at the beginning of 2020. The reason CoD is being preferred as an investment over other IP like World of Warcraft is due to the fact that first person shooters are a much more widely played gaming genre and is therefore more marketable/profitable when selling to a mass audience.

With regards to revenue and growth, it is tricky to ascertain the exact level coming from these e-sports leagues as the company classifies this revenue as ‘other’. However, we can see the growth has been somewhat modest from 2019 to 2020 at only 6% - representing roughly 8.5% of total revenues. Realistically we would have liked to see a larger increase in revenue from 2019 to 2020 with a completely new league in CoD being introduced.

From this article, it is clear that the Call of Duty League is the growth driver whilst Overwatch is seemingly heading in the opposite direction.

As the overall e-sports industry continues to expand, ATVI are placing a bet on cementing a leading position within the industry. There is still a long way to go before we see this thesis play out, however the foresight to solidify themselves as part of the infrastructure within the industry seems like a winning strategy.

Gaming market

The gaming market is a complex beast It would take far too long for me to go into the granular details within this report, however I’ll attempt to outline the wider landscape for context.

Many among us will not realize the scale of this sector, but the gaming industry has grown to become the largest subset of the entertainment industry. Even bigger than the movie & music industry, both of which combined made $60.8 Billion globally in 2018. Around 80% of the total gaming industry revenue in 2018 and 2019 was attributed to the free-to-play business model. 

Video games have developed significantly over the past 20 years. Anything pre the year 2000 we were playing offline - it involved you on your own or with a friend sitting next to you.

With the widespread adoption of the internet in the early 2000’s came ‘social gaming’ - where you could be in your lounge playing against a player on the other side of the world. This phenomenon kick-started the growth in the gaming industry as gaming was no longer an anti-social activity and enabled a competitive element.

Roughly 10 years ago, the industry was more heavily concentrated towards console gaming (50%) with PC gaming making up about 33% and mobile only about 5%. This has changed dramatically over recent years, with mobile gaming growing to 33%, PC gaming dropping to 26% and console gaming dropping to 30%.

This article outlines the huge potential growth happening currently in mobile gaming industry. To summarise:

• Covid drove demand for mobile gaming. This demand doesn’t seem to be reducing as Covid is slowly going away.

• Users worldwide downloaded 30% more games in the first quarter of 2021 than in the fourth quarter of 2019

• Spent a record-breaking $1.7 billion per week in mobile games in Q1 2021. That figure is up 40% from pre-pandemic levels.

Activision Blizzard have done a good job of changing their product mix over this period of time to represent the changes happening within the industry - most notably with the acquisition of King (mobile games) in 2016.

Growth

Even though 2020 was an abnormally good year for the gaming industry (and ATVI in general) it doesn’t look like growth is slowing.

“Call of Duty mobile reached 500 million total downloads during the first quarter, helping the company as a whole generate $2.9 billion in trailing 12-month free cash flow -- 103% more than the same period a year ago.”

Moving with the times in order to target a whole new player-base has enabled Activision to dramatically increase their user-base

By adapting a long-loved franchise to new systems, Call of Duty was able to dramatically expand its potential player pool. The CEO Bobby Kotick has expressed his desire to carry forward this formula to other games - "Call of Duty is the template we're applying to our proven franchises."

It’s hard to predict the growth within the gaming industry as it’s constantly evolving and adapting to various technologies. For example, we have completely new gaming mediums coming into play over the next decade such as Virtual and Augmented reality - we have no idea how these will play out over the long-term.

We can, however, draw some generic insights (Grand View Research):

• Free2Play (F2P), Massively Multiplayer Online (MMO), and multiplayer games have progressively gained popularity, a trend which is anticipated to continue over the next eight years.

• The rising disposable income level is leading to an increased consumer spending on gaming products.

• Large-scale adoption of more advanced gaming consoles equipped with sophisticated features such as record and share and cross-platform gameplay.

• The trend of social media gaming is expected to have a positive impact on shaping up the market growth. For instance, a substantial percentage of the global population use social networking sites such as Facebook and Reddit for gaming.

• Growing popularity of eSports tournaments and the increasing number of professional gamers are anticipated to increase sales of video games and accessories along with gaming hardware and software.

• The video game market is experiencing high demand in various avenues such as educational institutes and corporate enterprises. The adoption of gaming as an educational tool provides opportunities for deeper and cognitive learning. The concept of ‘gaming to learn’ has been around for quite some time. However, the actual potential for gamification possibilities in the academia vertical is being exploited only recently.

Some independent growth projections include:

• Grand View Research predict the U.S. gaming market to increase from $151B in 2019 to $450B in 2028 at a CAGR of 12.9%

• Research and Markets predict the global gaming market to reach a value of US$ 287.1 Billion by 2026, exhibiting a CAGR of 9.24%.

Metaverse

As mentioned above, one of the most interesting aspects of the gaming industry is the increase in social inter-connectivity. A more and more widely held belief is that video games are beginning to act as not simply a place to play games, but a place to hang out with friends.

This brings us onto the subject of the Metaverse, which is a complex and relatively undefined area in its own right - but is likely to be crucial for the future of gaming and the way we connect. I posted a thread not long ago giving a brief overview of the metaverse (below), which goes over most of what you will need to know.

The ‘modern’ ideas of the metaverse - pioneered somewhat by Matthew Ball and his fantastic essays - isn’t visible in any form just yet. In fact, nothing even comes close. That being said, there are some examples of metaverse-like ‘ideas’ present within modern gaming and more specifically the Battle-Royale games such as CoD and Fortnite.

• Cross platform play.

• Increasing number of concurrent players (CoD experimenting with 150 players in a lobby).

• Custom avatars more common. There are even secondary markets selling in-game items.

• Areas available just to ‘hang out’ and chat with friends.

• User generated content is available.

This ability to add a layer of autonomy to the game, to make it feel personal to you, the player, is crucial to the continued stickiness. You are much less likely to leave the game (and therefore the virtual marketplace) if you have a bunch of psychological reasons to keep you there.

Humans love autonomy and identity. So the games best serving this to the masses will likely finish on top.

Social gaming

Within the context of gaming it looks increasing likely that Call of Duty and other Activision Blizzard franchises (but most likely Cod) will look similar to a social network. Not necessarily anything to do with a ‘metaverse’ - but it will likely share some of the social aspects.

Activision will benefit from this in the sense that once we learn how to play the game and our friends learn how to play the game - we have purchased our in-game items, upgraded our weapons etc. it will be a much harder mental task to switch to another game.

In addition, the positive social re-enforcements we get from playing the game with friends that connects winning a game (for example) to CoD is another strength for the IP. The gamer is far more likely to go out and purchase something Call of Duty branded because they have that positive experience.

I remember making a similar argument for Disney in a previous article, where strong IP mixed with positive experiences and the optionallity to purchase that IP via a different medium is a powerful thing.

Overall, the increases in social experiences within gaming can only be good for ATVI as more players use the games as a place to meet.

Management

Bobby Kotick - CEO

As mentioned earlier in the article, Bobby Kotick is an interesting character with a rich history. Interestingly, he has also proven himself to be an astute CEO with an incredible eye for detail and a healthy obsession with capital allocation (similar to Warren Buffett) - indicating in past shareholder letters that he looks up to the famous investor.

Bobby is young for a CEO at 57 years old, yet has over 30 years experience of successfully growing and operating Activision.

He is passionate about the business and has over 2.5million shares in the company - so a large personal stake.

“I think that you can’t do what I’ve done for 30 years without that relentless focus on doing better. I come to work each day wanting to improve. And so I think that commitment to excellence, and wanting to improve can come across sometimes as dissatisfaction or unreasonableness.”

Dennis Durkin/Armin Zerza - CFO#

Dennis Durkin worked at Microsoft for 12 years and as the CFO/COO of Xbox, before joining ATVI in 2012 as the CFO. The insights Dennis was able to bring from Microsoft (semi-competitor) I’m sure will have been invaluable over the years.

“Dennis has been a key contributor in some of the most value-creating moments of our history, including the buyback of control from Vivendi in 2013 and our expansion into mobile through the acquisition of King.”

In the most recent earnings call the company announced the appointment of the new CFO - Armin Zezra.

"“Also in the service of our shareholders, I'm pleased to introduce Armin Zerza as our new chief financial officer. Armin's deep experience as a global finance and operations executive and his contributions as chief operating officer of Blizzard and chief commercial officer of the company, make him especially well suited to serve as our next CFO.

In his six years with the company, Armin has been a central figure in the company's continued growth and record financial results. He has the commitment to profitable growth and operational excellence that our shareholders have always recognized us for. And Armin comes to the role with an incredible team assembled by Dennis and Thomas over the last decade.”

Bull Case

1. Strong IP:

• Activision Blizzad are in a strong position with their intellectual property - a position they have built up over the past 3 decades by creating and acquiring new innovative content. Arguably, however, the Call of Duty franchise is the the most valuable aspect in the ATVI ecosystem, although WoW, Diablo, StarCraft, Candy Crush and Overwatch all have potential to be strong brands.

  The first CoD title was created and released in 2003 by a games development studio called Infinity Ward which was purchased by ATVI. The first release garnered a Metacritic score of 91 - making it rank within the top 3% of all time games. Since then, the company have released a new version every year.

  The CoD franchise has sold more than 400 million units to-date, cementing is as the number 3 all-time highest selling franchise behind Mario (~805M) and Tetris (~495M). The brand loyalty Call of Duty has built up over the past 20ish years is unmatched.

2. Huge opportunity with E-Sports:

• The E-Sports industry is just getting started.

  In 2021 alone, E-Sports is predicted to have more viewers than any sports league (apart from the NFL). This growth is predicted to continue over the next 5-10 years - posing a fantastic opportunity for ATVI to capitalize on a growing market.

3. Gaming, and more-so ‘social gaming’, is set to explode:

• With the rise of titles like Fortnite and Roblox over the past 5 years, we have seen a massive move towards gaming for the sake of meeting up and talking with friends.

  Fortnite offers features allowing players to join a game chat without having to actually be playing the game. And from personal experience, a large reason why I game at all is to connect with friends who I would not otherwise speak to.

  Social gaming has come a long way over the past 2 decades, but still has a long runway in my view.

4. Adopting free-to-play business model:

• Similar to the point above, the adoption of the ‘free-to-play’ business model has given the company a new lease of life - stimulating overall engagement as well as in-game sales.

5. Optionality from IP:

• The benefit for ATVI of having a large user-base emotionally invested in your IP is that they have the ability to create revenue generating content/products outside of gaming alone.

6. Benefit of scale:

• Most large gaming franchises like CoD also receive some scale benefits.

  If we take marketing as an example, Activision most likely spends over $200 million on marketing alone for a single Call of Duty game release. Then when you compare this to other game franchises that would struggle to make $200 million in revenue, you can begin to see the benefit of scale.

  Additionally, due to the sheer popularity of the game with streamers, (currently number 2 behind Fortnite) the CoD title will reach much larger audiences - and engaged audiences at that. This fact alone will more than likely lower the unit cost of marketing via these channels.

  

  Lastly, the strategy of using the current large user-base to market other titles ‘in-game’ is proving to be a useful too. For example, the free-to-play Warzone game held an in-game event to release the trailer of the new 2020 Cold War game. Over 1 million people turned up to participate in this event.

7. tailwinds from the pandemic:

• ATVI were clearly one of the major beneficiaries of the global pandemic. With millions of people out of work and having more free time, video-games became a standard past-time. Revenue rose 24.6% to $8.1 billion, while net income rose 46.2% to $2.2 billion.

8. Experienced management

• Management have a history of good decision-making with acquisitions, pay cuts and over 30 years of experience within the gaming business.

Bear Case

1. Increased competition:

• As with any expanding industry, the level of competition increases as the potential opportunity becomes more clear. Alongside this, the barrier to entry for becoming a game developer is reducing significantly.

2. Too concentrated on one franchise:

• The trouble with focusing too heavily on only a handful of franchises/IP’s is the risk that players and developers essentially get bored. Also, the over-reliance on one source of revenue is a huge risk.

  IP fatigue is real risk (for both players and developers). In order to tackle this issue the company had to innovate. The CEO stated in a recent interview about giving control to the dev team - “They’re the ones that make the decisions about what the product is going to be or what content they’re going to create,” “And the business is way too large for me to be able to get involved in those kinds of decisions. I don’t have the skills that our heads of studios and heads of franchises have.”

  The company’s ability to create high-quality content consistently is a massive factor in the continued success.

3. Are they really innovating enough?

• The question has to be asked whether ATVI are innovating as much as they could be considering the lack of presence in the AR/VR industry (as one example).

  My opinion on this one is that yes, the company are doing enough. They are experimenting with mobile, free-to-play and e-sports already. Bobby Kotick stated recently that “Activision Blizzard will not roll out VR products until we feel like we are pushing the art form forward."

4. Questions over management:

• On one hand it could be argued management have shown some level of insensitivity. For example, in 2019 the company laid off 800 employees after a very successful 2019. Also the company has been accused of underpaying staff whilst taking home large checks.

  

  Alongside this, there are genuine questions about overall employee happiness - as seen in glassdoor ratings that have been declining over the years (above).

  On the other hand, it seems management are aware of negative public opinion and are making steps to correct this. Taking recommendations from shareholder groups, Bobby Kotick reduced his compensation, cutting his base salary in half to $875,000. He will still get bonuses based on how the company performs over multiple years, and his contract has been extended through March 31, 2023.

Financials

If we start by taking a broad look at the price movement of ATVI over the past decade, we can see the company have generally outperformed the majority of the gaming industry alongside various benchmarks including the NASDAQ and S&P 500.

This is a good indication that, over the longer term, Acvitision Blizzard are capable of thinking ahead of the competition and making significant changes where necessary.

Q1 2021 performance

Bobby Kotick - “Everything was up, year over year. Call of Duty was up. Candy Crush was up considerably. Blizzard was up. Across the board, the business is going well. The pattern is strong. Free-to-play introduces people to the franchise.”

• 27% revenue growth to $2.28 billion for the first quarter ended March 31

• Activision Blizzard (including King) had 435 million MAU’s, compared to 397 million MAU’s in the previous quarter. Kotick said in the earnings call that the goal is to hit a billion users, and he noted Call of Duty gained more than 100 million players in the past year

Activision

• Activision’s Call of Duty franchise continued to outperform last year’s results as people continued to play a lot more games during the pandemic

• MAU’s tripled over the past couple of years, with the current number sitting at around 150M (up 40% from Q1 2020).

• GAAP revenues for the first quarter ended March 31 were $2.28 billion, up 27% from $1.79 billion a year ago. GAAP EPS were 79 cents, compared to 65 cents a share a year earlier.

• Call of Duty: Mobile’s debut in China in December generated tens of millions of new players, said Daniel Alegre (the chief operating officer of Activision Blizzard) in the analyst call.

Blizzard

• Revenue growth +7% from 1 year ago, led by strong growth in the Warcraft franchise. World of Warcraft’s Shadowlands expansion has grown, and Blizzard had 27 million MAUs in the first quarter.

• Overwatch expected to arrive in 2022.

King

• Revenue growth of 22% in the quarter

• 258 million MAU’s in the quarter (down from 273 million a year ago).

• One driver of growth was Crash Bandicoot: On the Run, which launched March 25 and has seen more than 30 million downloads to date. That likely helped with MAUs.

• 70% growth in advertising net bookings in the first quarter, with significant increases across both direct brand advertisers and partner networks. Bookings have stayed strong in the second quarter

• Mobile is continuing to benefit.

Rev vs EPS

From first glance, over the past decade, EPS (earning per share) has been growing at an impressive average of 20% per year compared to revenues which have been averaging around 7% comparatively.

The explanation for the disparity between EPS and revenue growth is down to several factors. One is the move from physical to digital (higher margins) for which the whole of the gaming industry is experiencing. Two, Activision Blizzard repurchased 1/3 of their outstanding shares from Vivendi in 2013 at roughly $13.60 per share. That investment alone has returned an average of 28% per year against the cost of debt which was 5%. And three, the purchase of King in 2016 for a reasonable price which enabled the company to get into the mobile gaming industry.

Monthly Average Users

Another important metric to consider is the MAUs (Monthly Active Users) as this is a good general proxy for the overall health of the business. From the graph below, we can see there has been a steady decrease in overall MAUs since late 2016 (roughly since the acquisition of King).

In late 2019/early 2020 we can see a spike in total MAUs which looks to be mainly driven by the pandemic, however a substantial amount of the growth within this period could be attributed to the introduction of CoD Warzone, CoD Mobile and CoD E-Sports league. This indicates the strategy of concentrating investments towards the most successful IP is clearly working.

Learning from companies like Disney & Nintendo - maximising the potential of your best IP can be a winning strategy. And I think Activision Blizzard will be closely following this road-map.

Revenue/profitability

As a direct result of the increase in MAU’s, profitability has also been increasing for Activision. As the game has continued to mature, providing map updates, map alterations, gun additions, new characters and more ‘in-game’ purchasing options - ATVI’s profitibility has began to noticeably increase. This is because the ‘in-game’ section of revenue is by far the higher margin portion of the revenue.

The above chart illustrates the increase in profitability over the period of time from 2018 to now (Q1 2021). And we can see that since the inception of CoD warzone in early 2020 (period 9 on the chart below) total net bookings has climbed significantly - leading to an overall increase in revenues in the periods where, traditionally, net bookings are lower.

These results stem from the additional options for in-game purchases, as evidenced by the 4 consecutive periods of in-game bookings above all-time highs.

Gross Margin

The margin makeup of Activision Blizzard over the past few years has changed significantly due to several reasons, but the main one being the change from physical sales to digital. As this change within the gaming industry continues, we are likely to see the gross margin element of ATVI increase over the next 5-10 years as the focus shifts to mobile and digital sales which are inherently higher margin areas.

In addition to this, another driving factor for the potential increase in overall gross margins will be the reduction in platform fees (hosting) due to improvements in technology efficiencies.

Currently the gross margin sits at around 72% with the operating margin at 35% and net income at 27%. With the tailwinds mentioned above, it’s within the realms of possibility for gross margin to continue to increase over the coming decade to around 78% within the next 10 years.

Operating Margin

Next, comparing operating margin to that of competitors within the industry shows that ATVI is significantly above the industry average of around 18.5%, and has been consistently operating above the competition for quite some time now. This dominance in operating margins is good to see.

I would expect that as Activision Blizzard continue to grow and invest over the next decade, we will see somewhat of a reduction in R&D expenses as a percentage of sales as the company move focus to their most valuable IP. Secondly, the move to the free-to-play model will encourage an increase in in-game sales which have an inherently higher margin makeup. Lastly, as the e-sports industry continues to grow, we should expect to see increasing margins here too.

Balance sheet

• Current assets = $10.92B

• Total Asssets = $23.42B

• Current liabilities = $3.18B

• Total liabilities = $8.09B

ATVI currently have, and have historically had, an extremely strong cash position (as we can see from the most recent balance sheet snapshot). This can be seen as a good and a bad thing. Good in the sense that current/Total assets easily cover the current/total liabilities, and the fact it allows the company to be in a good buying position should the right opportunity present itself. On the other hand, the opportunity cost of holding so much excess cash is a reality if there are other, better, opportunities to invest in the market/projects at any given time.

Bobby kotick (CEO) has a reputation for prudent capital allocation as many of his philosophies regarding investing and capital management relates closely to those of Warren Buffett.

Adding to the above, and re-enforcing the point about waiting for the best opportunities to present themselves, the purchase of King in 2016 was a great opportunity at a reasonable cost.

Cash Flow

Taking a quick look at the cash flow situation - we can see ATVI operate a strong cash position, with the majority of the cash flow coming through their operations. Historically, as seen below, the Cash Flows have been somewhat predictable, following a seasonal nature, with the majority of sales (and therefore cash) coming at the end of the year (near christmas). The change in strategy towards ‘free-to-play’ and ongoing e-sports leagues should result in more of a consistent cash stream - relying less on the success of the yearly titles.

The Valuation

When we begin to compare some of the key metrics with other companies in the gaming industry, we start to get an idea of how well ATVI compare.

Firstly, looking at the operating margin between the 4 companies, ATVI’s sits at 35.19% for the past 12 months - more than double that of every other competitor. This operating efficiency dominance is within the context of significant revenue growth - 32.8% compared to the next closest which is Ubisoft at 25.6%.

Importantly, we can see that ATVI are not just leading in one of these metrics, but in many.

Multiples

Looking at the multiples we can immediately see ATVI are trading at the richest EV/Revenues valuation of 7.6X.

However, if we then look at the EV/EBITDA ratio (purple table above), we can see ATVI trading at somewhat of a discount to (or at least on par with) their nearest rivals. This is with the context of much better top-line revenue growth, better operating margin and a less cyclical business model.

If we were to say ATVI were trading at a similar EV/EBITDA ratio to TakeTwo (28.93X) then the company would have a market cap of $94.46B and therefore a share-price of (94.46/0.77702 *777M shares outstanding*) = $121.57 which represents a potential upside of 32%.

I would guess most of the current pricing assumes that Activision Blizzard will struggle to keep up with the uptick in business from the pandemic, and therefore the relative success seen throughout 2020 will revert back to pre-pandemic norms. However, in my opinion the business has fundamentally changed - a new strategy is in place in order to focus on the popular IP and reduce the cyclical nature which will benefit them for the long-run. Adding to this, CoD Warzone is still the second most streamed game over 1 year on from its release and CoD (the overall franchise) is number 3 in most titles sold ever with 400M copied - coming in behind Tetris and Mario.

Conclusion

To conclude, as Activision Blizzard continue to cement their position within the gaming industry with their valuable IP, capable management and a robust yet evolving business model. I am confident they can continue to lean into the tremendous opportunity that is ‘gaming’ over the coming decade.

The past several years has seen the industry evolve rapidly - adopting new features and hardware (such as social gaming, e-sports and VR/AR) which has completely altered the gaming landscape. ATVI has adapted quickly to these changes, bringing in new business models for existing IP (free-to-play) and dipping their toes in completely new areas (e-sports). Both of these moves are encouraging, as it signals managements intent to bring ATVI into a new generation of gaming.

That being said, there remains several very real risks…

• The management become far too reliant on one IP (CoD)

• Management too cautious with investing cash

• The gaming segment doesn’t take-off like we predict

• Much of the current upside over the next decade is already factored in

However, I believe the overall future for ATVI is a bright one. The recent changes to the company have come at a perfect time - stimulating engagement and overall sales throughout the pandemic, leading to increased profitability and greater long term potential.

ATVI is a strong play on the future of gaming.

Cheers,

Innovestor

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My aim with these deep-dives is to make the research process of investing in individual stocks more accessible. Enjoy!

1. Thesis

2. Key takeaways

3. The business

4. Market Opportunity

5. Competition

6. Bull Case

7. Bear Case

8. Financials

9. Conclusion

1. Thesis

E-commerce is slowly but steadily becoming the norm. The past decade has seen Amazon rise to be one of the worlds most influential companies, and is one of the few that if it were to disappear tomorrow, we would most likely see a dramatic impact on the global economy. The company has slowly but surely weaved its tenticles into almost every core activity we do - entertainment, food shopping, clothes, general shopping, business operations, AWS (the list goes on).

Technology is dragging traditional retail kicking and screaming into the 21st Century. 15 years ago smart phones were only just emerging and the majority of shopping was completed in traditional bricks and mortar stores. Just 15 years and 1 global pandemic later, we can see e-commerce becoming a more ingrained part of our everyday lives.

With that being said, MercardoLibre are looking to use the blueprints of the first movers in order to apply a similar model to Latin-America - a rapidly evolving demographic in terms of digitisation and technology adoption.

The company have been quietly executing over the past decade in order to be in with a shout of total continental domination. Management recoginse the longer-term opportunity present within the Latin American market, and are therefore sacrificing short-term profits by investing heavily in the platform. All this with the intention to grow market share for long-term continued success.

Whilst macroeconomic risks may challenge the company’s prospects (such as currency fluctuations as well as political turmoil), the powerful tailwinds are more than likely to fuel the company’s future growth.

2. Key takeaways

• Meli are heavily concentrated on both e-commerce and fintech, so could be considered the love-child of Amazon, Square and Paypal.

• Latin America are roughly 10 years behind the U.S. in terms of e-commerce purchase rates (currently 4% - roughly where the U.S. was about 10 years ago).

• MercadoLibre intends to drive forward environmental objectives such as: clean transportation, land conservation and preservation, energy efficiency, renewable energy, green buildings and pollution prevention and control.

• “Present in 18 countries including: Argentina, Brazil, Mexico, Colombia, Chile, Venezuela and Peru. Based on unique visitors and page views we are market leaders in each of the major countries where we are present.”

• Latin America’s middle-class composition jumped from 20-30 percent to 60-70 percent over the past 10 years. However, half of that middle class is in a vulnerable position.

• 59% of Latin America have internet access

• 70% of adults are unbanked.

3. The business

3.1. History

The current CEO, Marcos Galperin, attended Stanford Graduate School of Business at age 26 where he came up with the idea for MercadoLibre in 1999. Soon after he had the idea, he was able to convince Stello Tolda (current COO) and Hernan Kazah to join him on the journey to create one of Latin America’s most successful e-commerce companies.

Hernan Kazah - “At the time there were like 80 other companies throughout Latin America following the same business model. We may have had a great team and long-term vision. But the idea was not unique. Even our friends sometimes got confused about which business was ours.”

After years of building up MercadoLibre, expanding into new markets and raising funds - the company became the first Latin American company to be listed on the NASDAQ and to this day is Latin America’s most popular e-commerce site.

Coincidentally, on the same day, (august 9th 2007) BNP Paribis froze $2.2B in assets - signifying the start of the global financial crisis.

Compared to their major international competitors (Amazon, E-Bay, Alibaba) MercadoLibre was a relatively late-mover - 5 years later than Amazon, 4 years later than Ebay and 4 months after Alibaba. Although not first to the scene, Meli have used their lagging position in the market as an advantage, learning from the mistakes of their competitors.

3.2. Company overview

‘What does MercadoLibre do?’ is not such a simple question to answer. The company have their fingers in many different pies.

Meli aims to enable e-commerce and digital payments throughout Latin America by delivering a suite of technology solutions across the complete value chain of commerce. The company have established themselves as the largest e-commerce player in Latin America, and operates across 18 countries, with a market leading position in each of the major countries.

Latin America, which comprises of over 650M people, is also one of the fastest growing regions in terms of digital/technological adoption. These factors will serve as a huge tailwind over the next decade, however the region also entails significant risks, such as currency fluctuations and civil unrest.

3.3. How they make money

Mercadolibre currently operate in 18 countries, some of which include Argentina, Brazil, Mexico, Colombia, Chile, Venezuela and Peru. The company are market leaders based on unique visitors and page views in each of the major countries in which the they have a presence.

At the core, Meli’s business model is predicated on the innate belief that entrepreneurs are the driving force of the economy - and that the empowerment of entrepreneurship can drive economic growth.

The company started out by simply taking a cut of the sales from the original online marketplace (e-bay type model). Nowadays, Meli delivers e-commerce and digital & mobile payment solutions to both buyers and sellers via different technology verticals.

“Our company was born with a purpose: to democratize commerce and money, equalizing the opportunities between large companies and small entrepreneurs, by reducing geographical and economic gaps.

This virtuous ecosystem is guided by a conviction and is that entrepreneurs are the true agents of change. That is why, through what we call Entrepreneurial Effect, we promote those who lead the strategies in which we work and generate a triple impact; for your business, for your communities and for the planet.”

Lets dive deeper into the various aspects making up the entirety of MercadoLibre’s model. There is a lot to unpack…

As outlined by the above graphic, there are 6 main segments to the business; Libre (marketplace), Envios (logistics), Credito (credit), Shops, Mercado pago (payments) and Libre Publicidad (advertising). This combination of products and services amalgamates in a well oiled ecosystem - elevating the average person’s ability to buy, sell, create a business, and access credit… all within one system.

These elements have been the result of a slow but steady building process over the past several decades.

1. Libre Marketplace:

   The marketplace is (and always was) the core of Meli’s business. Starting off as an eBay replica, the company operated an automated e-commerce platform allowing anyone to buy/sell goods online.

   As arguably the most well established of the business segments, you would maybe expect growth to somewhat plateau. However, as technology/internet penetration continues to grow within Latin America, there is still plenty of room for growth. Advertising alone has the potential to substantially increase returns. Amazon, for example, operate mainly in the US which has an almost fully penetrated internet market, and are predicted to generate over $26B in 2021 alone.

2. Envios (Logistics):

   Envios operates a very similar model to Amazon logistics, with a mixture of solutions - including drop-shipping, fulfillment, cross-docking & flex. But at it’s core, the Enios service is a powerful tool to connect otherwise disparate locations. This is achieved through a mixture of first and third-party logistics providers.

   Part of the recent strategy from management was to double-down on investments in Meli’s logistics. As a result of these investments, Meli is currently positioned as the leading logistics service within the region - this is taking into account that Envios is only available in 6 of 18 current locations.

   • Over 208M items shipped

   • Grew over 130% y/y

   • Network penetration of 80%, up from 46% y/y

   • 74% of all volume delivered in less than 48 hours

   • Free shipping threshold reduced

3. Libre Credito: Relatively straight-forward - Libre Credito provides users of the platform access to credit (loans) at favourable rates.

   The Credito service solves the regional problem of the majority of people needing access to credit in order to build and scale small businesses, however lacking access to credit. Via Credito, Meli are able to underwrite customers who would otherwise not be eligible for credit.

   The direct effect of this is an increase in small businesses selling on the platform, which leads to an increase in products… therefore fueling the fly-wheel.

   

   The company are also starting to offer credit for buyers, given the low penetration of credit card holders in LatinAmerica. This has allowed normal people to buy higher-ticket items - thereby increasing the attractiveness of becoming a seller on the platform. 

4. Mercado Shops:

   A similar idea to that of Shopify - the ‘Shops’ division enables a user to set up an online store, with the benefit of having access to other valuable ecosystem assets such as traffic from marketplaces and easy integration with payment solutions.

5. Libre Publicidad (Advertising): Enables businesses to promote their products and services on the Internet through MercadoLibre. As mentioned earlier - the potential to grow the online advertising business as more and more people use the platform is a huge revenue opportunity.

6. Mercado Pago (Payment solution): 

   Akin to Paypal or Square. Over the past several years Meli has introduced an integrated payment system, allowing Latin America to move away from cash. The payment business is getting really big, really fast.

   Originally, Mercado Pago started out as a service where you could deposit cash, transfer to credit, then use it in a card form. The popularity of this service, combined with the introduction to third parties/bricks & mortar retailers saw an explosion in usage and uptake. Meli had stumbled onto a potentially huge growth lever.

   • Total Payment Volume reached almost $15B, growing 129% y/y

   • Reached a total of 630M transactions for Q1, growth of 117% y/y

   Under this business segment, Meli operate several different financial service products - credit, Point of Sale systems (similar to Square readers), pre-paid cards, digital wallets, merchant services, and investment accounts (Mercado Fondo).

   Mirroring the company’s overall strategy/ethos, the sheer variety of payment services shows their intention - to create an ecosystem where the added value of the combination of services is unmatched. This desire to create a comprehensive financial system stems from the inherent lack of banking infrastructure in the region.

   4% of the US and 1% of the UK are unbanked - compared to 63% of Mexio and 54% of Argentina. 

3.4. Management

One of the standout aspects in the story of MercadoLibre is the competence of the management team, spearheaded by the CEO - Marcos Galperin. Beneath Galperin we have Dan Rabinovich (COO), followed by a handful of ‘Presidents’ and Vice-Presidents’ who are essentially CEO’s of the various departments within their own right.

From various interviews over the years, a picture emerges of a passionate and highly competent CEO in Galperin - who has managed to slowly curate a team of highly effective executives across a range of different domains.

• Pedro Arnt - CFO

• Osvaldo Giminez - President of Fintech

• Martin de los Santos - Vice President of Finance

• Stelleo Pasos Tolda - President of Commerce

• Ariel Szarfsztejn - COO of Mercado Envios

2 examples of management’s effectiveness…

Overcoming obstacles

Over the past decade, Galperin had a vision of improving the logistics infrastructure within Latin America - and to achieve this he started Mercado Envios in 2013. Over the following years the company invested large sums of money into the venture. By the latter half of the decade, MercadoLibre’s infrastructure system spanned to Brazil, opening up completely new (very large) markets.

However, in 2018, Brazil’s national postal service raised it’s prices - resulting a huge blow for the company.

Instead of backing off when finances were under severe pressure, Galperin decided to invest more and more money into MercadoLibre’s infrastructure system - expanding fulfillment and free-shipping capacity within the reigon.

This risk paid off. By 2019, Mercado Envios (the logistical arm of MercadoLibre) were handling over 80M packages per quarter across six countries. MercadoLibre were fully established as the core logistics within the region.

This upfront investment into the business will likely prove to be a deciding factor in the future success of the company.

Knowing the market

A question you may be asking yourself is “why can’t another global e-commerce player get involved within the Latin American market? The opportunity it offers is so great - why would someone like Amazon ignore it?”

One of the answers is the fact that management have a good understanding of the intricacies of operating within the Latin American Market. Galperin and his team decided early on to adopt the structure of different teams for different geographies. This allowed the company to be more agile in responding to differences within the regions - adapting product-market fit to the local circumstances. Other companies, like Amazon, adopted more of a ‘top-down’ approach. Which has seemingly been less effective.

4. Market opportunity

This graph, from the company’s 2018 business overview slides, is a great way to visualize the potential for Latin America to grow into their position within the overall market. There is evidently still a long runway ahead.

Covid was a large factor in the uptick in online e-commerce sales. From Statista: “In the week starting April 6, 2020, e-commerce revenue in Peru increased ten times (that is 900 percent) compared to the week starting March 9th In Latin America. Altogether, the growth rate in the period amounted to 230 percent. The changes were linked to the outbreak of COVID-19.”

If the pandemic had only lasted 2 or 3 months, I believe we would have been back to our old ways of traditional retail. However, the fact the pandemic is still ongoing (over 1 year later) has resulted in the formation of new habits. Habits are a powerful thing, and not easy to change.

In my opinion, Online commerce is here to stay. From Statista: “Of digital buyers surveyed in Latin America, 78 percent said they were willing to continue shopping online after the sanitary emergency.”

4.1. Total Addressable Market

“In 2018, the percentage of consumers who made at least one purchase online in the previous 12 months grew to 93% of internet users in the U.S., 97% in the UK, and 92% in China. The market of developed countries is in its maturity phase”

The TAM (Total Addressable Market) is one of MercadoLibre’s greatest opportunities, yet potentially the most daunting challenge.

Latin America’s current population sits at roughly 660M and boasts one of the fastest internet penetration growth rates over other nations - and there is still a long way to go in comparison to other continents. For comparison, Europe’s internet penetration sits at 88% and North America’s sits at 94%.

When trying to figure out the potential market opportunity available for MercadoLibre, it is worth separating out the two distinct areas of operation - eCommerce and Digital Payments.

E-comm

• According to statista, revenue in the e-commerce market is projected to reach $49B in 2021 with an expected CAGR (compound annual growth rate) of 8.34% - Resulting in a projected market volume of $68B by 2025.

• In 2020, more than one third (roughly 220M) of internet users in Latin America will have purchased products online. By 2022, this figure is expected to grow to nearly 35 percent, reaching over 277 million digital buyers.

• In 2019, retail e-commerce sales in Latin America surpassed 70 billion U.S. dollars. According to forecasts taking into account the impact of the COVID-19 pandemic, this figure is expected to reach almost $116 billion by 2023.

• In 2020, e-commerce sales were estimated to account for 5.6 percent of all retail sales in Latin America. This figure was forecast to continue growing in the following years, surpassing seven percent by 2023. Comparatively, U.S. e-commerce penetration levels are much much higher at around 33%. The U.S. experienced similar levels of e-commerce penetration as Latin America in 2009.

• Meli leads in most countries they operate including: Brazil, Mexico, Argentina, Colombia, and Chile. These five countries comprise roughly 86% of the e-commerce market in Latin America combined.

Digital payments

• Business opportunities represented by the unbanked sector in Latin America is projected to be $34 billion (however this is a fairly old statistic).

• Market size of mobile wallet transactions is lowest in Latin America at roughly 1% of total global transaction size. This is predicted to increase to about 4% by 2025. Still plenty of runway ahead.

• In Latin America, cash is still popular for a number of reasons – lack of banking infrastructure, lack of access to credit, and a mistrust in financial institutions. 71% of Brazilians report using cash as the main means for paying for their daily lives.

Similarly to the e-commerce market, the statistics demonstrate a large opportunity for MercadoLibre within the Latin American market - both with e-commerce and digital payments. Both opportunities are young in terms of runway, with so much of the market left to penetrate.

For me, the really exciting area of development for MercadoLibre is Mercado Pago, as it represents possibly the greatest opportunity in getting the majority of Latin America involved in the financial system as well as the Meli flywheel.

5. Competition

As the reigon has developed, more and more foreign players are looking to get a slice of the action.

Amazon initially entered into the region in 2012, Alibaba in 2015 and Shopee (SEA) look to be the most recent entrants. Competition is hotting up - and it’s a real question of whether Meli can survive against substantially deeper pockets.

Taking a brief look at Shopee (one of the 5 main arms of Sea Ltd) - it is “Sea’s e-commerce platform and is the leading e-commerce platform in Southeast Asia and Taiwan by gross merchandise volume. Unlike the developed markets, the internet economies in Southeast Asia are still expanding rapidly and Shopee is on track to acquire a significant share of this expansion. Shopee also has footprints in Latin America including Brazil and Mexico. Shopee provides consumers an easy, secure, fast, and enjoyable online shopping experience that is enjoyed by tens of millions of consumers daily.” - Wolf of Harcourt Sea investment Thesis

The Asian company have a slightly different overall strategy than Meli. They aim to get customers onto the platform via the popular games divition - Garena.

For example, their most popular mobile Battle Royal game, Free Fire, is a great way to get users involved within the ecosystem. Not only is gaming an important aspect of getting users on-board, the addictive social features surrounding the games encourage users to open and play the apps multiple times per day. There are plenty more strategic routes in order to get people involved and using the platform that Meli simply don’t possess.

Worringly for MercadoLibre, Shopee’s strategy seems to be working. The Shopee app is the 6th most downloaded app on the google play store in Brazil.

Amazon, Alibaba, Americanas and OLX are all also serious players in the e-commerce industry. For example, Alibaba have made a deal with Atlas Air in order to improve their logistical infrastructure within Latin America.

“The move comes as Cainiao (Alibaba’s logistics company) has seen its parcel volumes to South America take off this year; in the third quarter of 2020 it transported more than 8m packages, double the number transported during the second quarter of this year.”

As for Amazon, late last year the company announced plans to open its biggest distribution center yet in Brazil. Whilst at the same time opening 2,000 jobs in Colombia - mainly in customer service. And in Mexico, the company have kicked-off another payment option that makes it even easier for users to complete purchases using cash. 

Overall, even though competition within the reigon is heating up, I think Meli will welcome it. Part of the company’s strategy over the past decade has been to learn from the mistakes and successes of the first movers. Keeping a low profile whilst executing on targets will be key to the company’s future success.

Are Meli safe from Amazon?

No one company is really safe from Amazon (with the one exception of Alibaba). Any business in almost any market has a risk of Amazon finding a way to price-match and therefore drive down margins.

That being said, Meli acts as more of a Paypal/Amazon hybrid. With a large amount of Meli merchants running bank accounts within the platform - the ecosystem is sticky. It would take a extraordinarily large push from Amazon to somehow untangle the existing network effects.

6. Bull case

1. Competent management

MercadoLibre are founder-led.

Galperin, one of the co-founders over 20 years ago, is still at the helm and has been one of the main driving factors of growth at Meli. So much of what we see today - the logistics network, the payment network - is mainly a vision from Galperin. He is someone who saw e-commerce and digital payments early and capitalized (and more importantly executed) on the opportunity.

“Galperin trust disclosed ownership of 3,900,000 shares of Mercadolibre Inc (US:MELI). This represents 7.8 percent ownership of the company.”

2. Evolving e-comm and Digi Payments industries

As discussed in one of the sections above, MercadoLibre are capitalizing on the underlying opportunity of the adoption of both e-commerce and digital payments within Latin America.

With a region double the size of North America and with a much reduced level of internet and digital wallet penetration, MercadoLibre are in the perfect position to capitalize on the rapidly growing e-commerce industry. There is still plenty of runway here.

4. Large TAM

Similar to the point above, Latin America represents a population nearly double the size of the US (660M compared to 370M), which indicates a potentially larger market size than Amazon if executed correctly. As stated on the investor relations page, the company is the leader within many of the countries it operaties in, including Brazil and Mexico - which represent roughly 60% of the e-commerce market in LatinAmerica.

“Based on estimates from the Statista Digital Market Outlook, Mexico and Brazil would together account for more than 60 percent of the e-commerce market in Latin America in 2020.”

E-commerce sales only accounted for 3.1% of total retail sales in Latin America last year, according to Statista. But Meli estimates the market will still grow at a compound annual growth rate (CAGR) of 8.3% between 2021 and 2025 as internet penetration rates rise.

5. Strong history of innovation

Meli has a rich history of innovation. The company started as an e-Bay replica but quickly added many different strings to their bow in the form of Mercado Envios, Pago, Fondo, Credito, Shops and Publicidad among others - creating a sticky ecosystem of banking, logistics and commerce.

6. Focus on growth

Again, this is a testament to the management team and their willingness to take risks at a time when the company is under financial pressure. The executive team are aware this is a long game, and therefore need to focus on building a robust infrastructure - thereby forgoing short term profits for the long term domination of the Latin American market.

7. Strong Network effects

Part of the beauty of the MercadoLibre ecosystem is the intertwined nature of each of the different components. At first glance it looks complex, however the model makes logical sense. And once you are within the flywheel, the benefits are obvious. Put simply, the more merchants Meli can get to sell on the platform increases the level of buyers, which then increases the desire to be a merchant - and the flywheel continues.

8. Robust growth & emerging profits

Unique active users grew by 78% in 2020 to reach a total of 132.5M, up from 74.2M in 2019. The first quarter of 2021 has already seen unique active users increase by 69.8M in the three months ending March (representing 52% of the total unique active users).

The company’s annual revenue expanded by over 6 times from $651.8 million in 2015 to $3.97B in 2020. However, due to large investments in infrastructure and S&M costs, MercadoLibre hasn't been profitable over recent years. Net loss in 2020 was 0.7M, down from a net loss of 172M in 2019.

2021 earnings are expected to more than double, even as revenue growth slows.

7. Bear Case

1. Economic and political risks

One important thing to remember here is that we are dealing with Latin America as a whole, which brings with it a myriad of issues. Just looking at the past several years we have seen political scandals, hyperinflation and corruption, just to name a few. These are generally considered the associated set of risks when operating within emerging markets.

2. Currency fluctuations

Foreign exchange rates can have a huge impact on MercadoLibre’s operations. Due to the Securities and Exchange Commission rules, Meli have to use the foreign currency rates and translate those to dollars for the financial reports.

Two examples:

• Over the past 5 years the Argentine Peso has devalued rapidly against the USD.

• In 2017, Meli had to exit Venezuela due to the country defaulting on its government bonds.

Currency fluctuations alone are why some big investors have sold their MELI positions.

3. Overvalued compared to competition

We will take a look at the valuation in more depth later on in the article, however just from an initial glance you can see the relative valuation between competitors is high, although has contracted significantly over the past several months.

This, combined with the steep increase in share price over the past 3 years (from roughly $300 in 2018 to the current price of $1324) has contributed to the relative overvaluation.

4. Slowdown in growth

The past year has been nothing short of a once in a life-time boom for e-commerce - the result of which being a boost in revenue of 70% y/y. It is unlikely this growth trend will continue at the rapid pace at which Meli shareholders are accustomed to, however with the large total addressable market available - there is still plenty of growth runway ahead.

5. High expectations, heavy investments, loss making.

Similar to the above point - expectations are high and the stock has appreciated considerably over the past year. Meli will have to continually demonstrate growth to rationalize their current valuation. They have invested heavily into building out their infrastructure and technology, and are at a pivotal point where they will have to start proving the justification behind these investments. Eventually they'll have to show their business model is sustainable and can turn a profit. There are a number of ways for the company to falter.

6. Competition

As mentioned in one of the earlier sections, competition within the region is heating up. And with entrants like Amazon, Alibaba and SEA ltd looking to get in on the action, the coming years could be tough for Meli - especially if the competitors decide to invest heavily within the region.

7. Over-reliance

94.2% of the 2020 consolidated net revenue figures came from a mixture of Brazil, Argentina and Mexico. Having a revenue concentration of too few geographical locations could prove to be a hindrance - especially if each of those countries operate at a high risk of political or economic turmoil.

8. Financials

Lets start by zooming out to look at the performance of Meli (as a stock) over the past 5 years. As we can see, when bench-marking against the S&P 500, Nasdaq, Amazon and Alibaba - MercadoLibre have outperformed each.

8.1. Revenues

Taking a snapshot of MercadoLibre isn’t an easy feat. Especially considering the breadth of operations over the differing countries and business divisions. Therefore, I think it will be useful to try to separate these out as much as possible.

But to start, lets look at overall revenue. On a TTM (Trailing Twelve Months) basis revenue has increased by 90% in one year, from $2.475B to $4.7B. And looking that on a quarterly basis, net revenues for Q1 were $1.4 B, a year-over-year increase of 111.4% in USD and 158.4% on an FX neutral basis. This looks healthy.

Covid has absolutely been a major contributing factor in the past year’s positive operating results, as more and more people have become accustomed to making purchases from the comfort of their own home.

e-commerce:

If we firstly look at the e-commerce aspect of Meli (Mercado Libre, Envios & Shops), we can see strong growth in overall volume of goods sold on the platform - indicating the investment in infrastructure starting to pay off as demand for Meli’s services increases.

• GMV (gross merchandise value) grew to $6.1 Billion in Q1 2021, representing an increase of 77.4% growth on a USD basis, and 114.3% on an FX neutral basis.

• MercadoLibre currently have about 25.4% of total Gross Merchandise Volume as a percentage of total retail e-commerce sales in Latin America.

• In Brazil, the largest market, Meli doubled the number of items sold and nearly doubled GMV versus 2019.

This is somewhat expected, however it’s useful to note that 2020 was MercadoLibre’s strongest year (by far) for Gross Merchandise Volume, surpassing the $20B figure. An overall growth rate of 51% compared to 2019.

Interestingly, if we compare the GMV value to that of Alibaba and Amazon (although not really a fair comparison), we can see Meli still has a long runway ahead - considering the U.S. has half the population.

An additional way of looking at the e-commerce growth is to take a peak at Total Payment Transactions, which have grown by 115% in 2018/19 and 128% between 2019/20. This is a testament to the heavy investment into the Envios aspect of the business, which was a result of investment from paypal in 2019 (just before the pandemic - good timing!). For example, Mercado Envios shipped 208.1 million items during the first quarter, representing a 130.7% year-over-year increase.

All of these factors are lowering the delivery times, increasing the number of goods/services available on the platform, and thereby fueling the flywheel.

Fintech:

Secondly, if we take a look at the Fintech aspect of the business - Mercado Pago. We can see a business division doing very, very well.

• Total payment volume (“TPV”) reached $14.7 billion, a year-over-year increase of 81.8% in USD and 129.2% on an FX neutral basis.

• Total payment transactions increased 116.7% year-over-year, totaling 630.1 million transactions for the quarter - almost double the amount of transactions for the entirety of 2018.

• Off-platform TPV grew 82.5% year-over-year in USD and 136.4% year-over-year on a FX neutral basis, reaching $8.5 billion.

As of Q3 2019, more transactions were made outside of the MercadoLibre marketplace than were taking place inside it.

8.2. Profitability

The profitability of MercadoLibre is a mixed-bag. On the one hand, the company needs to keep investing in S&M and logistics in order to grow and compete effectively, however at some point the company needs to start making consistent profit. And you would hope that, as the company continues to grow and the unit economics get better, profitability should be right around the corner.

From the below graph it is clear that as MercadoLibre have started their growth trajectory, gross profit has started to rapidly decline. Not exactly what we want to see.

Having said that, when we benchmark Meli’s gross profit with similar competitors, we can see a similar trend - and actually, their gross margin is currently the highest.

Overall, it looks like the majority of the large infrastructure investments are in the past, including a $440M share re-purchasing. “The company incurred $91 million in financial expenses this quarter, turning a very strong EBIT quarter into the red. However, the main driver of this is nonrecurring. We recorded a $49 million charge related to our convertible debt repurchase transaction. We also increased year-over-year tax payments from increased earnings in multiple geographies.” Therefore we should start to see a significant growth in profits from here on out.

In addition to all of this (and as mentioned before), the Forex fluctuations will add some level of turbulancy to their results, over and above a company operating within only the US market.

8.3. Operating costs

MercadoLibre’s operating income has been a mixed bag over the past 5 years - hovering somewhere between -$100M and +$100M on a quarterly basis. The past 12 months have been good for Meli, with $248M in operating profit compared to the previous years TTM value of -$193M.

As we can see from the below chart, Meli have historically leaned on the sales and marketing as a lever for growth. Though we can see that this expense dropped rapidly as covid hit due to it not being a necessary expense.

“We decided to invest less aggressively on the marketing side to acquire new users. We decided to save those marketing dollars for later in the year where we hope these countries will be open.”

8.4. Balance sheet

• Current assets = 3.9B

• Total Asssets = 5.2B

• Current liabilities = 3.2B

• Total liabilities = 5.22B

Meli’s balance sheet at first glance looks generally fine - however the current assets don’t cover the total liabilities, which is always a cause for concern. If we look in slightly more detail we can see the increase in overall liability was mainly driven by an increase in loans payable (from $860M to $1.65B).

Unfortunately I cannot see the details of what exactly is included in the ‘loans payable and other financial liabilities’ section in the Q1 updates. I will be keeping an eye on the balance sheet for future quarters to see if this value keeps increasing.

8.5. Cash Flow

Meli have $1.18B in cash as of Q1 2021, an $80M decrease since the end of the previous quarter. This quarter has seen Meli burn through significant amounts of cash in all three areas - CF from operations, CF from investments and CF from financing.

• The driver CF from operations were the ‘payables and accrued expenses’, and the ‘funds payable to customers and amounts due to merchants’.

• The driver of the decrease in CF from investments was the ‘purchasing of property and equipment’ along with ‘changes in principal of loans receivable’.

• The driver of the decrease in CF from financing was a $1.8B ‘Payments on repurchase of the 2028 Notes’.

Historically, Meli’s cash flow has been somewhat erratic, with no clear source of financing. Ideally, as Meli evolve from their hyper-growth stage into a more mature company I would like to see cash flow from operations be the primary source of income. I don’t see this happening on a consistent basis for quite some time as there is still plenty of growth ahead with significant investments to be made.

8.6. Valuation

As always, relative comparisons are hard and oftentimes misleading. No two companies are exactly the same. In this case I will use Amazon, Alibaba, SEA, and Shopify as benchmarks.

From the graph above we can see that MercadoLibre, although are not cheap, look to be a relatively good price in comparison to other players within the e-commerce industry. Also, their valuation has contracted significantly over the past 6 months - indicating now might be an attractive entry point.

The graph below also seem to indicate these next weeks/months as a good entry point, as the price has dropped below the 200day moving average.

*Firstly, Thanks for making it this far. If you would like to help support my writing, feel free to buy me a coffee via the link below.*

Buy me a coffee

9. Conclusion

To conclude, as a company started by two guys at Stanford business school over 20 years ago, it would have been difficult to imagine the scale and complexity with which MercadoLibre operates today. In the process of building an e-bay replica for Latin America, the team at Meli have created an ecosystem that enables Latin America to take a leap forward with regards to economic empowerment.

MercadoLibre are set to be the primary beneficiary of the global trend towards internet adoption and therefore e-commerce. Latin America are currently about 10 years behind the U.S. with regards to these factors, so have plenty of runway to grow.

All of this is not without risk (and nor should it be). Political, economic and geographical issues, along with the introduction of powerful competition, raises significant question-marks over MercadoLibre’s ability to succeed - not just as a business, but as a stock. However, I believe Meli are best placed to dominate in the Latin American market and will be able to keep up their track-record of exceptional execution.

Cheers,

Innovestor

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My aim with these deep-dives is to make the research process of investing in individual stocks more accessible. Enjoy!

1. Thesis

2. Key takeaways

3. Streaming terms

4. Business overview

5. Advertising

6. Bull Case

7. Bear Case

8. Financials

9. Conclusion

1. Thesis

The cable-cutting revolution is well underway - and with that, paid TV is taking a back-seat. Time spent watching traditional TV has, and continues to, fall off a cliff. This chart from a Matthew Ball article perfectly demonstrates the shift currently taking place within the industry. The value proposition of streaming is simply too great.

The basis of my thesis is this - as the older generations continue to leak from the sinking ship that is linear television and younger generations begin to mature - OTT and CTV services will continue to grow. With this, advertising dollars will need to be re-directed towards CTV. If Roku can establish themselves as the new ‘go-to’ TV operating system, then they will be able to attract the lions-share of traditional TV advertising dollars.

Since 2019, 1 in every 3 Smart TV’s sold in the US were Roku operating systems, making Roku the No.1 OS for smart TV’s in the US. Alongside this, Roku logged over 18.3 billion streaming hours last quarter - an increase of 1.4 billion since the previous quarter.

Due to the leading position with regards to both ad-tech and market share, I believe Roku are perfectly poised to take advantage of the opportunity.

2. Key takeaways

• Roku are an advertising play on the cord-cutting trend.

• Industry-leading ARPU at $32.14

• Active account growth slowing slightly with 2.4M (totaling 53.6M) in Q1 showing possible slowdown in streaming momentum

• Streaming hours increased 49% y/y to 18.3B

• The Roku Channel reaches roughly 70M (more than double Q12020)

• 3 consecutive quarters of net profits ($76.3M)

• Revenue up 79% y/y to $574M

• Platform segment revenue (Ad-based) more than doubled y/y to $466.5M

• In the first three months of 2021, more than 85% of adults 18-49 who watched The Roku Channel were unduplicated with traditional TV

• Embarking on a strategy of acquiring, licencing and producing original content.

3. Streaming terms

I will be abbreviating Connected TV (CTV) and Over the top media (OTT) at various points throughout the article. But in essence, CTV is the device/operating system used to stream OTT services like Netflix.

What is Linear TV?

Linear TV is a traditional system in which a viewer watches a scheduled TV program at the time it’s broadcast and on its original channel. It also can be recorded via DVR and watched later. Linear TV still boasts the largest market, however, reach is fragmenting due to the increasingly competitive streaming landscape.

4. Business overview

Roku originally rose to popularity as a connected television device - helping pioneer the ability to stream apps like Netflix and HULU on your ‘not-so-smart’ TV.

As the years have gone by and as technology has developed, Roku have transitioned towards more of an advertising model as opposed to selling individual pieces of hardware (which they still do).

The Roku devices are sold mainly in the US & Canada, although have been expanding internationally over the past several years - reaching new territories such as Brazil.

The company are big believers in ad-supported tv, which they see as an under-served part of the market from a consumers point of view. Everyone knows people come over to streaming primarily to be able to watch what they want when they want. However what most don’t realize is the second most common reason for the switch - which is to save money from over-inflated cable bills. Roku recognized a large chunk of consumers would be willing to watch ad-supported TV as long as the ad experience isn't too painful and the content is good. The fundamental business model is built on this assumption.

4.1. Strategy

The strategy here can be simplified into several simple aspects.

1. Gain high market penetration by selling connected TV hardware at a low margin.

2. Develop a high quality advertising platform using big-data.

3. Attract advertising dollars from the fall-off from linear TV.

4. Maximize Advertising efficiency.

5. Profit

Lets break that down…

The overarching goal here is to create a platform where Roku are the number one Connected TV operating system in the world - enabling the connection between the entire TV ecosystem. It will be a one-stop-shop for all your TV needs. This serves as a win win for both ROKU and the SVOD channels like Netflix and Hulu etc. as Roku provides these services with a large audience whilst these services increase the volume and quality of data Roku use to serve ads, thereby increasing the quality of ads.

For this to happen, Roku’s hardware needs to be simple, effective and bug-free. As someone without a Roku TV, this isn’t something I can speak to directly - however after trawling through the reviews & comments it seems like this statements holds true for the most part.

1) Gain higher market penetration:

In order to capture a greater market share Roku need to keep increasing the number of active accounts.

To achieve this, the company sells hardware such streaming players, accessories and TV’s with Roku built-in. Alongside this, Roku work with hardware brands who licence the operating system in order to manufacture and sell Roku-based TV models.

The important aspect here is being able to get these connected TV devices and software to as many people as possible - therefore the margin on this aspect of the business is low in comparison to the platform aspect (13.8% compared to 66.9% in the most recent quarter). These margins have remained relatively stable, with a slight decrease in platform growth revenue over the course of several years.

2) Develop a high quality advertising platform:

One of the ways to achieve this is to fuel the Roku fly-wheel. If Roku focus on improving the user experience and engagement aspect of the platform, the rest will follow.

More content in the Roku channel drives engagement - that engagement drives (as it is predominantly an ad-supported model) more ad inventory. As a result of this, the increasing demand coming over on the advertising side diverts more money back into spending on content, which results in higher quality ads (due to more data)... And the flywheel repeats.

3) Attract advertising dollars from the cord cutting trend:

There is strong evidence to indicate that traditional TV ad revenue is shifting towards connected TV.

A quote from a recent article from Beth Kindig…

“About $10 billion has been spent on Connected TV ads compared to $70 billion on pay television ads in the United States alone. Pay-TV ad spend is now expected to decline by 15% to $60 billion this year due to the postponement of live sports and also due to an increase in cord-cutting from covid.”

As the Roku operating system is currently the number 1 operating system in the US - I believe the company are best placed to capitalize on this opportunity.

4) Maximize advertising efficiency:

ARPU (average revenue per user) is a good metric for the efficiency with which Roku are able to monetize their audience. As you can see from the image below, ARPU has been increasing rapidly over the past year, with a 32% y/y increase from Q1 2020.

The steady increase in active hours, Streaming hours & ARPU is good evidence that the fly-wheel effect is indeed working. With more users on board, more data can be collected about user habits - therefore increasing advertising efficiency over time.

4.2. Revenue streams

The core of Roku’s revenue is centered around three main pillars - Advertising, The Roku Channel and Premium Features - all of which come under ‘platform revenues’.

Advertising: Advertising is the core of the business. Advertisers pay to have their content displayed on the Roku channel, which they are seeing as a way to engage customers more efficiently. Roku’s growing user base of over 53.6 million users has been a catalyst with this. In addition, Rokus average revenue per user (ARPU) is around $32.14 (up 32% y/y).

The Roku Channel: This is a specific channel Roku owns/curates and one of the only places where the company are able to show ads. The Roku channel helps with content discovery, which feeds into advertising dollars and keeps customers coming back to the platform. Roku help you discover new content, similar to YouTube or Spotify.

Premium features: This includes movie rentals and subscription based services. Roku Pay is integrated into the system in order to make the purchasing experience much more streamlined - reducing friction.

Roku is also a hardware company. In the financials, revenue is broken down into two main categories - Platform Revenue and Player Revenue (hardware).

As you can see from the below chart, the platform revenues overtook player revenues in 2018 and have been pulling away ever since.

Platform revenue consists of advertising, content distribution, subscription and transaction revenue shares, premium subscriptions, billing services, branded channel buttons and licensing arrangements.

Player revenue consists of hardware, embedded software and unspecified upgrades on a ‘when and if-available’ basis. This section makes up roughly 26% of TTM (trailing-twelve-month) total revenues - and has been steadily falling in each of the past 4 quarters, from 45% of total rev in Q2 2020 to 23% of total rev in Q1 2021. This decrease in revenue share signals at Roku’s core intentions to be a dominant player in the ad space. Other factors such as logistical issues (suez canal/chip shortages) and the fact that Roku are going for high-penetration of devices so selling at low margins are also key drivers of the increasing gap.

4.3. Hardware

I won’t spend much time on the hardware available, as it’s all easily accessible on their site.

As mentioned above, Roku originally started by selling devices you can plug into your TV in order to access SVOD services like Netflix/HULU/Amazon Prime etc.

They have a stream bar as well as the Roku boxes that they are known for. These are plug and play devices that allow anyone to bring streaming into their homes. Even when comparing the Roku OS to integrated solutions like the ones found on newer televisions, Roku seems to have an edge in that the experience is more fluid, and the channel options are constantly expanding. They’ve placed technology at the forefront of their design and have built a base of loyal users who generally enjoy using their platform. They sell their devices at every big box retailer (including Walmart, Target and others) which makes their platform accessible to all consumers (even ones with limited technical ability)

In addition to these, Roku creates their own Smart TV’s alongside integrating their operating system into a variety of third-part smart TV brands. This strategy makes the Roku operating system hard to avoid - thereby gaining long-term penetration into the Smart TV OS market.

One thing to point out here is that I am UK based. And because of that, my exposure to Roku products is limited. As you can see above, the company have only just released their first integrated television into the UK market. I expect to see much more of Roku over the coming years.

5. Advertising

• In March, linear TV ratings for adults 18 to 24 was down 22%. Q1 TV ad spending was down 11%, according to MediaRadar. Meanwhile, Roku doubled monetized video ad impressions on the platform.

• Ad spending by major agency holding companies with Roku more than doubled.

• Americans on an average day will spend more time on TV streaming than all major social media platforms combined: 3x Facebook, 2x YouTube, and roughly 2.5x Instagram, TikTok, and Snapchat combined.

Advertising in general has taken some heat over the recent years with companies like Facebook and Google testing the limits with respect to personal data and using that data to sell ad-space. Many folks are looking for alternatives.

Other social media outlets such as Snapchat and Pinterest have majorly benefitted from the rotation away from the big boys of tech. I believe as advertisers continue to rotate ad dollars, testing different mediums, Roku will benefit.

The direct nature of Roku’s relationship with advertisers along with the targeting accuracy of Roku’s ad platform results in a satisfied client. The ability to measure the effectiveness of the ads along with the ROI is another key plus point. In addition to this, it is safe to say that as traditional TV advertisers see the benefits from a more efficient ad model, Roku’s services will be in greater demand.

As I have mentioned several times above, advertising is a core aspect to the business-model for Roku. It’s safe to say the ad side of the business has gone somewhat under-the-radar over the past few years. However, it has simultaneously been the fastest growing aspect as of late.

User account growth has been accelerating, and with that, hours of streaming has been increasing at a similar rate. Billions of hours watched every quarter results in more engagement, which results in more ads served.

5.1. Acquisition of DataXu

The deal thesis when Roku acquired DataXu in late 2019 was that there was a significant advantage to roku & advertisers in combining capabilities from a winning DSP platform (reach & self service programming capabilities) with Roku's broad-scale reach, first party relationship with largest streaming audience out there, and all proprietary data that comes from that.

DSP - A demand-side platform is a piece of software used to purchase advertising in an automated fashion. DSPs are most often used by advertisers and agencies to help them buy display, video, mobile and search ads.

5.2. OneView

Roku’s OneView is the self-serve option for marketers who would like to purchase ads on Roku and integrate all of Roku’s data available for marketers in order to use at their disposal. Previously Roku acquired Dataxu DSP (demand side platform) and integrated it into OneView, allowing OneView to be even more efficient at obtaining and filtering the data marketers want.

The Oneview ad platform side of things is basically tripling whilst the overall ad business is growing very fast.

• Roku monetizable video ad impressions more than doubled y/y.

• You can reach an estimated four in five persons in the US using Roku’s OneView platform.

• Consumers now spend more time streaming than they do those other three touch points combined.

As consumers move to streaming and all TV advertising is streamed, advertisers are looking for a tool-set to scale their OTT advertising. They want self serve capabilities to optimize and to measure performance. Roku provides this.

5.3. Nielsen

“In April, we completed the acquisition of Nielsen’s video automatic content recognition (ACR) and dynamic ad insertion (DAI) team and technologies, which will accelerate our launch of an end-to-end linear ad replacement solution in partnership with programmers.”

This will be huge for ROKU as they will be able to integrate the Nielsen "always on" digital ad ratings into the OneView platform for marketers.

6. Bull Case

1. Roku is an advertising play rather than streaming play.

As an advertising play on the CTV/OTT market, Roku are unique.

As of Q3 2020, 49% of all programmatic OTT/CTV ads went to Roku. Amazon is second with 9%.

2. The future of TV will be app driven.

Streaming has been steadily gaining traction over the past decade. We have seen entrants from giants such as Netflix, Disney and Hulu. The ease of accessibility for streaming apps will be part of the main driver to have access to the Roku operating system. Roku is currently the number 1 operating system because they have managed to create a high-quality reliable product that people like to use.

3. Roku's moat is that they power the operating system of most TV's.

At a high-level, this might not seem like the most convincing moat, however we need to think about how difficult it will be for a newcomer to enter into the space and displace Roku - almost impossible. Nearly 1/3 smart TV's have the Roku operating system.

4. Superior economics of being a ‘neutral’ middle-man.

The agnostic nature of Roku’s business model in regards to the streaming wars enables them to benefit from the overall increase in eyeballs into streaming. The benefit of being a neutral middle-man enables Roku outplay their competitors as content providers with their own devices like Google, Amazon, and Apple are always going to have difficulty in negotiating with competitors to support their devices.

It would take a huge player to come in as a "neutral" competitor to unseat Roku from this position.

5. Revenue growth is expected to continue.

Y/Y revenue growth hasn’t dipped below 48% over the past 3 years and in some ways looks to be ramping up from here.

Some proportion of the growth in Active Accounts, Streaming Hours, and ARPU is down to the Covid working from home situation. However this isn’t a trend that is going away. The direction of travel is clear - over the next decade, streaming will command the majority of advertising dollars.

6. Roku’s ARPU is insane compared to other tech companies.

Although Netflix has access to a user-base that far outweighs Roku’s, they don’t have the capabilities to monetize the audience as effectively. If we compare ARPU between the two companies, Roku is steaming ahead with $32.14 compared to Netflix’s Average Revenue per Membership of $10.73. Roku achieves this through a mix of advertising options that maintain a non-invasive experience for the customer while providing significant value to the advertiser.

Reed Hastings hinted at this in January when he mentioned that Netflix will not monetize its users any further by offering advertising options because it would be too difficult to compete with the big players in advertisement (Google/Amazon/Facebook/Roku).

7. Planning to add more content to the Roku Channel.

Roku is constantly adding new content to the Roku channel. One example of this is the recent acquisition of Quibi’s entire library. This, along with the rampant on-boarding of content to The Roku Channel (as evident on the balance sheet) indicates the intention moving forward - providing a more robust option for cord-cutters than simply a consolidated streaming app location.

The Roku Channel and scaling into more content. 175+ licensing partnerships are already in place and growing fast.

8. Expansion opportunity

The US is way ahead in the cord-cutting phenomenon, and this trend is global (unlike Roku’s current customer base). As technology continues to develop and become more affordable, we will see Roku expand into new territories.

7. Bear case

1. Question-mark over whether international expansion will work due to differing geographical economics.

Coming straight off the last bull-point… The US have an interesting relationship with the cord-cutting revolution in terms of economics. Historically high cable penetration rates and extremely high monthly ATV costs makes the decision to move to CTV fairly straightforward. Roku saves consumers a lot of money.

Whereas if you compare to the UK - the cost to watch television is generally inexpensive due to affordable and high-quality public broadcasters. Therefore the ‘need’ for something like Roku is reduced.

That being said, Roku's playbook of driving scale, driving engagement, then working on monetization once you've got enough scale is porting nicely to international markets.

Only 1 year ago Roku entered their first integrated TV into the UK. Ramping up ad monetization. Free ad supported TV is going to be a core experience.

2. How can they deliver more ads outside of the Roku Channel?

Roku are unique in that they are the closest thing to being a neutral content-provider within a competitive playing field, however - as they attempt to increase the level with which they monetize that channel, the more likely it is that content providers move to alternative streams of revenue.

The underlying concept of serving ads in a non-invasive way is certainly there, however Roku need to figure out a way to deliver more advertising whilst using the 3rd party apps like Netflix etc.

First mover advantage here is strong, but diversified revenue streams are relatively weak.

3. Connected TV is a commodity business, therefore has no significant competitive advantage.

Roku is much more than a connected TV device hardware company - they are an advertising platform. The whole point is you will be able to reach a wide audience and monetize those audiences through ADs. It doesn’t matter if it’s you TV, laptop, phone, set top box - Roku is aiming to become the operating system of streaming.

4. Big tech will be able to enter their devices into the market for a lesser price and compete directly with ROKU. This will drive down margins, making Roku obsolete.

Roku are already selling hardware at next to nothing and letting it impact their margins and they're doing that in order to become as ubiquitous as possible while the window is open.

Ad Video on Demand is a very new and emerging market. We can see this by the portion of traditional TV advertising dollars that are yet to move over.

So yes, the big tech companies like Google and Amazon are competing with Roku at the moment - in a very ‘head-to-head’ full on way. The fact that Roku have managed to remain in their number one position shows the strength of the business/brand.

5. What is Roku? (UK)

I live in the UK, and part of the reason I was skeptical coming into this is the lack of Roku brand visibility over here. I think this one somewhat comes down to the difference in existing television infrastructure within the UK compared to the US. Within the UK, we have free public broadcasters with a relatively inexpensive (or free) charge.

The US has much more of a need for Roku products, so it makes sense for the US to be the initial market.

6. Good product but no moat.

As mentioned before, the real moat here is the fact that Roku will be the No.1 operating system for connected TV. It may not sound like the strongest moat, and arguably it’s not actually a moat, however Roku are in the best position to be able to make this happen.

7. Competition

Even though Roku doesn’t have a large, or particularly threatening, group of competitors right now - it is extremely likely new players will enter the market as SVOD becomes mainstream. Attempts have been made with the Amazon Firestick (although relatively unsuccessfully), however as the market continues to develop we will almost certainly see more competitors attempt to grab a slice of the pie.

My prediction is that TV manufacturers will eventually settle on a standard operating system across the range of different TV’s. It’s entirely possible there will be 2 or 3 major operating systems - akin to Apple vs Android.

One recent development that highlighted the increased competition in the market was the Youtube distribution fight.

This was perceived as different than standard content dispute. Usually you would have a content publisher and a distributor, which results in different economic terms with a different viewpoint. Mutually agreeable economic terms is usually do-able.

This was not the case here. Roku were allegedly not asking for any different economics in relation to ad supported TV. Google was asking for unreasonable actions (e.g. to provide data that Roku don't provide others - biased and unbiased search results - looking to create requirements which would greatly increase the cost of the Roku players). These conditions were argues to be anti-competitive.

YouTube TV are actually still on the platform, however they have been made 'private', meaning people who had existing YouTube TV subs could still use it, but you can’t sign up to a new subscription.

8. Financials

Lets first zoom out to look at Roku’s journey since IPO in 2017 where we can see the price % change has been substantial compared to various benchmarks such as the S&P 500, Nasdaq, Netflix & Disney. Thoroughly outperforming each.

8.1. Profitability

*The revenue split has already been covered in section 4.2*

Roku has historically been an unprofitable company, with 2020 as no exception. This is mainly due to the company’s strategy of investing heavily in expansion. However, 2020 was close to being a profitable year, with $17M in losses and two profitable quarters in Q3 & Q4.

I can see Roku posting a profitable year in 2021. And it’s off to a good start, with $76.3M in net income - far and above the -$54.6M loss from Q1 2019. Historically the first two quarters are the poorest performing quarters, with sales picking up in the latter half of the year. For the second quarter, Roku issued guidance of net revenue between $610 million and $620 million and net income of $10 million-$20 million, indicating a positive year ahead for the Connected TV giant.

Steve Louden (CFO) “We anticipate revenue growth rates in the second half of 2021 will be robust, but at a slower rate than the first half. For the full year, we expect overall gross margins to be in the high 40% range. We anticipate that Platform gross margin will be similar to 2020 levels, as we expect the outperformance of content distribution to normalize in Q2 and in the back half of the year. Looking ahead at the Player business, as a reminder, we do not optimize for Player gross profit, but rather account growth”.

Covid has definitely been a factor in the past year’s positive operating results, resulting in more demand towards Roku - leading to higher margins.

As we mentioned earlier (3.2.), the revenue is split into two sub-categories - platform revenue and player revenue. Platform revenue commands the majority of the focus for Roku as this is where the higher-margin business lies. The graph below starts from Q1 2018 which is when platform revenue began to overtake player revenues. Since this point, the gap has been widening, and will continue to do so in my opinion. The split is currently 71% platform to 29% player.

So, taking into account that the platform revenues are increasing as an overall percentage of revenues, combined with the fact that platform revenues are the higher margin revenue stream (66.9% compared to 13.8%), we can expect the overall gross margin to increase over the coming years.

That being said, player margins are relatively unpredictable due to changing short-term factors, and platform margins have been reducing over the past couple of years which is a potential concern (~75% in 2017 to ~62% in the past 12 months).

Initially, platform revenues took a hit from the coronavirus pandemic as businesses all over the world were struggling with operating expenses. Therefore cutting marketing budgets to spend on advertising was inevitable. This situation has been steadily improving over the past year, with the platform margin increasing from 56% to 67%.

Steve Louden (CFO) said “Platform gross margins were more than expected due to a favorable mix of higher-margin activities as a result of new direct-to-consumer launches with investments in audience development and positive 606 accounting impacts from increases in the estimated lifetime deal values of our content distribution agreement”.

8.2. Operating costs

Typically Roku has encountered operating losses over the company’s time being public. 2020 changed this, with the last three quarters producing positive operating income of 13.20%, 10.02% & 2.65% respectively. This is compared to the typical operating loss of between -5% and -17%.

It’s also important to remember that with the recent acquisition of DataXu, Roku has acquired the respective operating expenses - which can be an interesting wrinkle.

This isn’t the most interesting chart, but shows that Roku’s have managed to maintain fairly consistent operating costs over the past 5 years, indicating strong management.

8.3. Balance Sheet

• Current assets = 2.75B

• Total Asssets = 3.49B

• Current liabilities = 682.12M

• Total liabilities = 1.05B

Roku’s balance sheet looks healthy as it stands, with total ‘current’ assets being able to fully pay off total liabilities by 2.62X - so Roku is safely able to continue operating without a problem for the near future.

Looking in a bit more detail, Roku’s largest liability is the accrued liabilities (currently sitting at $477M), which is essentially Roku acquiring the right to stream content for free on The Roku Channel. Arguably, this is a good sign as it indicates the company’s commitment to improving the product and thereby a focus on continued growth. This number has been increasing rapidly over the past year, with 2020 seeing 75% increase from 2019, and Q1 2021 seeing a 37% increase from Q4 2020.

Additionally, their marketing accrued liabilities increased by over 6 times between 2019 and 2020, showing the intent to expand and grow the user-base is of top priority.

Another large increase is the lease payments - driven mainly by the current expansion and the need for new facilities.

Overall, their balance sheet looks healthy.

8.4. Cash Flow

Roku has 2.1B in cash as of Q1 2021, a 1B increase from the end of 2020. However the net cash from operating activities decreased from $143M in Q4 2020 to $95M in Q1 2021. The overarching majority of the company’s cash is raised via financing activities, with the last quarter seeing a huge uptick in the cash available via financing (below).

The above chart shows that, historically, Roku’s main source of cash has been from financing activities, with a huge uptick in the past quarter. Ideally, we would want to see cash flows from operations overtake cash flow from financing at some point - as this indicates a healthy business which is financed organically.

The risk with this spike in cash flows from financing activities is that Roku either take on more debt, or end up diluting the shares. In this case, it’s a dilution of shares as the majority of this increase comes from “Proceeds from equity issued under at-the-market offerings, net of offering costs”.

8.5. Valuation

It’s hard to compare Roku with their main competitors such as Google, Amazon, Apple, Netflix and maybe Disney. as most of these competitor’s streaming elements are only a fraction of the overall business - whereas Roku is a pure-play. The closest comparison is arguably Netflix.

As you can see from the above chart, even though Netflix are carrying substantially higher levels of debt, Netflix are still valued at a more reasonable rate. It’s a fair comment to make that Roku are still overvalued at the current point in time, which poses relative risk.

Alternatively, simply looking at price, Roku recently touched the 200 day moving average, which presents a tempting opportunity to buy.

I strongly believe, Roku is set up for a good buying opportunity at the moment, and if they care able to execute over the next 5 years, I can see the company growing into a $80B-90B market cap.

*Thanks for making it this far. If you would like to help support my writing, feel free to buy me a coffee via the link below.*

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9. Conclusion

To conclude, as the cord cutting trend continues to gather momentum, more and more TV ad dollars are leaking from linear TV to Connected TV. Roku are a tremendous ‘pure-play’ in connected TV ads space - with a large share of the market, growing user-base, growing hours watched and an industry-leading ARPU of $32.14 (with room to grow).

Roku sits firmly in the middle of the competition for eyeballs within the streaming sector, while the other SVOD services such as Netflix, Amazon and Disney jostle for market share via new content.

Roku’s upside is agnostic to the ongoing ‘streaming wars’ - benefitting from the overall upward trend of streaming. In other words, as long as the overall streaming industry continues to grow and Roku maintain their position within the industry, then the company will do very well. Roku is an advertising play. If you have faith in the cord-cutting trend playing out, Roku will likely be a good investment.

Lastly, as a company whose share price has been rocketing over the past several years, finding an entry point has been difficult (to say the least). These recent lows in the stock market have resulted in Roku hitting their 200 day moving average - and I believe this may be a good opportunity to buy a great company at a reasonable price.

Cheers,

Innovestor

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1. Key highlights

2. Intro

3. Business

4. Tesla Vs Nio

5. Deliveries

6. Innovation

7. Bull case

8. Bare case

9. Financials

10. Conclusion

1. Q1 Key highlights

• Global chip shortage dampening deliveries for first half of Q1.

• Q1/21 financials showed surprising strength in vehicle and gross margin, pointing to an ability to increase operating efficiency at scale amid headwinds (chip shortage).

• Beating Q1 delivery guidance with 20,060 units

• NIO customers used Nio Pilot for a total of 62,417 hours - up 278% y/y

• Expansion into Norway in September

• Expectations to enter 5 more European countries next year

2. Intro

Before we get into this one, it’s important to point out that with young Chinese growth companies like NIO, there are some inherent risks. Not simply because the company is Chinese-based and operates with a different set of inherent risks, but more the fact that they are competing within an industry near the beginning of it’s growth trajectory. The Electric Vehicles industry is a complex industry, and one that is filled with competition and conflicting interests. It’s entirely likely only several EV car manufacturers end up ‘winning’ in the long-term.

3. The business

NIO are a Chinese smart electric vehicle company operating at the premium end of the market. They are currently based in Shanghai, with expansion plans currently in-place in the US, UK Norway and Germany. The name translated in Chinese (Weilai) means ‘Blue Sky Coming’, which is said to outline the company’s commitment to environmental change.

Nio design, manufacture and sell electric smart vehicles, and have 4 main models produced on a large-scale – the ES8, ES6, EC6 & ET7.

Normal EV’s contain batteries which, when drained, will need re-charging. The problem is, this tends to be fairly time-consuming. For comparison, it takes less than 5 minutes to fill up a regular car vs the roughly half an hour it would take to fill up a Tesla at a normal charging station.

This is where NIO comes in. They are pioneering battery swapping technology which will allow users to reach full charge in about 1/3 of the time as it would take to charge at a charging station. This is achieved by operating various battery swapping stations throughout a city where the user would simply drive up, leave the swapping station to do it’s thing, then 10 minutes later have a completely new battery in their car at 100% charge.

And cost-wise, it’s fairly inexpensive. Firstly, you can buy the car with or without a battery. If you buy without, you have the ability to rent a battery from NIO at a low cost. And secondly, the battery swapping service is free for the initial owners of the car - then the subsequent users can purchase the energy they use when re-charging (just like with electric charging stations).

For this plan to be feasible, it seems necessary to have a high number of battery swapping stations in each city, however it’s not quite there yet.

Up until now, NIO has deployed 193 battery swapping stations, 134 supercharging stations and 327 destination stations across China. It has also given access to over 380,000 third-party charging piles.

Additionally, and to help with the number of battery swapping stations available, Nio offers a fleet of rescue vans with built-in chargers. These vans will meet you wherever you happen to be, in case you run out of battery whilst not being near a swapping station.

4. Tesla Vs Nio

I am aware Tesla aren’t directly comparable to Nio, however it’s interesting to compare & contrast the two companies - especially as they both operate within the same overarching market.

Batteries

As mentioned above, Nio buyers have the choice of whether to buy the car with a battery or without. Purchasing without makes the car more affordable. For context, roughly 1/3 of people buying Nio cars will choose the option to buy without the battery and rent the battery at a lower cost over a longer period of time.

Price

The result is is that Nio are therefore able to undercut the price of the comparable Tesla Model. For example, lets take Nio’s cheapest car (the ES6) and compare it to the equivalent Tesla model (Model Y). You can buy an ES6 in China for roughly the equivalent of $42,000, whereas you should be able to pick up a model Y for about $39,000.

Then, if you take into account the cost savings from choosing the ES6 without the battery, you would be paying roughly £7,700 less - resulting in a lower initial cost by roughly $4,700.

Range

Tesla claims the Model Y will do 314 miles on one charge according to the latest tests. While Nio says the ES6 can top 380 miles - however these figures are from an older type of test, so not quite as reliable. Realistically, the ES6 could probably do about 300 miles in normal driving conditions.

From carwow.co.uk…

“Tesla claims the Model S Long Range can do 412 miles on a charge according to the latest WLTP tests, and the Plaid + can do more than 520 miles. If you convert these numbers into NEDC figure (like Nio uses) that’s getting on for almost 600 miles of range. But, Nio claims the ET7 can go even further – it reckons that top-spec cars can do 620 miles between charges. That’s more than most petrol and diesel cars can do without a fill up.

Part of the reason the Nio ET7 can go so far is because its 150kWh batteries are some of the largest fitted to any electric car you can buy. And, when you chuck in a bigger battery you get more range – it’s as simple as that.

So, what’s stopping Tesla from putting an even larger battery in the Model S. You know, to show Nio who’s boss? Put simply, bigger batteries take longer to charge. It’s just like giving a car a bigger fuel tank – you can drive further, but it takes longer to fill up.

And this is where Nio has the edge. Because, no matter how big it makes its batteries, they still take pretty much the same amount of time to swap. So, when you run out of juice you’ll be ready for another 620 miles in as little as three minutes.”

Speed

The new ET7 is the Nio equivalent of the Model S - an upmarket saloon promising the longest range, fastest motors and the best tech. The quickest version of this car will do 0-60mph in 3.9 seconds. Just as quick as the new BMW M4 Competition, but still significantly slower than the latest Model S Plaid, which can do 0-60mph in 1.99 seconds.

The fastest ‘Performance’ version of the ES6 has 550hp and it can do 0-60mph in 4.7 seconds. There’s also a coupe version called the EC6, which is even faster. It does 0-60mph in about 4.5 seconds, which is only a second slower than the fastest Tesla Model Y Performance.

Summary

“Nio has has reach the 100,000 car deliveries number, and done more than 2,000,000 battery swaps. It’s just launched its fifth new car since 2014, meaning (on average) it releases a new car every 18 months. Tesla has been around for more than 13 years and it’s only launched 6 different cars in that time: the original Tesla Roadster, the Model S, the Model X, The Model 3, The Model Y and the Cybertruck…”

5. Deliveries

• 7,102 vehicle deliveries in April. 125% increase y/y. Considering the five day production shutdown and chip shortage - this is not bad at all.

• 20,060 deliveries in Q1 2021, a 422.7% increase y/y.

• TTM (trailing twelve months) deliveries totals 59,950.

  • This beats the previous years TTM deliveries number of 20,414 - a 193% increase in vehicles delivered.

If we look at the predicted numbers for this year, they are on course to deliver about 80,000 cars if the growth remains flat. However, if the second half of the year sees a pick-up in the global supply of chips, we could see a NIO boost delivery numbers in Q3 & Q4 - pushing the 100k figure.

Q2 will still likely be impacted by the global chip shortage, but the company can still take orders. They are also backed-up with ET7 deliveries - which gives me even more reason to believe NIO can reach that 100k figure.

6. Innovation

NIO are innovating aggressively and, in doing so, are offering something distinct.

Suite of charging solutions (‘NIO power solutions’):

• Power Home and Power Home Plus for ‘home changing solutions’ - standard and ultra-speed home chargers where practical for users.

• Power Swap – Innovative battery swapping stations offering battery swapping service within minutes. As of October 31, 2020, NIO had 158 Power Swap stations covering urban areas and expressways across 70 cities.

• Power mobile – charging trucks offering rapid charging for 100km range within 10 minutes. As of October 31, 2020, NIO had 318 Power Mobile charging trucks.

• Power Charger – reliable fast charging piles located in parking lots and other locations easily accessed by users for them to locate, use and pay for through the NIO app. As of October 31,2020, NIO had approximately 701 Power Charger piles in operation, covering 52 cities, and provided over 440,000 one-click power services.

• Power express – 24 hour on-dmand pick-up and drop-off charging service

• Access to the nationwide charging network consisting of over 390,000 publicly accessible charging piles.

Battery as a Service Model (BaaS) – allows users to purchase electric vehicles and subscribe to usage of battery packs separately. Essentially you can purchase the car without the battery pack and subscribe to a battery, even upgrading later down the line. Lower initial cost for consumers.

Autonomous Driving - NIO are pioneers in automotive smart connectivity and enhanced Level 2 autonomous driving. NOMI, which is believed to be one of the most advanced in-car AI assistants developed by a Chinese company, and is a voice activated AI digital companion that personalizes the user’s driving experience.

In early January, Nvidia & NIO announced a partnership which will offer advanced automated driving capabilities.

“The cooperation of NIO and NVIDIA will accelerate the development of autonomous driving on smart vehicles. NIO’s in-house developed autonomous driving algorithms will be running on four industry-leading NVIDIA Orin processors, delivering an unprecedented 1000+ TOPS in production cars,”

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7. The bull case

1. Strong brand

2. Constant innovations such as BaaS

3. Strong management

4. China is by far the world’s largest auto-market.

5. Their only real competition in the luxury EV market is Tesla. I’m not sure we could even count Tesla as a direct competitor.

6. Global expansion into Europe.

7. They seem to have major government support as well as what seems like unlimited funding from tech giant Tencent.

8. Speculation, but there is maybe potential for a robo-taxi fleet somewhere down the line.

NIO are pretty much doing all they can to create a competitive advantage within a market that will likely be filled with competitors with deep pockets over the next 10 years.

7.1. The Brand

7.1.1. Are Nio too important to fail?

“This is the first chance China has to establish an entry-level luxury brand. Can the company be allowed to fail? This is the marriage of militarized state manufacturing on one hand and big tech software/battery development on the other.”

7.1.2. Brand positioning

It could be argued that vehicles, just like smartphones and other pieces of technology, are statements about your status or personality. Essentially, these objects represent who you are and presents a signal towards others as to how you would like to be perceived.

As a luxury brand, Nio are positioning themselves next to the likes of BMW and Audi - at least, this is how the CEO (Li) sees the main competition. The company are building a brand people want to identify with.

An interesting statistic: “During the first nine months of 2020, luxury cars outperformed mainstream models in the US market. The market share of luxury models increased to 44.3% in 2020, from 40% in 2019”.

Tesla’s aim is to lower the price of their cars steadily over time, whereas Nio’s aim is seemingly to target the higher-end ‘luxury’ market - taking advantage of the increase in demand for this type of vehicle.

The brand has several similarities to Apple:

• Sequential (simply named) models - EC6, ES6, ET7 & ES8

• Convenience oriented - Battery as a Service (BaaS).

• ‘Nio Houses’ - Similar to Apple stores in appearance

• Aiming for high-ticket ‘luxury’ customers

• General focus on ‘community’

As a strategy within China, I think this will work well. Especially considering China has one of the fastest growing ‘upper-middle’ and ‘upper’ class groups.

7.1.3. Nio Day

Great marketing strategy with the goal of releasing new models each year.

“We held our first “NIO Day” in December 2017 at the Beijing Wukesong Arena, where we introduced the seven-seater ES8. We launched our second volume manufactured electric vehicle, the ES6, to the public on our second “NIO Day” in December 2018. Our first two NIO Days consisted of presentations by our Chief Executive Officer, Bin Li, who introduced our ES8 and ES6, respectively.

We plan to hold NIO Day each year on which we introduce our new vehicles and products to users.

We launched the ET7, a flagship premium smart electric sedan, at our fourth NIO Day on January 9, 2021. The ET7 features NIO’s latest NAD (NIO Autonomous Driving) technology including NIO Adam, a super computing platform, and NIO Aquila, a super sensing system. We will begin making deliveries of ET7 in the first quarter of 2022”

7.2. Battery as a service (BaaS)…

Battery as a service is a simple yet effective idea. As mentioned earlier in the article, Nio users can drive into a battery swap station with a low/dead battery and have it replaced by a fully charged one in a matter of minutes. The next version of these battery swapping stations will make it possible for the user to stay inside their car whilst the swap is taking place. It is estimated to perform up to 312 swaps per day.

BaaS is a key element to Nio’s overall strategy, so they need to get it right. A key element of the business model is the ability to be able to purchase a car at a reduced rate - because of this, the Battery as a Service element needs to work well and be accessible/convenient. Therefore increasing the number of these stations is key, and definitely something to keep an eye on with regards to meeting targets.

Nio recently partnered with Sinopec Shanghai Petrochemical Company Ltd (a state-owned oil and gas company). The intention is to build more battery swap stations. Sinopec stated that they aim to have 5,000 battery swap stations in their network by 2025, as they aim to transition to a higher presence in electricity and non-oil business. Nio is targeting 500 battery swap stations by the end of 2021.

Competition

Tesla tried battery swapping in 2013, however left the idea behind when they decided to focus on the superchargers/giga-factories.

It’s not wholly clear which method of charging will be the most efficient, as more and more people adopt Electric Vehicles the economics of charging will surely change. There are upsides & downsides to both, which this Quora thread is useful at highlighting.

In addition, a handful of companies around the globe are trying to deploy similar systems. For example, Blue Park Smart Energy, a competitor in China with government influence, is doing something similar. In addition, American start-up Ample, have started operations in California, catering for fleet vehicles.

Overall, there is still a long way to go in the race to see which method of EV charging works best. Maybe, eventually, it will be a mixture of both. Nio are doing a good job in innovating within this category. If they can establish themselves as the leader in BaaS technology/infrastructure, then it’s possible they could supply other EV’s (already seen somewhat here with Ford).

7.3. Strong Management

NIO's CEO went to one of the highest-regarded Universities in China - Pekin University, majoring in sociology. Li started his first business at 21, then not long after joined Bitauto Holdings Ltd - a portal providing consumers with in-depth information about cars. He was the CEO there for 8 years, during which time the company went public. In 2014, Li started NIO.

It’s a broad-brush assumption that American companies are the ones innovating with cutting-edge ideas, while the Chinese can only compete in lower production costs through cheaper labour. However, the Chinese culture rewards entrepreneurship maybe even more-so than the US - shown by the fact that Beijing now has the most billionaires in any city in the world.

Understanding the customer is key, and Li seems to get this. His history speaks for itself, and he has been busy meticulously growing Nio over the past 7 years from the ground up. This is something I love to see.

7.4. China is the world’s largest auto market

It’s no secret China is one of the biggest EV markets in the world, alongside being the largest overall automobile market globally.

Due to a want/need of government to reduce emissions - politicians and high-up government officials have expressed the need to increase the amount of EV’s on the road. China has one of the worst pollution outputs in the world, and this is one way of tackling the problem.

In addition, China’s middle class is (and has been) one of the fastest growing group over the past 10 years. These underlying factors will almost certainly result in large levels of demand for products like Nio’s.

• The demand for the global electric vehicle market is projected to value at $1,212.1 billion by 2027, according to a new report published by Million Insights, with a CAGR of 41.5 % from 2020 to 2027.

• The global electric vehicle market was valued at $162.34 billion in 2019, and is projected to reach $802.81 billion by 2027, registering a CAGR of 22.6%.

• Pune, India estimate the global electric vehicle market to reach $985.72 Billion by 2027, exhibiting a CAGR of 17.4% during the forecast period.

We are at the beginning of an Electric Vehicle revolution over the coming decade, which will continue for much longer due to a variety of interconnected factors.

1.3M EV’s were sold in China in 2020 - representing roughly 40% of the global EV market. This figure is expected to increase by 50% in 20201…

As mentioned earlier, the chip shortage will likely have a dampening effect on the deliveries of EV’s in the short-term. However, demand is likely to continue to increase in the long-term, with low estimates of 60K deliveries, target estimates of 80K and bull-case estimates of 100k deliveries in 2021.

Another point to be aware of is that Asia and Europe markets account for 74.8% of the TAM in 2019. This puts NIO in a good position to be able to solidify their position as a market leader in the Asian markets whilst also expanding into Europe (specifically Norway).

Nio has a large runway for growth if the company can continue to expand and innovate over the coming years. It seems like there is plenty of opportunity within the Chinese market to reach a growing user-base.

To illustrate this, Nio’s TTM Revenue currently sits at $3.4 Billion, whilst Tesla’s TTM revenue sits at $35.94B - demonstrating the potential room for growth within this market.

7.5. Expansion into Norway

As briefly mentioned above, Nio are beginning to expand into Europe - beginning with Norway. I’m not sure there’s too much to be said at the moment, however this is something I will be keeping a close eye on, as it could be key to the company continuing to expand the brand.

Here is the recent Norway launch event, if you would like a flavour of what is to come.

8. Bear case

Even though there is much to be said about the positives surrounding Nio and their business-model, It’s also important to be able to recognize the potential shortcomings and risks… of which there are many.

1. Nio are yet to be profitable and continue to burn through millions every quarter.

   • For a company still in the growth phase and looking to expand - this is normal. However they can’t keep this up forever, so will need to improve their cash flow from operations at some point soon, which they have been doing recently.

   • I will be following this quarter by quarter.

2. Their liabilities have been steadily expanding since mid 2018, from about $1B to about $5B. Long term debt also continues to grow at an alarming rate.

3. History of management using share dilution techniques to raise funds.

   • Very likely to continue to use this method in order to cover losses if they can’t reach positive operating profit within the next 2 years.

4. The global chip shortage is still ongoing

   • This could significantly impact Nio’s short-term targets, which is likely to impact the stock price over the short-to-mid term.

5. Question as to whether excessive spending on marketing assets like ‘Nio House’ is worth the investment at a time where the company is trying to grow

   • You could argue the introduction of elements such as Nio House are key to building a solid community of loyal customers.

6. The stock is expensive.

   • However recent pullbacks have lead to a more attractive price.

   • Nio are currently trading at an EV to Revenues of 15.01 compared to the end of 2020/beginning of 2021 where the company was trading at around 40X.

   • For reference, Tesla, has been trading at more conservative EV/Rev multiples, however Nio has only recently began to dip below.

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9. Financials & valuation

The past 2 to 3 years has been a wild ride for NIO.

As Electric Vehicles have been propelled front-and-center, the Chinese-based EV manufacturer has experienced a huge spike in demand for their product, leading to exponential growth. The simplest way to highlight the level of growth is by looking at the share-price alongside the TTM Revenue.

On Feb 10th 2019, the share price was sitting at $3.87 before shooting up to an all-time-high of around $62 (a 1502% increase).

Similarly, Q1 TTM revenue in 2019 was $961M, $1.084B in 2020 followed by $3.410B in 2021. Representing a 13% and 215% increase respectively.

9.1. Revenues

As mentioned above, revenues are growing rapidly, mainly due to their current position within a rapidly expanding market. Over the past 8 quarters we have seen an average quarterly revenue growth of 35% with the latest quarter producing $1.2 Billion in revenues, resulting in the TTM revenues of $3.41 billion. This TTM $3.41 billion is up 215% y/y from $1.084 Billion for the same period last year.

All this indicates healthy growth and the continued ability of NIO to expand operations within a rapidly growing market.

Looking forward - NIO is forecasted to grow its revenues to $5.4 billion this year, with another 59% growth forecasted for 2022, and revenues for 2023 expected to be $12.5 billion (up 45% versus 2022's expected revenues).

9.2. Profitability

Margin-wise, the gross margin is relatively low - currently at 19% for Q1/2021 -and has been rising steadily over the past several years. That being said, they started from a negative position only 1 year ago.

Objectively speaking, and from first glance, this isn’t a great outlook. A 20% gross margin doesn’t leave the company with much room to maneuver. However, two points. 1) If we look at the trend of NIO’s margin over the past two years on a q/q basis, we are looking at a positive uptrend with almost consistent growth - this is mainly driven by the increase of vehicle margin in the first quarter of 2021. And 2) it’s important to compare the industry standard margins, which happen to be fairly similar in this case…

And if we delve sligtly deeper, we can see the reason for this increase in overall gross margin is attributable to an increase in the vehicle margins. These vehicle margins are driven by “the increase of vehicle delivery volume, higher average selling price, as well as lower material cost. The increase of vehicle margin compared to the fourth quarter of 2020 was mainly attributed to higher take-rate of NIO Pilot and 100 kWh battery package. Which are mainly driven by the increased improvement on the overall vehicle margin.”

9.3. Balance Sheet

Lets take a look at the company’s ability to pay off their current liabilities (short-term) and non-current liabilities (long-term debt). Firstly, the below graph isn’t super clear, however it shows that from a point in mid-to-late 2020, the company’s total assets have eclipsed their total liabilities, which is always something we like to see from a liquidity standpoint.

If we look at the exact numbers, NIO’s current assets of $7.91B are able to pay off the long-term liabilities of $2.62B 3X over, and the total assets 1.5X over.

The above graph also shows that at a point in mid-2020, the company’s assets began to outweigh both the current and non-current liabilities. A good question to ask is why and how did this happen? From what I can gather, the company capitalized on the high level of interest in the market at the time by issuing 68M new shares.

“NIO's offering of 68 million new American depositary shares was completed on Wednesday at a price of $39 per share, raising about $2.65 billion before fees.

With this stock sale, NIO joined a growing list of publicly traded electric-vehicle companies that are taking advantage of high investor interest and lofty valuations to raise additional cash.”

Realistically, this isn’t the most encouraging sign. I would much rather the company not have to issue millions of shares in order to generate cash - however, the timing on this was good due to levels of demand.

Overall, I’m relatively pleased with the balance sheet, especially considering the company’s history of burning through cash. However, we need to ask ourselves whether the methods used here to raise cash is sustainable in the long-term.

9.4. Cash Flow

As we can see from the below table and graph, Nio have been operating largely through external financing over the past 4/4 years. The only year with positive CFO (cash flows from operations) has been 2020. This is a good sign, as it shows that with scale, the business is beginning to move towards a more sustainable model.

9.5. Valuation

*Disclamer for this part* - due to the amount of assumptions I would need to make, I will keep the valuation fairly simple. I have used a model from Joshua Tai, who has recently completed a VERY deep dive on Tesla. I thought his valuation model was easy to understand and made sense for the EV market.

1. Vehicles delivered - This is a lot of guess-work. Feel free to try some different numbers if you would like. 8,000,000 deliveries by 2030 seems fairly optimistic, however, the Chinese EV market is by-far the largest in the world, and 8,000,000 is less than half of Tesla’s goal by 2030 (20 million).

2. Price of the cars - I have assumed the average price of the cars will continue to decrease as the technology evolves and the business begins to benefit from economies of scale. Therefore I have estimated a 5% y/y reduction.

3. Gross margins - Again, as economies of scale kicks in, I can see gross margin increasing. I have used 2% per year growth in this case as I think that’s a reasonable average over the long-term.

4. Operating profit - Seeing as the company are currently loss-making but moving swiftly towards profitability, I have given 1 more year of loss followed by 5% operating margins growing at 15% per year. Operating profit of 18% by 2030 seems reasonable, if slightly on the high side.

5. Tax rate - Not sure on this one, estimated 25%.

I have chosen a relatively high forward P/E value of 25X based on the average for the industry currently, this estimates NIO to be worth $337B by 2030. And with roughly 1.6B shares outstanding - we can estimate a 2030 share price of $210.

Again, there are so many different factors at play here - so do mess around with these numbers yourself to see if you come up with something a bit more robust.

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10. Key takeaways & Conclusion

Before I conclude, I would like to point out 5 key takeaways…

1. The EV Market is only just getting started and has the potential to be gigantic within the next decade. The opportunity is huge. That being said, Nio are not the only EV company operating in the Chinese market. As the market continues to develop and the key technologies evolve, we could easily see new players enter the market. There is a tonne of money to be made here, and with that, many people wanting a slice of the pie.

2. Nio are pioneers with the BaaS model for charging batteries. However, just because they are innovating, it does not mean that their method will be the go-to method for charging. Time will tell.

3. Nio stock price is looking far more attractive over the past month as the price contracts. I would be looking to buy somewhere in the range of $15 - $25.

4. The company are yet to be profitable, however are heading in the right direction.

5. Stock dilution. Even though Nio are laser-focused on growth at the moment (which is fine), it’s worth keeping an eye on the issue of stock dilution and raising cash via debt as, generally, you would want to raise cash organically.

Overall, Nio are an interesting company with heaps of potential. Their mission is clear, the products are stunning and the macro-conditions are looking favourable for sustained growth.

However, in order to solidify themselves as a serious player in the space, I would like to see improved margins along with a sustained increases in revenue/delivery growth and signs of success with the expansion into Europe.

Patience is key here - if you can pick Nio up at a reasonable price, then there is plenty of upside to be had.

Cheers,

Innovestor.

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1. Quarterly Highlights

2. Business Overview

3. Innovation

4. Market Opportunity

5. Bull Case

6. Bear Case

7. Financial/Valuation

8. Concluding remarks

1. Quarterly highlights

• Revenue increased 66% y/y to $770 million

• Market Cap of $92B

• ARPU (Average Revenue Per User) increased 36% YoY to $2.74

• Still making losses ($(287)M compared to $(306)M for the prior year), though margins improved from (68%) to (39%).

• First ever quarter of positive Free-Cash-Flow, having improved $131M y/y.

• DAUs (Daily Active Users) were 280 million in Q1 2021, an increase of 51 million, or 22% y/y.

• For the first time, the majority of the DAUs for the quarter were on Android.

Outlook:

• Revenue is estimated to be between $820 million and $840 million , compared to $454 million in Q2 2020 (80%-85% y/y).

• Adjusted EBITDA is estimated to be between $(20) million and breakeven, compared to $(96) million in Q2 2020.

Summary

To summarize, not a bad quarter for Snap Inc as the company has achieved their first ever positive free cash flow - something investors have been looking to see for a while now.

2. Business overview

2.1. Company

Snap Inc class themselves as a ‘camera company’ - distinguishing themselves from social media counterparts such as Facebook, Twitter and Instagram. Apart from this distinction, I would say their main differentiation is the focus on the younger demographic.

2.2. Mission

Taken straight from the Investor Relations page...

“Snapchat is an app that empowers people to express themselves, live in the moment, learn about the world, and have fun together. It's the easiest and fastest way to communicate the full range of human emotions with your friends without pressure to be popular, pretty, or perfect.

Snap’s camera supports real friendships through visual communication, self expression and storytelling. Moving forward, our camera will play a transformative role in how people experience the world around them, combining what they see in the real world, with all that’s available to them in the digital world.”

2.3. Product

Many of you reading this will have either used, or know kids who use Snapchat on a daily basis. The core product is a simple idea - a picture-based chat platform, allowing you to connect with friends mainly through the medium of images. The distinguishing feature here would be the fact that images disappear after being viewed.

Although completely unique when the company first started, the easily replicable nature of the Snapchat platform has lead to other social media companies mimiking aspects of the product.

The core product is relatively simple, however contains several different aspects…

1. Camera: The Camera funtcion is at the core of the product. When a user opens the app, they will be greeted with a selfie view - the idea here is to encourage instant use of the app via sending pictures to friends.

The camera also includes a powerful Augmented Reality function (which we will talk about later) that is able to understand, interpret, edit and augment a scene in real-time - enabling the next generation of computing.

Although the AR function is core to the product, I believe it is somewhat underrated in terms of potential added value.

• Over 5 Billion Snaps are created every day on average

• Over 200 Million users engage with AR every day on average

2. Communications: Another vital aspect to the core platform is the ability for the user to chat with friends. Similar to other social-media chat platforms, the user can send text and images along with the ability to play games among other things.

• A typical user opens the app over 30 times per day

• Over 30 million users play ‘in-chat’ mini-games each month

3. Stories: The story function allows the user to upload pictures to their 24 hour reel in chronological order, essentially allowing everyone to see what the person has been up to over the past 24 hours.

Originally, this was a unique feature to Snapchat - however due to the relative simplicity of the product, almost every other Social Media platform has implemented some form of stories. In my opinion, this fact shows how powerful of a product idea stories really are.

• 70% increase in time spent watching stories in 2020

4. Snap Map: Snap Map is essentially a ‘find my friends’ feature - allowing the user to see exactly where their friends are, updated in real-time.

I’m personally not a fan of having a bunch of people know exactly where I am all the time, however I can see it’s value and the fact that it is a good way to encourage people to open the app.

That being said, a cool feature of Snap Map is the ability to see where exactly there is a large gathering of people (possibly a concert) shown by a heat-map. Then, when you click on the heat-map you are able to view other people’s public stories - therefore getting to experience the event in an authentic way without having to be there.

• Over 250 Million users use Snap Map every month

• Over 35 Million businesses are viewable on snap-map

5. Spotlight: This isn’t exactly comparable, but is most similar to Tik-Tok or Instagram Reels, where Snapchat feeds the user popular Snaps created by the community. It provides a destination to share user-generated content.

• Over 125 Million Monthly Active Users on Spotlight

• Distributing over $1 Million per day to the top performing videos

2.4. Revenue streams

Unfortunately, the company doesn’t really break the revenue out by segment in their financial statements - however the majority of Snap.Inc’s revenues (99% as of 31 Dec 2020) come from advertising. The other 1% of revenues is generated from the sale of ‘spectacles’ however they do not class this as material.

Effectively, seeing as Snap.Inc’s platform is free to use, the company focuses on monetizing this user-base through ads.

2.4.1. Self-service

Snap.Inc are in a good position with their advertising platform after having transitioned to a self-service advertising model in 2017. This move increased the efficiency with which advertisers are able to purchase advertising space on the platform, along with increasing the the ability to interrogate campaigns better. This has set the company up with a good base to push off from over the coming years.

“Snap Ads allows advertisers a way to tell stories similar to the way Snap's users do, while also providing additional features such as long-form video, and the ability for users to visit an advertiser's website or install an advertiser's app. AR Ads includes Sponsored Lenses or Sponsored Filters. The former provides users with branded augmented reality experiences. The latter provides entertaining, artistic overlays that allow users to interact with an advertiser's brand.”

2.4.2. User-base

The user-base for the Snapchat platform is young and comes with an impressive level of penetration:

• In the US: 75% of the 13-34-year-old population and 90% of the 13 to 24-year-old population.

• Outside of the US: 60% of the 13-34 year-old population and 80% of the 13 to 24-year-old population.

2.4.3. Monetizing their audience

The company are focused on three main points in order to drive the continued demand for advertisement.

1. Improve ranking, optimization, and measurement in order to drive ROI

2. Build out sales and marketing functions to support needs of ad partners.

3. Deliver innovative ad experiences

These three focuses allows Snap.Inc to drive ad performance at scale for businesses around the world.

In addition, it seems like this is the correct focus moving forward due to the increase in demand for advertisement that Snap.Inc specializes in. E.g. mobile ads are set to grow faster than desktop, and video is set to grow faster than non-video. The relatively unexplored area with regards to advertising is the AR space, which we will see unfold over the coming months/years.

2.4.4. Other

I think long-term we may see revenue streams from e-commerce sales or other AR hardware (similar to spectacles) as these markets continue to develop. However this is purely speculative as it stands.

3. Innovation

Snap.Inc are particularly interesting when it comes to innovation. This chart below is a good indication of the level of innovation output over the past decade.

I think it’s safe to say that most of the ‘innovations’ listed in the above chart wouldn’t exactly be considered ‘cutting-edge’ in terms of the technology being used, however the sheer volume is the impressive part here.

Due to the younger demographic and quick nature of a user on the Snapchat platform, the level of innovation demand is greater on Snapchat compared to their social media counterparts. This point is expanded in greater detail by KnowHowCapital in their weekly newsletter…

Before I go on to talk about AR, I want to point out several of the company’s recent additions which are likely to be pivotal in their future strategy.

1. Camera Kit: “Camera Kit is a complete end-to-end solution to include Snap’s AR platform into your own applications. Access a turnkey suite of tools and services, from Lenses AR experiences creation to Lens carousel management and analytics, to enable AR technology for your community.”

2. Mini’s: “Snap Minis are lightweight, simplified versions of apps that live within Snap’s Chat section. These apps — built with HTML — are designed to improve engagement among users by enabling them to perform a range of additional tasks without leaving the Snap app.”

   “Though a relatively new concept in the U.S. and U.K., the mini apps model is quite popular in Asian markets. Tencent’s WeChat has attracted over a million miniature apps that allow users to perform a range of tasks.”

3. Local Lenses: “Local Lenses essentially enable users to interact with an AR overlay of a real-world location. You can virtually paint whatever you like over the shops and streets, and your contribution will then be visible to any other Snapchat user who visits the site.”

3.1. Augmented Reality

Snapchat are one of the few companies with a major focus on innovating within the AR space. This decision to focus heavily on the AR ecosystem could be a healthy long-term play.

I always come back to this slide because I think it’s super interesting. In Ark’s 2021 big ideas report, they predict Augmented reality has the potential to grow from a $1B dollar industry today to a $130B industry by 2030. This is fueled by the increased investment from companies like Snap.Inc, Facebook and Apple - therefore accelerating the widespread adoption of this technology.

I thoroughly believe Snap.Inc have a long-term vision to be one of the world leaders in consumer-level AR. Below, I will outline Snapchat’s AR operations and why I think this puts the company in a good place moving forwards.

3.1.1. Lens Studio

In 2017 Snapchat introduced Lens Studio, which allows the creator community to use the same tools as internal Snap.Inc employees to be able to develop Augmented Reality lenses.

Lens studio

Today, over 75% of Snapchat’s users (200M+) engage with AR on a daily basis.

3.1.2. Creator Community

The AR creator community currently makes about 30% of the Snapchat AR lenses that are available. The community is made up of over 150,000 creators from nearly 200 countries and territories who create a wide variety of AR experiences across different geographies and cultures.

3.1.3. Future Potential

The future value of this technology on the business is hard to visualize at the current time due to AR only just getting started - however Snap.Inc seem to be signalling their intent to enter into the AR e-commerce space with some of their recent acquisitions.

Examples include:

• Screenshop: an app which scans your photos to identify style choices - then provides clothing recommendations based on those findings.

• Bitmoji fashon products - Now, with Snapchat's full-body tracking tools, users can create life-sized versions of their Bitmoji characters, which they can overlay onto real-world scenes. 

• FitAnalytics - Sizing technology company that powers solutions for retailers and brands.

• 2D & 3D full body tracking to be used in trying on clothes

• Developing new AR enabled spectacles.

• Partnered with the fitness company ‘Sweat’ to launch a full body Lens to track body movement while exercising in order to recommend optimal form to Snapchatters.

• Partnered with Gucci to launch the first sponsored LiDAR Lens which projected a 3D camping site around the user to promote the The North Face x Gucci collaboration.

All of these developments point towards Snap.Inc targeting the e-commerce market.

“We believe that AR can really help retailers on the top and bottom line and also provide a really compelling shopping experience for consumers as well. We're experimenting in many other areas though. I can highlight Minis as an example or native checkout where we're really trying to remove friction from the checkout process overall, so that brands who want to host their own store on Snap can make it really easy for folks who want to buy their products to essentially tap and buy in one click with safe credit card data and things like that.”

3.1.4. AR statistics

• The number of Snapchatters engaging daily with our augmented reality Lenses grew more than 40% yearover-year in Q1 2021

• Over 260 million Snapchatters engaged with Valentine’s Day Lenses over a two-week period

• Lunar New Year Lenses reached over 125 million users.

• We released Lens Studio 3.4 with improved capabilities around hand tracking, 3D multi-body tracking, and full body segmentation and a new asset library of 3D models, materials, scripts, and presets to help creators build Lenses.

• On average, Lenses created by our community via Lens Studio accounted for more than 50% of daily Lens views.

4. Market Opportunity

In terms of market opportunity, this is a hard one to quantify.

4.1. AR

As hinted to in the Ark graph above, the Augmented Reality portion of the business looks to be one of the key drivers of future growth over the next decade. What is currently a $1B market has the potential to reach $130B by 2030.

4.2. Advertising

Snapchat is an advertisers dream. High engagement combined with a user-base growing in purchasing power will see the demand for Snapchats Ad business only increase over the coming years. The company transitioned to a self-serving ad platform (similar to what Pinterest are currently implementing) which will provide the company with a good base for advertising revenue growth.

4.3. International

International expansion is potentially a large market opportunity. Monetization internationally is at a much earlier stage when you take into account the ARPU, however plans are in place to capture this high level of current penetration.

“We do have so much room to grow in some of the world's most established advertising markets outside of North America, where we have really strong smartphone penetration. In countries that comprise over half the world's digital ad spend, Snapchat reaches 70% of 13 to 34-year-olds. So we're already there with deep penetration of critical demographics that our advertising partners are eager to reach. So, in 2021, to answer your question, we're going to be making these investments in sales and sales support teams to capture the opportunity, the way that we have in North America in the coming quarters and going to grow those teams to grow top-line growth in the years ahead.”

4.4. Purchasing power

Snapchat’s user-base is young. The company reaches over “70% of 13-34 year-old’s in countries comprising of over half the world’s digital ad-spend”. This stat has several benefits, however the overarching benefit relates to the indirect purchasing power Snapchat are building.

One factor derived from the current user-base being young is the relatively low purchasing power. The younger the user, the less likely they are to have any sort of significant disposable income. Therefore even if these users are willing to spend on the platform, the likely overall spend is going to be low.

However, if we zoom out to take the longer-term view - as these users pass through the various stages of their life-cycle, we will see the purchasing power of these groups becoming increasingly stronger.

If Snapchat are able to acquire customers at this early stage at very little cost and have the ability to keep them engaged throughout their development stages, then by the time the person has reasonable levels of disposable income the theory is that this person is far more likely to stay within the Snapchat ‘ecosystem’ - thereby increasing the overall customer lifetime value (LTV).

5. Bull Case

1. Strong built-in network effects

   SnapChat increases in value to the user as more people sign up to use the platform. This creates more of an incentive to frequently use the app - a virtuous cycle.

2. Confidence in revenue growth over the coming year.

   Expected revenue growth for the second quarter (y/y) is predicted to be between 80-85%, which is made to look slightly better than reality due to a slow Q2 2020 due to the beginning of the pandemic.

   During its investor day in February, it predicted it would generate more than 50% revenue growth over the next few years.

   Snap believes the expansion of its ecosystem and its gradual evolution into a social commerce platform for online shopping will drive that consistent growth.

3. User-base is growing at a steady rate

   Daily active users grew 22% year over year to 280 million during Q1, which matched the growth rate in the fourth quarter. The company predicts DAU growth at 22% y/y to 290 million in Q2.”

4. Effective and growing ad platform

   Snapchat’s ad platform has been growing substantially in terms of effectiveness over the past 5 years or so as the company has added new features designed to capture the users attention for longer and increase engagement.

   Penetration into the younger demographic is strong. Within the US, Snapchat reaches 75% of the 13-34-year-old population and 90% of the 13 to 24-year-old population. Outside of the US (UK, France, Canada & Australia) Snapchat reaches 60% of the 13-34 year-old population and 80% of the 13 to 24-year-old population.

5. Decreasing infrastructure costs

   “As Snapchat's DAU and ARPU has grown, the infrastructure cost per DAU declined 13% year over year to $0.62, marking its lowest infrastructure costs per DAU since its public debut. It attributed those lower costs to better negotiated rates for several of its cloud services.

   Lower infrastructure costs can also free up more cash for Snap to increase innovation, strategically acquire companies and to boost headcount.”

6. History of successful innovation

   As discussed in the section on innovation above, Snapchat have been aggressively adding to their list of innovations at a rapid pace - providing significant value to the end users.

7. The Augmented Reality market has the potential to be huge, and Snapchat could be a leader in the space.

   Discussed in detail above, the market for AR is potentially huge within the next decade. Snapchat are positioning themselves well to be able to capture a sizable chunk of this growing pie.

8. Capturing large audience with long term purchasing power

   Due to the high penetration in the young user base, as this demographic’s purchasing power increases over the coming years, Snapchat will benefit from higher levels of spend - especially if they can successfully integrate e-commerce into the platform.

9. A possible re-opening play

   Evan Spiegel (CEO):

   “During the pandemic, a lot of folks sort of shrunk their social graph. They started talking more to their family members or really close friends. And what we're seeing now in the United States, which is really exciting is that people are going out more. And they're seeing more friends or they're returning to school or work. And so, their social graph and the people they're interacting with on a regular basis is starting to expand. And that sort of communication with that wider social graph drives a lot of the frequency of use of Snapchat. And then, of course, the conversion then to our other platforms and products that we offer.”

10. Opportunity to increase ARPU & DAUs

    The company’s average revenue per user (ARPU) increased 36% year over year to $2.74, which accelerated from previous quarters. Its ARPU increased 66% in North America and 36% in Europe, though it dipped 7% in the rest of the world due to the impact of its overseas investments.

6. Bear Case

1. Competition. As we have seen over the past several years, the competition within the social media space is heating up. Companies like Instagram, Twitter and Facebook have all been able to replicate some of Snapchat’s key (unique) features. Can Snapchat continue to compete within this market?

2. The company never reaches profitabilitiy. Due to the fact there is no clear path to profitability for Snapchat, it is possible the company never makes any profits - however this is unlikely. The company are working hard to make the most of the potential AR opportunity up ahead.

3. Negative press. Due to the nature of the platform, there have been many reports of misconduct by adults targeting underage teens. Unless Snapchat can figure out a way to control this issue, it may bring unwanted negative attention to the brand.

7. Financials

7.1. Overview

• Q1 Revenue increased 66% y/y to $770M for Q1.

• 2021 FY TTM (trailing twelve months) revenue stands at $2.81B, representing a 52% increase following on from the previous year’s 46% increase.

• Gross margin for the quarter stands at $366M (46.39% of the $770M in revenues) and 52% for the TTM value.

• Operating losses of $303M for the quarter are fairly consistent with the past several years of operating loss.

Looking at this as a snapshot, it’s not the best looking set of finances. On the positive, revenues are growing at an attractive rate, and are predicted to continue to increase at (or above) these levels moving forward, which is impressive. However, the fact that the company are yet to produce any positive income with advertising as their main (and basically only) source of revenue is fairly concerning.

The path to profitability for Snapchat is slowly becoming clearer with the implementation of e-commerce onto the platform being one route to successfully monetizing their huge DAUs. However, ‘clearer’ is still not clear in this case, which causes some concerns.

All this being said, I find that it’s less useful to forensically examine the finances of these growth companies like this. Mainly due to the fact that these guys are taking a massive leap of faith on cutting edge technology which may or may-not pay off in the long-term.

7.2. Profitability

I think gross margins are a fairly important comparison to be able to make in this case, as it’s hard to increase your operating income without improvement in the gross margins.

The below graph shows how Snap.Inc’s gross margin stacks up against their competitors. Snap.Inc have consistently fallen behind their direct ‘social media’ competitors.

Again, I’m going to refer back to KnowHowCapital’s graphs on their Substack regarding Snapchat and Pinterest’s margin compared to ‘R&D’ and ‘Selling & Marketing’ as a percentage of sales, as I think they make an incredibly insightful point. *Please do check these guys out.*

Essentially, the point made is that for social media platforms like Snapchat and Pinterest - as the user-base matures, we want to see gross margin stabalise whilst ‘R&D’ and ‘Selling & Marketing’ expenses (as a percentage of total sales) fall. This is the path to profitability.

When looking at Snapchat (above) we can see gross margins steadily improving, however these other costs are staying at elevated levels. Part of the reason for this is that the company’s strategy involves innovating heavily to retain users and expanding internationally to gain new users - two vital factors for future profitability.

If we then compare to Pinterest (below) we can see a more stable gross profit for a longer duration, combined with falling ‘R&D’ and ‘Selling and marketing’. Exactly what we’re looking for!

7.3. Balance sheet

Firstly, lets take a look at the company’s ability to pay off current (short-term) and non-current(long-term) liabilities. To be conservative, I will take the ‘cash and cash equivalents’ along with ‘marketable securities’ into account regarding current assets. This adds up to $2.6B. And if we compare this to the current liabilities of $581M, we can see that the company has the ability to pay off any short-term debt 4.4X over.

This $2.6B doesn’t quite cover the total liabilities on the balance sheet of $3.3B. However, the total current assets come close - and the total assets far exceed this figure, at $5B.

Overall this is a relatively healthy balance sheet. However, the bottom line is that Snap.Inc are still losing money y/y. So the issuance of debt to be able to finance the various innovations present in the sections above can only go on for so long. At some point soon, the company need to start generating positive cash flows which, luckily, they have finally started doing.

7.4. Cash Flows

The company finally reported their very first Free Cash Flow positive quarter. The company did $126M of Free Cash Flow from a base of $770M revenues, which equates to roughly a 17% FCF margin.

Historically, the company’s past Free Cash Flow position hasn’t been great. The graph below shows how this story is beginning to change as of more recently. As you can see, the company reported a positive free cash flow in Q1 2020, however due to $11M of Capital Expenditures the final figure ended up at $(5)M.

If we look at the breakdown of cash flows over the years for Snap.Inc, we can see that the business has been fairly consistently fueled by cash flows from financing, with cash flows from operations beginning to slowly grow. This is a good sign. Hopefully they can keep increasing CF from operations over the coming year.

If we caompare this to Pinterest’s Cash Flows (below), we can see that over the past couple of years the company has been predominantly financed via inflows from financing (such as debt issuance), though this trend has subsided recently - with Cash from Operations now being the main driver (just).

Typically, these results are expected for companies in the relatively early stage of growth. However, we do want to see increased inflows from operations as the company establishes themselves. It’s good to see the beginning of this trend with Snapchat.

There is still a long way to go due to the difficulty of earning solid operating income with their advertising business model, however I can see this improving over time as more revenue sources mature and the Augmented Reality market develops.

Realistically, we want to see the ARPU increase, as this is an area of huge opportunity and something Snap.Inc are falling behind on slightly.

7.5. Valuation

I’ll briefly look at some relative valuation in order to get an idea of where Snapchat are in relation to their social media counterparts. To do this I will look at the Enterprise Value to Revenues ratio.

We can see that Snap.Inc are the most richly valued out of this bunch, with Pinterest - in a similar position from a growth standpoint - with an equally high multiple. You could argue the justification being future growth rates are likely to be significant over the coming years which may justify the premium.

And if we look at these taking into account the 3 year trailing median, we can see Snap are currently trading at 13.8X. Meaning they are currently trading at a significant premium to the 3 year average.

Note: Thanks to everyone who made it this far. If you enjoyed, please subscribe or share the article as it really helps me out!

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8. Final Thoughts

Snap.Inc is an interesting company. They combine a mixture of messaging, content, advertising, software, and hardware in a way that challenges the idea of what it means to be a typical ‘social media’ company.

They were once a business I dismissed due to an unclear path to profitability alongside not seeing how the company could stand out in a competitive field - up against the likes of Facebook, Twitter, Pinterest, Apple and Microsoft.

However my tune has changed somewhat recently, as I am beginning to understand the company’s vision for 5-10 years down the line. This vision, as I see it, centers around bridging the divide between physical and digital worlds in a way that was once not possible. The major tool being utilised to achieve this will be Augmented Reality.

If the company can continue to gain new users, maximise the ARPU opportunity and sustain positive cash flows moving forwards (as has been the case in recent updates), then I can see big future upside for this stock.

Proceed with caution.

Cheers,

Innovestor

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1. Intro

2. Quarterly Highlights

3. The Streaming Landscape

   1. History

   2. Competition

   3. Predictions

4. Bull Case

5. Bear Case

6. Finances

7. Closing thoughts

1. Intro

In this article I will explore the streaming company we all know and love - Netflix.

I will take a look at the history of the streaming industry, dive into the current landscape and think about what the future looks like regarding competition in the industry.

In addition, I will briefly be reviewing some of the fundamentals from this last quarterly earnings report to try to understand current investor sentiment and how we might see 2021 playing out for the company.

2. Quarterly highlights

As the lockdown is beginning to lift in some pockets of the world, we are starting to see the effects this is having on companies who significantly benefited from the global pandemic this time last year.

Netflix stock was down considerably after earnings were released on Tuesday. This sharp decline is mainly due to worse than expected subscriber numbers - which is seemingly the only thing investors care about. The company saw an increase in subscription numbers of 3.98M, missing the 6.29M target. Looking forwards, they are predicting a far more subdued Q2.

Most of these dampened results stem from pulled forward growth into 2020 from 2021, i.e. 2020 was far above expectations, which makes comparing 2021 numbers to expected growth tricky and somewhat misleading.

“In Q1, paid net additions of 4m were below our 6m guidance (and the 16m net additions in the year ago quarter) primarily due to acquisition, as retention in Q1 was in line with our expectations. We don’t believe competitive intensity materially changed in the quarter or was a material factor in the variance as the over-forecast was across all of our regions. We also saw similar percentage year-over-year declines in paid net adds in all regions (see our Regional Breakdown table below), whereas the level of competitive intensity varies by country.”

The takeaway for me here is that Netflix feels these lower-than-expected results weren’t down to increased competition in the industry (with Disney+) but more to do with external factors such as the world beginning to re-open and less people needing the Netflix service.

I’m not too worried about a contraction in subscriber growth, as 1) this was somewhat expected as the world begins to resume, and 2) much of the growth from 2021 was pulled forward to 2020 - with the expectation of improved growth in the second half of the year.

Guidance for Q2 is further subdued to 1M compared to a consensus of 4M.

“We project paid net additions of 1m (vs. 10m in the prior year quarter) with our UCAN and LATAM regions expected to be roughly flattish in memberships. We anticipate paid membership growth will re-accelerate in the second half of 2021 as we ramp into a very strong back half slate with the return of big hits like Sex Education, The Witcher, La Casa de Papel etc.”

• Revenue beats expectations by 0.37%

• EPS beats expectations by 25%

• Operating margin reached all-time highs (27%)

• Full year FCF on track to be roughly ‘break-even. FCF for Q1 was $692M for 2021 compared to $162M for 2020 - “very close to being sustainably FCF positive and that we no longer have a need to raise external financing to fund our day-to-day operations”.

• Average Revenue per Membership for all regions comes to $10.73

  • United States & Canad = $14.25

  • Europe, Middle-East & Africa = $11.56

  • Latin America = $7.39

  • Asia = $9.71

3. The streaming landscape

Streaming is a rapidly evolving/growing industry. Over the past several years we have seen some major entrants into the market that are making a material impact on Netflix - the industry leaders. In this first section I’ll aim to give a bit of background, explore some of the competition present and finally, outline how I see it playing out over the coming decade.

3.1. History

Similar to music streaming, television has been entrenched in a traditional model since its mainstream adoption somewhere around the 1930’s. Most have been using a ‘Pay TV’ model for the majority of the past 50 years – paying for individual linear channels/bundles with Sky/Virgin/many more. And this model made sense…

The introduction of Netflix (and other streaming services) since 2007 has seen a sharp decline in the number of people using the linear model. To show this, the movie rental business in 2006 stood at about $5.5 billion, with blockbuster making up about half of that. Fast forward to 2021 and Netflix alone is a business worth about $25 billion in revenue. With the larger digital streaming market adding up to roughly $70 billion.

Due to the fundamental change in the product being provided to the consumer, the economic landscape of the industry is drastically changing. No longer is there an incremental added cost in order to discover new movies - for the price of £9.99 per month, you have access to a seemingly endless collection of movies/TV shows.

The TV industry has been using this standard model for decades without any complaints from a consumer standpoint. It benefited both parties in that consumers paid a simple fee for scheduled programming, and TV networks made billions in profits from carriage fees whilst allowing advertisers to reliably reach millions of people.

This all changed with the introduction of the internet. 

It took a while to fully kick in, but by mid-way through the 2010’s, Netflix had pretty much fully established themselves as the go-to SVOD (Streaming Video On Demand) offering. 

This new form of TV - which bypassed the standard TV networks and went directly to consumers - enabled an entirely new business model. 

“In 2007, Netflix pivoted from mailing DVDs to streaming video on the internet—ad-free content delivered for (initially) only $7.99 a month.”

The chart below nicely shows the change in consumer behaviour away from traditional linear TV Over the past decade. Almost every age-group have begun to move towards the streaming model.

The fact of the matter is that Streaming’s value proposition to consumers is simply much clearer - more content, greater flexibility, better UI, add-free and a lower price. Pay TV is on it’s way out, and with it’s exit comes new entrants into the SVOD market....

3.2. Competition

As I see it, there are currently a handful of competitors operating within the SVOD industry who are in the contention to win long-term. These include Netflix, Disney+, HULU, Amazon, HBO Max, Apple TV and other niche players.  

I find the entire TV industry particularly interesting, mainly due to the impressive ability of these media companies to be able to extract more money from customers than was previously possible. By this, I’m talking about how we, as consumers, have perceived the change to SVOD to be a good one - but is it really that good for our wallets?

Yes, we now have the ability to watch almost anything and subscribe/unsubscribe to any of these subscription services at will. However we have ended up with essentially a set of paid ‘channels’ - just without the standard cable tv infrastructure.

The industry lowdown

Netflix: Netflix are the original streaming model. In the mid 2010’s, Netflix moved from mailing DVD’s to streaming. Today, Netflix has a current reach of 204 million global subscribers and a market cap of $242.92 Billion.

As the industry has developed over the period, of the past 10-15 years, Netflix have had to adapt their own business model. We have seen a move from majority licenced content to a more ‘in-house’ approach with ‘Netflix Originals’. The company can no longer purchase content from suppliers like Disney and NBC, and are therefore forced to create its own content.

“Netflix’s cash content spend is up 5x since 2014, but its movie library has shrunk 40% and its TV library is down 25%.”

Disney+: For an in-depth look at Disney, see my recent article.

Disney are one of the most dominant (if not THE most dominant) media company in the world with a quite frankly incredible depth of quality IP.

Previous Disney focused on monetising this IP mainly through conventional ways including theme parks, theatres and merchandising. However, since Nov 2019 the company have began to dip their toes into the world of streaming, and as of Jan 2020, the streaming service has amassed over 94M subscribers - the fastest growth out of all providers in such a short period of time.

As this service evolves it will become yet another crucial touch-point in the overall Disney ecosystem.

Hulu: Launching around the same time as Netflix, Hulu struggled with uptake due to less than impressive original content.

With Disney’s recent acquisition of 21st Century Fox, Hulu is to be bundled within the Disney+ package, allowing Disney to reach a broader audience (i.e. not just kids and adults searching for nostalgia).

Prime Video: Prime Video isn’t really in the same league when it comes to streaming. Prime-video is more of an ‘add-on’ to the overall Amazon e-commerce store with the role of drawing more people in to subscribe for a prime membership.

HBO Max: HBO is possibly one of the more established competitors, with a history of high-quality shows. However, it has taken the company way too long to release their competitive product.

Apple TV+: Apple TV+ launched around a similar time to Disney +, however due to almost no original content has struggled to gain a footing.

3.3. My predictions moving forwards

It’s important to note some major differences between each of these. For example - Netflix’s business is solely based on streaming, whilst Disney’s business heavily relies on other aspects such as live theatre + theme-parks. Therefore, a win might look different to each of these companies.

Disney+ (94.9M):

Firstly, lets take a look at Disney+

The past year has been a roaring success for Disney’s DTC offering . The company launched their ‘Direct to Consumer’ product in November 2019 (just in time for a global pandemic), and since then has grown to 94M subscribers paying an average of $4.03 per month. In the first year, this segment represented roughly 10% of the company’s overall revenues - whilst the most recent statistics show the DTC element captures 22% of overall revenues.

As evidenced here, Disney are much different from their streaming counterparts, in that they don’t wholly rely on revenues generated from the streaming segment of their business. Most of Disney’s core business revolves around the ability to monetise the plethora of valuable IP over differing mediums.

I don’t think I will ever get tired of sharing the below image which nicely outlines the sheer scale of the IP at their disposal.

Disney have managed to act with the agility of a growth startup in order to roll-out an entirely new revenue stream within several short years - and they have executed almost flawlessly. Disney will be a winner in this space. But what does this mean for Netflix?

HULU (40M): Disney’s acquisition of 21st Century Fox, completed in March 2019, further added to their offerings - as now HULU will be bundled in with the Disney catalogue, adding a wider variety of shows - targeting a larger audience.

Netflix (204M): Disney’s entrance into the streaming industry had Netflix shareholders worried throughout 2019. However, since the launch of Disney+, the Netflix share price has increased almost 90%. Possibly somewhat to do with the pandemic - however, a great deal of this increase in consumer sentiment derived from the company’s ability to defend itself against a well-executed attack on their moat.

“I want to note here that a good sign of your moat is to see if it withstands attacks from high quality competitors. Disney launched a well thought through, expertly executed strategic attack on Netflix earlier this year and it doesn’t seem to have dented their moat one bit.”

As evidenced from the graph above - Netflix are leading the streaming war race, however competitors are starting to make some serious headway.

Part of the company’s competitive advantage is the fact that the catalogue of possible movies and films to watch is so broad it seems almost never-ending. The result is a low churn as people always feel there is more value to be had.

Prime Video (100M): Amazon is another of the streaming contenders I see winning long-term. However this is not because they excel at producing top-teir content, but because the prime video offering adds enough value to make the benefit of buying into the Amazon Prime eco-system worthwhile. 

Winning in the streaming sector for Amazon means improving retention and spend for Prime customers. By this definition, Amazon will win. 

Apple TV (35M): I’m not too familiar with Apple TV and its offerings, however my understanding is the service hasn’t decided exactly what it wants to be quite yet. The service launched with a thin offering of original content with the plan to slowly acquire a backlog of shows. I’m not sure how I see Apple TV winning here.

HBO Max (40M): HBO Max will more than likely acquire a large amount of customers due to the reputation of quality broadcasting alone. However, in terms of being a generation-defining part of pop culture, as HBO was, it will lose. HBO's famous tagline is, "It's not TV. It's HBO." Now, it's definitely just TV. 

Other niche services such as Curiosity Stream: In my piece on Curiosity Stream, I argue that their “flexible business model along with multiple avenues of content monetization and differentiated content offerings allows CuriosityStream to succeed where other similar ventures have failed. Other similar ventures have had more limited business models, expensive content and narrower go-to market strategies.”

Overall, the previous 10 years has been somewhat of a golden era for television. This ‘golden era’ has resulted a plethora of streaming services jumping into the market - trying to gain a piece of this massive pie.

Over the coming years we are likely to see a large consolidation within these services. The end result will still be beneficial for consumers, with more content, cheaper overall prices and with less ads.

4. Bull case

1. Netflix puts out so much volume in terms of content compared to the other streaming services. A multi-user family has simply absorbed the bill due to the level of perceived value from always having something new to watch. They do not think about the cancellation decision each month - resulting in a low churn rate.

2. Long-term, Netflix are likely to be dominant in the global SVOD market. I personally see this market consolidating at some point over the next decade. When this happens, Netflix - as industry leaders - will be best placed to accrue operating leverage

3. Expanding margins: Recent quarters have seen Netflix’s operating margin rise significantly. This rise may somewhat be due to several of the factors stemming from the pandemic, such as lower content spend and lower marketing spend from a reduced availability of productions.

   It is possible we see this margin contract over the coming year as operating costs rise, however Netflix are in a strong position moving forwards.

   “We plan to steadily increase operating profit and margin as we balance growth with profitability. With our rapid increase in content spending, and our growing emphasis on owned original productions, cash outlays are initially greater than content amortization, constraining free cash flow relative to profitability.”

4. High-quality original content. Ability to churn out ‘hit-shows’ is unparalleled, which further solidifies the company’s value proposition. This chart below, from the Entertainment Strategy Guy’s Substack, further highlights the dominance of Netflix’s TV series dominance.

5. TAM is huge: “Netflix’s addressable market stands at 50-70% of the developed world and 20% of the developing world based off of 1.6 billion television households worldwide” - Beth Kindig

   1. Statista show a CAGR of 10% to 2025, resulting in a projected market volume of $251B by 2025.

   2. Research & Markets project the Over the Top (OTT) Market was valued at $85.16 Billion in 2019 and it is expected to reach $194.20 Billion by 2025, registering a CAGR of 13.87%.

   3. Allied Market Research estimate the global OTT market size to be valued at $121 billion in 2019, and is projected to reach $1,039 billion by 2027, growing at a CAGR of 29.4%.

6. Recurring revenue is a powerful tool for any business. Netflix have a strong brand and product offering which results in a low churn and a relatively ‘safe’ source of recurring revenue.

7. Subscriber growth is still strong, but slowing - international could be the key. Reed Hastings mentioned in the investor call… “So outside of China, I think pay television peaked at about 800 million households. So lots of room -- and that was several years ago that it peaked, lots of room to grow.”

8. Fended off direct attack from Disney+ - shows strength of brand/product.

9. Huge distribution network, making producing a show via Netflix extremely attractive.

10. Relatively price inelastic: strong value proposition so consumers normally understand price increases. Netflix looking to raise prices at some point over the coming year.

5. Bear case

1. Intensifying competition

Competition within the industry is heating up. And one player coming in late to the game that may cause a serious threat (although not directly within SVOD) is Roku.

“It's easy to compare Roku's roughly 50 million users to Netflix's 200 million and to assume Roku is a much smaller company or lagging the subscription behemoths, such as Disney Plus. This is a mistake as the ad-based video-on-demand (AVOD) market is a newer market than subscription-video on demand (SVOD). The AVOD market is distinguished from SVOD because it's primary driver is pay-TV ad dollars rather than the cord-cutting trend or subscribers.”

The addition of streamers means more people will be looking for ad-based-video-on-demand, which is Roku.

Netflix could be missing-out on a tonne of revenues which are coming into streaming from paid TV. Paid TV ad spend is set to decline whilst connected TV ad spend is set to rise. If Netflix can’t figure out a way to cash in on this revenue stream, then they will be missing out on revenue.

A large amount of ad spending is staying with paid TV for now, due to the fact that it remains effective. However, over time, as more people join the cable cutting revolution - this number will only dwindle. 

This comment from Reed Hastings in the conference call nicely outlines Netflix’s opinion on competition at the moment. I.e. they don’t see Disney as a threat, more-so YouTube.

“Our largest competitor for TV viewing time is linear TV. Our second largest is YouTube, which is considerably larger than Netflix in viewing time. And Disney is considerably smaller, but we're sort of in the middle of the pack.”

…adding to that…

“We had those 10 years where we're growing smooth as silk and then just a little wobbly right now. And of course, we're wondering, "Well, wait a second, are we sure it's not competition?" Because obviously, there's a lot of new competition. And we really looked through all the data, looking at different regions where new competitors are launched, are not launched. And we just can't see any difference in our relative growth in those regions, which is what gives us confidence that it's intensely competitive, but it always has been.

I mean, we've been competing with Amazon Prime for 13 years, with Hulu for 14 years. It's always been very competitive with linear TV, too. So there's no real change that we can detect in the competitive environment. It's always been high and remains high.”

2. Production delays: Self explanatory, but should be less of an issue moving forwards. Lots of upcoming content to look forward to over the coming year.

3. Content costs: The cost of content to make a Netflix original series is lofty (reportedly $16B in 2020).

4. Advertising: As mentioned above, as consumers continue to make the switch from linear to SVOD/Connected TV, Netflix could be losing out on substantial revenues if they decide not to implement ads on the platform.

5. Password sharing: "Yeah, we're probably going to keep trying things, but everyone relax, the streaming police are not going to knock on your door and ask you for your wallet. You know us -- we're not like that."

6. Liable to lose licenced content: This article (although 2 years old) highlights the risk of over-reliance on licenced content.

7. Is growth stalling? (counter to the above point on growth potential): This graph shows that Netflix’s worldwide growth numbers may be beginning to stall. Have the company reached a plateau in terms of subscriber growth? Is it a case of all other streaming services catching up from here-on-in?

6. Finances

I’ll take a brief look at the finances here as I think looking at the half year point/full year point is more valuable.

Revenues

Unsurprisingly, TTM revenue growth is incredibly strong at 23% ($21B to $26B). This was mainly driven by external factors surrounding the global pandemic, forcing the population to stay at home and therefore needing entertainment. Netflix filled this gap nicely.

We can see a similar story for the y/y Q1 revenue growth, which stands at 13%.

Breakdown by geog?

From the below chart it is clear that the focus on future growth lies internationally in terms of increasing the level of revenue generated within both Latin America & Asia Pacific. Over the past quarter, there have been reports of $500M investment in Korea, 40 new films and series in India, along with more of a focus on Japan. The question still remains around whether this investment will lead to an increased willingness to spend on premium content...

The below chart, provided in Netflix’s shareholder letter, shows the disparity in ‘ARM’ (Average Revenue Per Membership) between the different geographies. If Netflix can improve the product market fit in the relative regions, then they are likely to see this number rise over the coming years.

Cost of Revenues

• Costs of Revenues as a percentage of overall revenue has remained relatively stable across all quarters at 61%/62%, leaving a gross margin of 38%/39%

• Operating margin reached all-time high’s of 27% in Q1 2021 mainly due to lower content spend and lower marketing spend. Content amortization only grew 9.5% y/y in Q1 2021 vs 17% in Q1 2020. This resulted in a 10% point y/y jump in our operating margin.

Other costs:

Marketing: Marketing costs have generally decreased over the past year as there has been less new content to distribute, and less need for physical marketing campaigns. 2019 = 13.6% 2020 = 8.7% 2021 = 7.2%.

Technology & Development: Technology and development costs has remained stable over the last 2 years, clocking in at around 7 or 8% of revenues.

G&A: G&A has also remained relatively stable at between 4% and 5%.

Profitability

Is the company profitable? Yes, Netflix are a profitable company. Profits increasing fairly steadily over the past 5 years alongside revenue growth. Operating margin has shot up drastically over the past year as Covid has provided the company a nice boost.