InvestAndRise.com has been started to help the readers invest in two seemingly different things – Equities and Life. The objective appears too broad, weird and cliched right?. Wouldn't disagree!! Both of these two themes have been toyed with and beaten to death across all platforms. My sincere effort are aimed at not making it another run of the mill stock analysis and life gyan repository :-)
** I will be creating an equity research report for ABSL AMC. For now, I am sharing the summary of my analysis and valuation (long-term return expectations) of ABSL AMC **
** Analysis and Valuation dated 29/7/2022 **
2 months ago, I had put out an equity research report on HDFC AMC, in which I had valued the firm at 28x earnings. In this post, I will present my valuation summary of another AMC, Aditya Birla Sun Life
ABSL is the 5th largest AMC in India by overall AUM. HDFC is 2nd. SBI leads, followed by ICICI ABSL and HDFC AMC are the only two listed companies in the top 5
As of F23-Q1, ABSL has an overall and active equity AUM of ~โน3000B and ~โน1200B (i.e. 40% equity mix) with a market share of 8% and 6.5% resp, while HDFC has an overall and active equity AUM of ~โน4000B and โน2000B (i.e. 50% equity mix) with a market share of 11%
ABSL reported a PAT of 46% and EBTDA of 65%, well behind that of HDFC (PAT 57%, EBTDA 78%).
Why is ABSL less profitable than HDFC AMC? 1. Active equity is the most profitable asset class (do remember that pressure on equity yields continues owing to low priced NFOs and material gross flows), but HDFC’s higher mix of equity is a key but not the only reason for its higher profitability 2. Both ABSL and HDFC incurred ~200 Cr in other expenses โ BD, new fund offering, marketing and tech expense. This is 14% of ABSL and 8% of HDFCโs revenue 3. HDFC incurred 13% employee expense, ABSL 18% This industry has economies of scale. HDFC seems to be getting the scale benefit. It certainly is maintaining a tight ship.
ABSL IPOed last year in Oct. From a high of โน20,000 Cr, it has fallen to โน12,000 Cr. HDFC has not done well either. Market seems to have priced in the low present and future yields and the continual debt outflows with these listed players trading near their lows
Now, I will use some rounded numbers to derive the return expectation of ABSL โ 1. Ind active equity AUM is expected to grow to โน 40,000 B from โน 18,000 B today 2. ABSL AMC derives ~70% revenue from active equity. They reported a quar. avg. active equity AUM of ~โน1200 B. If they can slow the active equity market share decline to 5.5% by FY27 (from 6.5% today), they will reach an active equity AUM of โน 2,300 B (i.e., ABSL active equity continues to grow slower than ind) 3. ABSL derived an active equity yield of ~72 bp in FY22. With ongoing equity yield pressure, this may drop to mid-60s 4. ABSL revenue in FY27 = โน 2,300 B * 0.65% / 70% = ~โน 2,100Cr @ same 46% PAT in FY27 = 46% * ~2,100 = ~980 Cr 5. Using 1-4, mybase caseDCF valuation of the company is ~โน13,500 Cr i.e., 20x FY22 earnings
** valuation with underlying excel models and assumptions will be present in the equity research report **
Considering ABSL trades at this PE 5 years out: MCap by FY27 = 20 * 980 Cr = โน 19,600 Cr (from 12,200 Cr as of 29/7/2022); Adding 2.5% div yield (based on hist. payout), the ann. return over the next 5 years is est. at 13% (after accounting other income and using actuals) i.e., if ABSL AMC continues to grow below the industry amid a declining overall and equity yield environment coupled with higher interest rates, you could still expect 13% return over 5 years
Disclaimer: Invested. Please do your own analysis before investing.
In the video, I give a quick walk through of my report on the company. I primarily focus on the industry and my investment thesis. You would find more details in the report doc linked in gdrive
Mutual Fund AUM penetration in India is 12% of GDP vs the global average of ~60%. Emerging markets such as Brazil and SA are at ~50%. Overall MF in India has crossed INR 30 Trillion in FY21 by growing just under 20% over the last 5 years. As per estimates, overall MF in India will double over the next 5 years.
This capital light business has tremendous economies of scale since AMCs typically do not have to spend more in investment management and admin related expenses as they scale (this is a key reason why SEBI has set lower TERs for higher AUMs).
Moreover, this is a business where the big gets bigger since investors are more likely to park their capital with big recognized brands and also they are charged a lower expense ratio (owing to higher AUM sitting with the big brands)
By total QAAUM, UTI AMC is the eighth largest MF in India. It is one of the three AMCs listed. In an industry where AMCs are fighting tooth and nail over market share, if over the next 5 years, UTI AMC is able to grow its MF equity market share to 6.00% from 5.40% (as of FY21; 0.60% is huge when we are talking about an industry with INR 30 T in AUM) and maintain its market share in other MF segments and at the same time walk the talk around laser focused frugality (CEO has maintained that he is keeping a microscopic focus on employee expenses that are the most critical cost line item), then the current market valuation of INR 11,000 cr is very reasonable. Swings in projected market share and expenses either way reflects in the fair valuation.
Industry
Within MF, ETF (others) is the fastest (72%) growing category, following by Equity (26%)
Exhibit – 1: India MF AUM segment growthExhibit – 2: India MF AUM segment composition
Debt(income) has been on the decline, while equity has been sturdy at 42% and ETF(others) has been gaining AUM share.
Exhibit – 3: MF AUM forecast
As per CRISIL, Equity is estimated to increase its share to 46% and overall MF AUM is expected to double over the next 5 years.
Why MF segment composition is important? Mutual Funds are permitted to charge certain operating expenses for managing a mutual fund scheme โ such as sales & marketing / advertising expenses, administrative expenses, transaction costs, investment management fees, audit fees โ as a percentage of the fundโs daily AUM. All such costs for running and managing a mutual fund scheme are collectively referred to as โTotal Expense Ratioโ (TER), calculated as a percentage of the Schemeโs average Net Asset Value (NAV). SEBI has set different TERs for different asset classes. While, equity is allowed to charge a higher TER, whereas ETF being a passive investment segment has a significantly lower TER. Why this business has tremendous economies of scale? For schemes within each asset class, TER reduces with increasing values of AUM. The rationale of charging lower TER (on higher AUM) is that operating expenses for AMCs do not increase much with rising AUMs. While AMCs may be required to shell out more on marketing and sales, but admin and investment management costs typically do not increase as they scale and acquire higher AUM. Understandably, SEBI does not let AMCs charge the same TER as they scale since this business has tremendous economies of scale.
UTI AMC
Mutual Fund: UTI AMC Domestic Mutual Fund QAAUM was INR 1,829 billion as of 31 March, 2021, which accounted for approximately 5.69%, or the eighth largest amount, of the total QAAUM invested in all mutual funds in India. Of all the asset classes or segments within MF, equity (including hybrid) have higher yields. When AMCs talk about MF AUM, the first question one should ask is how much of it is ETF (which is very low yield), how much of it is equity (high yield) and how much of it is debt (med yield). AMCs hardly make money on ETFs, since they does not require active management. As of 31 March, 2021, 40% of UTI AMC’s MF was equity-related (included hybrid) and 23% was ETF. Rest was debt (income) and liquid.
Portfolio Management Services (PMS): UTI AMC has got the mandate to manage 55.0% of the total corpus on 31 October, 2019 of the Central Board of Trustees, EPF, accounting for INR 6,635 billion as on 31 March, 2021, which is 84.65%of their PMS AUM as of 31 March, 2021. This is great, but it is of low value since PMS has a very low yield (refer exhibit-5)
Exhibit – 4: UTI AMC QAAUM composition (all values in INR Billion)Exhibit – 5: UTI AMC – Sales of Services as a % respective QAAUM
Refer to exhibit 5. Equity (and hybrid) asset class has a significantly higher sales of service (or investment management revenue) as a % of QAAUM. It has been reducing since not only the segment AUM has increased over the years, but also the investment management revenue % is based on net daily AUM (which is highly contingent upon everyday inflows and outflows) and not the average AUM by the end of a quarter or fiscal. Moreover, in FY21, industry equity AUM witnessed a net outflow, hence AUM increase was entirely as a result of equity appreciation.
1. Revenue Projections
Exhibit – 6: UTI AMC – Case wise MF AUM Market Share by 2026
In my bear case, I assume that UTI will be able to sustain the same market share across all MF segments. With UTI’s focus towards grabbing a higher market share, I assume slightly higher market shares in my base and bull cases. Across the three cases, I assume that PMS, IB and RS AUMs will grow at inflation rate. UTI intends to develop its AIF business so I have assumed 2x inflation growth rate for this business. Now this very well may not be true, but I can live with these assumptions for now since they do not move the needle a lot (unless of course the AUMs in these business grow substantially). I will change my assumptions as and when I hear any specific management commentary on these subsidiaries.
Exhibit – 7: UTI AMC – Investment Management Fees (% of respective AUM) Projections
Refer exhibit-7. For each of the MF segments, I have projected investment management fees as a % of respective AUMs based on historical numbers. I have assumed a slightly declining trend since TERs reduce with rising AUMs. Note that I have combined equity and hybrid and started with a weighted average in management fees in 2022. For subsidiaries IB, AID and RS, I have taken the past 4 year average management fees %.
Exhibit – 8: UTI AMC – Revenue Projections (Projected Investment Fees % of AUM x Projected AUM)
Based on the forecasts in exhibit 6 and 7, I project out revenue over the next 5 years. Revenue = Projected Investment Fees % of AUM (exhibit 7) x Projected AUM (exhibit 6).
2. Cost Projections
There is a lot of analyst and management commentary on employee expense in the earnings call transcript since it is the most critical cost line item. I have considered the management communicated employee net fixed cost decline of ~65 cr (or 0.65 B; over the course of next 4 years) as a result of their ongoing employee retirement program. Moreover, I have also baked in the remaining ESOP expenses of 17 cr of the next two year as per the management commentary. Although, this business has significant economies of scale, they are required to pay for sales related performance incentives in order to gain market share. I computed unit variable expenses per billion increase in MF AUM (sans ETF and Liquid) in FY21 and used it to project variable expenses in future years. I assumed that rest of the fixed employee expenses increase at inflation rate.
Exhibit – 9: UTI AMC – Base Case: Employee Cost Projections
Then I go on to extrapolate historical Fees & Commissions and Other expenses as a % of MF AUM and Depreciation & Amortization as a % of gross assets to project these expenses in the future.
Exhibit – 10: UTI AMC – Base Case: Fees & Commissions, Other expenses and Depreciation & Amortization
3. CapEx Projections
In FY21, UTI AMC did a CapEx of close to INR 60 cr or INR 0.6 B. To project capital expenses, I compute the gross assets required to increase one billion MF AUM in FY21 (i.e. total gross assets in FY21 / increase in MF AUM). Let’s call it “CapEx increase factor”. Since this is a capital light business, it does not require significant capital expenses as they scale, hence I decline this factor over future years to project out the CapEx needed every year. I assume that maintenance CapEx needed every year is last year’s depreciation and amortization expense.
Exhibit – 11: UTI AMC – Base Case: CapEx Projections
4. Working Capital Projections
This is fairly straight forward. I baseline current assets and liabilities baselines as a % of revenue and use the baseline to extrapolate current assets and liabilities in the future. I use the same working capital projections for my three cases.
Exhibit – 12: UTI AMC – Working Capital Projections
I use these projections to build the P&L
Exhibit – 13: UTI AMC – Implied P&L based on projections above
Valuation
With all ingredients estimated, I go onto value the UTI AMC’s equity.
Free Cash Flow to Equity = Net Profit + Depreciation – CapEx – Change in Working Capital
I assume that the business will grow at the risk free rate in perpetuity. I go on to discount the estimated FCFE using firm’s cost of equity to arrive at the fair equity value of INR 10,286 Cr (or INR 102.86 B)
Exhibit – 14: UTI AMC – Base Case Valuation
Summary
As per my base case, the equity is slightly overpriced by 9% as of 7/18/21. I’d call it is reasonably valued. In my bear case, I assume that UTI AMC sustains its market share across all MF segments. Bear case is in no way harsh since even sustaining market share require a lot of work with all AMCs competing for higher share.
By total QAAUM, UTI AMC is the eighth largest MF in India. In this business, the big gets bigger since institutional and retail investors (particularly, direct retail) are more likely to park their capital with a big recognized brand and also they are charged a lower expense ratio (owing to higher AUM sitting with the bigger brand). What is going well for UTI AMC is that it has the highest penetration in B30 cities that command a higher MF AUM yield as compared to T30 cities. If UTI AMC is able to leverage its existing distributor B30 (and T30) footprint to increase market share and at the same time walk the talk around frugality (CEO has maintained that he is keeping a microscopic focus on employee expenses), then my base (and even bull case) is probable.
Exhibit – 15: UTI AMC – Valuation Summary
Hope this has helped. Give me a shout out for any questions on valuation. I will likely make a video in one of the coming weekends to give a detail walk through on modeling all the financial statements of UTI AMC. Please note that this writing is purely for educational purposes. Investors are advised to do their own analysis.
After coming across so many polarized views, I couldn’t stop myself from valuing this much talked about IPO. While I had originally intended to value the entire business, I had to contend myself with valuing their major business segment of “food delivery”. I have not valued “dining out” and B2B “hyperpure” (which is into suppling partner ingredients to partner restaurants), which are relatively small.
If Zomato is able to acquire ~60% of total addressable customers (from current ~50%) in an underpenetrated market, Avg Order Value (presently it is INR 400) grows at above inflation levels, ad (including discounts) and employee benefit expenses decline (as a % of revenue) significantly as the firm scales, then the food delivery business can justify INR 50,000 Cr of the 60,000 Cr market value. This is my “bull” case scenario. In fact, if the value of the other two smaller businesses is ~INR 10,000 Cr then this value combined with my “bull” case valuation will make the IPO fully priced However, my sense of the value of the food delivery business is centered on my more moderate (base case) assumptions that justify 50% of the market value. Either way, there is a certainly a lot of optionality, which does advocate a premium on the DCF valuation.
Market
As of 2019, online food delivery share in the USD 65B food service market (defined as non-home cooked food or restaurant food) was 6.5% (i.e. USD 4.2B) in India. Food service market in India itself forms only 8-9% of the entire food consumption market, when you compare to 40-50% in both US and China.
Per research from Nomura, presented in this news article, it is estimated that food delivery market will grow to USD 33B in 10 years. Quoting from the research: “We are positive on the Foodtech market and forecast a revenue potential of $6.5 billion by FY30F and assign a market value of $18.5 billion to the food delivery market. This assumes: 1) 20% CAGR in monthly transacting users, at around 87 million, 2) ordering frequency to improve to around 5.5 (vs 4 in FY21F), and 3) average order value CAGR of close to 2%. These should result in a GMV of around $33 billion by FY30F, assuming a 20% stable take rate, implying a revenue pool of $6.5 billion.” I have put these numbers in the table below –
Exhibit – 1
Structuring the valuation
I now go on to value Zomato under the following three scenarios:
Exhibit – 2
For my base case, I assume that Zomato will be able to maintain its ~50% market share in terms of the number of unique transacting customers in its platform. I further assume that the average order value (AOV) will increase at close to inflation levels from INR 400 currently. As per Zomato’s RHP, on an average, 6.8 million customers ordered food every month on their platform in Fiscal 2021 with an average monthly frequency of 3.0. I assume that in my base case the monthly frequency will increase to 4.5, which is below 5.5 as per Nomura’s estimates. I make such as assumption because the industry monthly ordering frequency in FY21 was higher than that of Zomato.
Unit economics
To value this business, it is important to understand the unit customer economics i.e. how much does Zomato earn and spend per customer. This is presented in the snippet from their RHP below.
Exhibit – 3
Value of Existing Customers
To value each customer (i.e. to estimate CLV, which is PV of retention adjusted future contribution profits per customer), I have projected out the contribution profit per order by using last year’s take rate or commission of 15.7% on AOV as my starting point (refer exhibit-2 for AOV estimates). I have assumed that customer delivery charge per order, delivery cost and other variable costs rise at close to inflation levels. I have assumed a slightly higher growth of 7.5% for discounts. Infact until FY20, discounts were a lot higher. It’s only now that Zomato has reduced discounts significantly. If they were to increase discounts (which they very well may) then I’d be overestimating CLV and subsequently the value of the food delivery business.
Exhibit – 4: Base Case – Value of Existing Customers
Using the above base case estimates, I get a value of INR 8,231 per customer over its lifetime.
Value of Prospective Customers
Value of a new (prospective) customer = Customer lifetime value (CLV) - Customer acquisition cost (CAC)
To now estimate value of new customers, I need to estimate CAC.
CAC every year = Ad and sales promotion expenses (net of discounts since discounts have already been considered in CLV estimate above) in that year / acquired customers that year
I need to project Ad and sales promotion expenses to estimate CAC every year. As Zomato achieves economies of scale, this expense should reduce as a percentage of sales (you'd hope to that happen else the business wouldn't sustain). I assume that the ad and sales promotion expenses fall from ~25% in FY21 to 17.5% of food delivery revenue in FY31. In absolute terms, in my base case these expense rise 10x e with # of unique customers increasing from 6.8M to 52.2M
Exhibit – 5: Base Case – Value added by new customers
Value erosion by other expenses
Now, what about the other expenses such as employee costs? I need to project them out and bake them in too.
Exhibit – 6: Base Case – Value erosion by corp expenses
As Zomato scales, employee expenses should reduce as a % of sales drastically. Note delivery partners are paid on a per delivery basis and those expenses have been considered in estimate of CLV (exhibit – 4). I assume that these expense reduce from 37% to 17.5% of food delivery revenue in my base case.
Putting it all together
Enterprise Value of food delivery business = Value of existing + new customers - corporate drag;
Equity value of food delivery business = Enterprise Value + Cash + IPO Proceeds - Debt
Exhibit – 7: Base Case ValuationExhibit – 8: Summary
I may have been too harsh in bear case and that reflects in my value / share. My sense of the value of the food delivery business is centered on the base case scenario, which makes the IPO over priced. However, please note that this valuation does not include the B2B hyperpure and dining out businesses. They are relatively small now, but may very well grow. In fact, if the value of these two businesses is ~INR 100,000 M (or INR 10,000 cr), then this value combined with my “bull” case valuation will make the IPO fully priced. Bankers are aware of the euphoria around this IPO and are sure trying to make the most of it. My “bull” case is not an attempt to match their narrative. This case may well play out if Zomato is able to grab a higher market share in an underpenetrated market and key parameters like AOV, # of customers, ad / sales (including discounts), employee benefits etc. unfold as per my bull estimates above.
To conclude, I will say that value of the firm depends upon your narrative. For any young growth and money losing firm, itโs hard to rely on limited history and make projections. The business model thrives on the hope that as the firm grows it will realize economies of scale resulting in declining non-direct operating expenses (as a % of revenue; in absolute terms it will rise). This valuation is built around that hope. Taking about hope! Hope this blog has helped. You can pick one of the narratives above (or perhaps be somewhere between). Do write to me if you have questions. Always open to talk about valuations.
In 2019, accounting rules regarding treatment of operating leases were changed. Under old accounting operating leases were expensed. As per new accounting, operating leases have finally found the place where they long belonged, the balance sheet. Retail, restaurants, airlines, logistics and telecom companies have significant operating lease obligations. With lease liabilities becoming visible as debt (and counter right-of-use asset in the balance sheet), does it change the risk perception of equity investors? While the new accounting treatment has been covered by myriad articles, in this blog, after briefly touching upon (the similarity and difference between) US GAAP and IFRS treatment of operating leases, I focus primarily on addressing equity investor risk perception, which is communicated by expected return. A significant increase in expected return implies that investor perception of risk has amplified since investors want to be compensated for bearing higher risk. In this blog, I examine the degree of increase in cost of equity (or expected return by equity investors) for US retailers and restaurants when the veil over invisible leverage was lifted back in 2019.
What has changed?
Before we dive in, let’s first understand what has changed.
With the new leasing rules, US GAAP allows operating leases to be recognized as either “operating” or “finance”, whereas IFRS allows recognition as “finance” leases only. Both of these lease accounting methods require operating leases to be capitalized i.e. recognize as right-of-use asset (representing the right to use the leased asset) and debt (measured as present value of future lease obligations).
Differences between operating and finance leasing becomes pronounced in their treatment of rent expense in the income and cash flow statement. Under finance lease, rent expense is broken into amortization (of the ROU asset) and interest expense (on the lease liability). Under “operating lease”, rent is recognized on a straight line basis over the lease term. There is immaterial change in the income and cash flow statement for US GAAP companies that have elected to go with โoperating leaseโ accounting. However, companies using โfinance leaseโ accounting (which is all IFRS companies) report higher EBITDA and EBIT (since rent expense is now recognized as a part “A” and โIโ) as opposed to companies using “operating lease” accounting. Moreover, the total finance lease expense i.e. total rent is higher (than the operating lease expense) for the initial lease term and then lower for the later part. However, the total rent over the lease term remains the same in both lease accounting methods.
Does investor risk perception following the lease related asset and liability recognition increase?
I have examined 23 US companies – 3 restaurants and 20 retailers with significant operating leases. For each of them, I have sourced their equity, debt, lease and assets values from the time when the veil over invisible leverage was first lifted back in 2019. For most companies this is June 2019 time frame when they reported their 2019 Q1 earnings. Costco, NIKE, Starbucks and Darden Restaurants are exceptions; they reported later that year.
Exhibit – 1
For each of these companies, I have estimated % increase in leverage (assets/book value of equity; in fact % increase in leverage translates to just the % increase in assets), absolute increase in Debt / Market Value of Equity (I should have ideally estimated the market value of debt as well. Book and market value of debt differ, but not substantially and certainly not like equity), % increase in levered beta and eventually the % increase in Cost of Equity following the accounting change. I have sourced sector specific unlevered betas, risk-free rates and equity risk premium from Prof. Aswath Damodaran’s website.
Let exhibit-1 with the intermediate calculations not overwhelm you. I have distilled the key metrics in exhibit-2 below.
Exhibit – 2: Clean version of exhibit-1 i.e. without the intermediate calculationsExhibit – 3: This is a chart of the table presented in exhibit-2
After capitalizing operating leases, the companies marked red (refer exhibit-2) – Capri Holdings (fashion), Urban Outfitters, GAP (clothes), Foot Locker, DSW, Caleres (footwear) and Dick’s (sporting goods): – were perceived as more risky by equity investors. The risk manifested in a higher return expectation evident by the amplified Cost of Equity (COE).
Why did their COE (or expected return) increase substantially? Because all these companies had substantial increase in the following
Financial Leverage following the accounting change
Debt to Market Equity, which in turn reflects in the % increase in levered beta
Refer exhibit-1 & 3: The % increase in levered beta (levered beta = unlevered beta * (1 + (1-tax%)*Debt/Market Equity), which is a measure of risk in the kind of business and the debt to fund those business, moves almost in tandem with both Debt to Market Equity and COE. It does peak abnormally for Kroger (grocer), Macy’s (departmental store), Michael Kors (Capri Holdings: fashion retailer), BigLots (general), Caleres (footwear) and GAP (clothing). Reason being that the equity for these retailers in June of 2019 (when they posted their Q1 results) was trading below their lease adjusted debt pushing their levered beta higher than others.
Companies marked green(refer exhibit-2) – Costco, NIKE, Target and Starbucks – did not experience any material increase in COE since their lease obligations as a percentage of market equity is very low. Not only, they saw the lowest impact to their overall debt and financial leverage than other firms, but also they have the highest market cap in the list resulting in immaterial leverage impact to their lease adjusted beta. Moreover, Costco and Target own more than 80% of their stores.
Companies in the middle (refer exhibit-2), specifically Chipotle Mexican Grill, Dollar General and Darden Restaurants experienced significant increase in leverage as a result of the accounting change, but had low-med increase in expected return (and perceived risk). This can be explained by observing the relatively low increase in overall debt to market equity and corresponding levered beta. This presents a key insight that operating lease capitalization led significant increase in leverage alone is not sufficient, but significant increase in leverage coupled with low market value of equity drives enhanced risk perception.
It has been almost 2 years since the invisible leverage has become visible. In this writing, I have solely discussed the impact of operating leases capitalization. Of the companies marked red, the ones that delivered high shareholder return (over the last 2 years) have been able to offset the increase in cost of equity to a certain degree, not only because of their higher market value of equity (partly due to COVID-led tailwind for consumer staples and brick-and-mortar accelerated pivot to online commerce), but also because of the fall in US equity risk premium since capital has remained resilient with investors wanting to pay for growth.
Zuora was founded by Tien Tzuo (ex-chief strategy officer at Salesforce) in 2007. Tien coined the term subscription economy to define the shift taking place from product ownership to service consumption (Uber and Netflix are very relatable examples of companies that helped enhance the movement form car and dvd ownership to โas a serviceโ). He started Zuora to help companies leverage the shift.
In this blog post, we understand Zuora’ business, analyze its financials and value the firm. If the bet on the subscription economy plays out, we believe that the firm could be worth 30% more than what the market is pricing it at.
Business
Zuora provides billing capability to companies starting subscription business or companies pivoting to subscription businesses. This has been there core capability. In the year 2020, Zuora added revenue recognition (RevPro) and platform capabilities (Central Platform) to its arsenal to focus on enterprise customers, which is a larger addressable market.
RevPro: Revenue recognition capability helps reduce the time it takes to close the books and thus decreases the manual effort (required to do revenue recognition) and optimizes the working capital.
Central Platform: Suite of developer tools that was launched early in 2020. It helps automate and orchestrate every touchpoint from the customer from service activation (order), payments, usage, renewals, upgrades, suspensions to internal operations like shipping and recognizing revenue (cash). In short, platform allows companies to extend and integrate Zuora into their business to help those companies orchestrate their subscription order-to-cash process. Platform features are now being used by two-thirds of the customer base (as of 2021-Q3, they had 653 customers with annual contract value of $100,000). Tien Tzuo describes central platform as a key competitive differentiator, particularly within the large enterprise deals i.e. not limited to high growth SaaS companies from Hi-tech and media but larger customers from industrial manufacturers as well e.g., Caterpillar, Briggs & Stratton and others.
Zuora also provides analytics and Configure Price Quote (CPQ) capabilities. Since every customer value different features and have different levels of willingness to pay, CPQ allows sales people the pricing flexibility to offer their prospective customers without burdening the finance team
In summary, Zuora’s cloud-based software functions as a subscription management hub that automates and orchestrates the subscription order-to-cash process, including billing and revenue recognition.
Financials
Since its IPO in April 2018, the company has grown from a revenue of $171M (in FY18) to $276M in FY20 with subscription revenue portion increasing from 71% to 75% (the rest being professional services). By the 9 months (Oct’20) in FY21, they have reported revenue of $226M with subscription revenue portion rising to 78%. They are expected to deliver a revenue of $302M by the end of FY21 (Janโ21) with subscription portion 79%. Moreover, customers with ACV equal to or greater than $100,000 was 653 by FY21-Q3 (Octโ20). They had 624 customers with ACV equal to or greater than $100,000 by FY20 (Janโ20). This group of customers represent 90% of their subscription revenue.
The company expects a CAGR of 25-30% over the next few years, but the market is not very optimistic (wouldn’t blame the market!). Their annual growth rate has declined from 51% in FY18 to 17% in FY20 (and further to 9% in FY21E). Although, they have not been growing at break-neck speed, but with the focus on enterprise customers, the growth is expected to pick up not in terms of # number of customers, but in terms of higher ACV. By end of FY20, they averaged ~$298K subscription revenue per customer.
What is going well for them is their strategy to move professional services to system integration (SI) partners. Professional services constitute the consulting and integration effort spent by Zuoraโs human capital. This segment has historically operated at a loss (and so it makes sense to move it to SI partners who can do this cheaper) and they expect it to operate at cost moving forward.
Valuation
Value of a firm is the present value of projected Free Cash Flows (FCF) to the Firm (FCF). FCF is the the portion of net operating profit after tax that is left after meeting the firmโs reinvestment needs. So to value a firm, one needs to project operating profit and reinvestments 5-10 years out (and discount them to present using the firmโs cost of capital)
We now project out revenue, margin and reinvestments to value the firm.
Revenue projections:
a. As per the following excerpt from Zuora’s FY20-Q4 earnings call “we see ourselves as a portfolio bet on the entire subscription economy, a position that gives us the opportunity to deliver 25% to 30% sustained growth over a long period of time.But what we see in these last couple of years is that the subscription economy is no longer just about high-growth SaaS companies like Zoom or Foresight. Subscription business models are being adopted by some of the largest companies across multiple industries all around the world. ” With enterprise focus backed up by new arsenal of products, we build our projections on Tien’s guidance of 25% growth in Subscription Revenue for the next few years. We assume that the growth continues till FY25 and we cap it to 15% by FY30 b. Aligned with the strategy to move services to SI partners, Professional Services Revenue reduces from 20% in FY21 to 10% by FY25 and further to 5% by FY30 As a result of these guiding principles, Zuora makes their first $1B in annual revenue by FY28.
According to a Markets and Markets report, the global subscription and billing management market is estimated to grow at 14% CAGR to reach $7.8 billion by 2025. As per our FY25E projections, Zuora will acquire a market share of 8.3% by 2025. There are other research reports with varying market sizes. MGI Research Forecast Report on Subscription Economy SaaS Tools estimates a $102 billion total addressable market (TAM) from 2016 to 2020, with 20% of Fortune 1000 companies adopting cloud-based enterprise solutions during that time
We could have anchored our story on an x% market share acquisition by FY25 and backed out the revenue projections from there, but we opted out of that approach since a.) Zuora has added products beyond billing and b.) there are high variance in addressable market sizes across different research reports. We have built our projections on shift happening from “product centric” to “as a service” models, which is based on the founder’s story.
Margin projections:
a. Subscription segment gross margin increases from 75% in FY21 (present) to 80% by FY25 and remains at this level from then on. b. Professional Services operate at cost from FY25 onwards. As per the FY21-Q3 earnings call they are aiming to operate at cost sooner. c. Non-direct OpEx decline as the firm scales resulting in first operating profit (~3%) in the year 2025 and it gradually increases to 22% (avg op margin of software app firms) by FY30.
Re-investment projections: We use capital efficiency ratio to estimate re-investments back into the firm.
Re-investment = Growth in Sales (in $) / Capital Efficiency;
Invested Capital = Working Capital + PPE + Goodwill + Intangibles + Operating Lease Asset + Capitalized R&D + Other Assets (excluding cash) OR
Invested Capital = Book value of Equity and Debt + Capitalized R&D - Cash
We capitalize R&D since the benefits of R&D extend beyond one year. This adjustment has a positive impact on the margin but it penalizes the capital efficiency.
We calculate a Capital efficiency of 1.19 for FY21 i.e. they make $1.19 of revenue on an invested capital of $1. We assume the same capital efficiency in the future years. We do not assume a reduction with scale since software application firms typically operate with a capital efficiency of close to 1 (after adjusting for R&D and operating leases)
Terminal Growth and ROIC: The firm will have competitive advantage and create value beyond year 10. With this belief, we assume an ROIC greater than the cost of capital beyond year 10.
We also believe that the 10 year T bond rate (or the risk free rate) will eventually rise to 2% from 1.1% now. With this belief coupled with the fact that firm will do well beyond 10 (albeit marginally), we assume a terminal growth rate (3%) higher than the risk free rate. If you think that this is too high or too low, we’d request you to hang on since we do measure share value sensitivity on the risk free rate towards the end of this section.
Cost of Capital: We have estimated a cost of capital of 6.49% in the base year. We assume that the cost of capital will gradually increase to 7.36% with the rise in T bond rate (risk free rate) to 2%. We do measure share value sensitivity on the cost of capital sensitivity towards the end of this section.
Putting it all together: Using the above assumptions and guiding principles, we estimate the enterprise value at ~$2.31B. We value the 7.9 M outstanding employee stock options at $83M and after netting off debt, options and adding back cash, we get a fair market value of the business at ~$2.33B, which is $19.7 per share. As of 1/22/20, Zuora traded at $15 a share.
We do a sensitivity analysis by varying terminal growth and cost of capital. The lowest fair share value that we get is $16.9, which is again higher than the trading price.
Return
As of this writing, Zuora is trading at a forward enterprise value to revenue (FY22) multiple of 4.6x (=$1674M / $364M). For context, SaaS companies are trading at a forward avg multiple of 20.5x and median multiple of 18.5x.
At the same 4.6x multiple 5 years out, Zuora will yield a compounded return of 15.5%.
Market Cap in FY26 = Current market cap ~$1.78B * (1+ Return 15.5%)^5 = ~$3.66B . Adding debt and netting off cash gives an EV of $3.55B (in FY26). Dividing this by FY26 revenue of $0.77B (refer projections exhibit): $3.55B / $0.77B = 4.6x
We have also computed the return at higher (and lower) multiples if you believe Zuora plays out this story and market begins rewarding (continues ignoring) the firm by pushing up (dragging down) the multiple.
Thanks for reading.
Gautam
Disclaimer – Currently, I do not own any stock of this company. This analysis should not be misconstrued as a buy / sell recommendation. Readers are advised to do their own analysis. Moreover, any opinion expressed in this blog post is solely my own and does not represent views of my employer
In this writing, I dive into Lyftโs numbers again and value the firm as it battles the pandemic. Valuation is built on the expectation that after mobility levels recover, economies of scale will start taking effect in the mid-long term. Using rider based economics in my DCF valuation, I value existing active riders at ~$15 B (estimated rider lifetime value $1,062 x 14.4 M riders by the end of 2020), new and returning riders at ~$39 B, corporate drag at ~$40 B and I get an equity value of ~$15 B ($15 + $39 – $40 + Cash – Debt) making the firm fairly valued. Key to sustain the valuation levels is rider growth with Lyftโs push into expanding the use cases it serves and delivering on swiftly reducing non-direct operating expenses as it scales.
Recent Actions
Until last year, Lyft had maintained a focused narrative. Uber, on the other hand has been aggressively expanding globally into food delivery and logistics besides ride-hailing. Lyft seems to be broadening the narrative now albeit with restrain. While this section of the my blog focuses on the recent actions by Lyft and how they are differentiated from Uber, this article provides an in-depth analysis on how Lyft and Uber differ in their overall strategies (although, the article was written before the two companies hit the bourses, it is still relevant in understanding the difference in company culture, origin and business models).
In Oct’ 20, Lyft announced a partnership with GrubHub that allows Lyft’s loyalty-program members free food delivery from GrubHub restaurants. An excerpt from the 2020 Q3 earnings call, “what’s happening to restaurants in the time like this, when they sell food on a platform, like Uber Eats, they get charged 20% to 30%, they lose 20% to 30% of their revenue to that platform. And so what we’re hearing from these restaurants and retailers, especially during the pandemic is they want to partner not someone that’s going to be, you know, taking 20% to 30% but they want to just have the delivery capabilities, which obviously the 1 million plus drivers we have on the platform, we can provide. So not interested in a consumer platform, interested in kind of more of a B2B organization level approach, which we think is differentiated, and where we can say hey, we’re not going to step between you and your customer unlike other platforms.” Food delivery is a crowded business. Although, it’s hard to say who will be the winners, but I believe the scales will tip in favor of firms who have created an “ecosystem” with a halo effect for other services since restaurants will likely partner more with delivery platforms which have an army of loyal users. Good examples of such “ecosystems” are UberPass and Amazon Prime loyalty programs.
They are also making inroads in health care. In Oct’ 20, they announced integration with Epic, a leading electronic health record system that is used by a majority of the country’s top-ranked hospitals. They believe that “Through this integration, health system staff will be able to book Lyft rides for patients directly through their health records, helping to ensure that transportation is never a barrier to good healthcare. We view this as a significant opportunity, because of the many health systems in the US that use Epic, nearly 70% have not yet worked with Lyft for their non-emergency medical transportation programs. In aggregate, the non-emergency medical transportation market represents a multibillion-dollar opportunity“.
In their pursuit to expand the use cases they serve, Lyft has very recently started focusing on partnering with retailers by providing them with a white label system for delivery. Quoting Co-founder John Zimmer, this is โdifferentiated in that we are focused on being a partner with the retailer as opposed to taxing them 10%-13% on the package and giving them the muscle they need to compete in the digital economyโ. It remains to be seen how this plan unfolds. We will model this use case explicitly as and when this happens and more clarity on specifics emerge.
I am not too overly optimistic about Lyftโs push into the autonomous vehicle (AV) segment. Uber has done way with their AV program. As per research by a leading consulting firm, AVs will drive out 45% of cost which are right now directly linked to drivers. Iโd argue that although driver costs will certainly come down, but this will come with the need to maintain a fleet of such vehicles either by owning or leasing them, which in turn will need more reinvestments back into the firm. Infact, the foray into car rentals(SIXT) implies maintaining a vehicle fleet either way. This is a capital intensive business with low economies of scale. Our valuation of Lyft is built on the expectation that economies of scale will take effect in mid-long term.
Lyft is doing a lot of things to gradually inch towards its vision to build a transportation network that can handle every single one of their customers’ transportation needs. While I may be skeptical about a few of the things they are are pursuing, the overall story seems to hold promise.
In the next section, I dive into the numbers and value the company as it battles the pandemic.
Valuation
As in my earlier blog post, the valuation framework that I have used is the one you would use to value companies driving the shared economy. The framework has been pioneered by Valuation Guru Prof. Aswath Damodaran. In his paper, Prof. Damodaran has explained how to incorporate user economics in a DCF Valuation. The fundamental equation to value such companies that Prof. Damodaran gives is simple and intuitive:
Value of a user based company = Value of existing users + Value added by new users โ Value eroded by corporate expenses
Please bear in mind that every valuation needs to have a fact based story, which is what we think of the company’s growth potential, margins, capital efficiency and user risk (i.e. would riders stick or ditch) supported by facts. In my valuation, I have taken some judgement calls at places where there is no historical data for extrapolation or historical data does not guide future performance (very true for young, growth and money losing companies).
1. Value of Existing Riders (or customer lifetime value)
I estimate the value per rider using the below simple equations:
Contribution from each Rider = Revenue per Rider - Cost of Serving (Cost of Revenue + Ops & Support) each Rider
Value per Rider = After tax Contribution from each Rider - Re-investments
Now, I will list the facts and frame my story for the parameters in these two equations.
a.Revenue per Rider
Fact – # of Riders and Revenue per Rider: Lyft had 22.9M active riders by the end of 2019. This represents 17% rider share. # of riders declined to 12.5M in 2020-Q3. Management expects revenue / rider to rise by 11-15% in 2020-Q4
2019 Q1
2019 Q2
2019 Q3
2019 Q4
2019
2020 Q1
2020 Q2
2020 Q3
# of Rider (M)
20.5
21.8
22.3
22.9
22.9
21.2
8.7
12.5
Revenue / Rider
$ 37.9
$ 39.8
$ 42.8
$ 44.4
$ 164.8
$ 45.1
$ 39.1
$ 39.9
Story – #of Riders and Revenue per Rider: We extrapolate the same growth rate to # of riders. This translates to overall ~$165 revenue per rider and over 14M riders by end of 2020.
Now, to project out revenue per rider in the future, we need the addressable market size and also need what % of that market will be captured by Lyft.
Fact –Addressable Market Size: As per the following excerpt from Lyft’s Q3-2020 earnings call, Lyft considers that their addressable market is $1.2T. (they don’t really provide the year and detail on how they got to this number) “we are going after and have been going after since day one the $1.2T consumer transportation market. And we have been laser focused on that. I think all of the same structural elements that have been shifting this market from one that’s been based on car ownership to transportation as a service are still as true today as they were pre-pandemic, and we think all of these forces will continue to be in play as we see the recovery play out. And just to talk about that for a second. Today’s car ownership ecosystem is extremely fractured. A typical consumer has to interact with 10 different companies just to keep up with the basics of owning a car. And at each step, you’re paying full retail prices. So you have a bad disjointed experience with very high prices. And our vision is to build a transportation network that can handle every single one of our customers’ transportation needs. So imagine taking those 10 different companies down to one. And we can create a completely frictionless customer experience and leverage the scale of our network to deliver incredible value to our customers. So that’s our vision. That’s the Total Addressable Market (TAM). I think it’s unchanged. And I think all of the secular trends at force, moving people from ownership to transportation as a service are still at play. If you look at what happened to DVDs and CDs as the world moves to streaming, when you can deliver something as a service at a lower cost with a better experience, that ends up being a really, really powerful combination.”
Although, Lyft has been expanding use cases by foraying into car rentals, bikes and scooters, I believe that this TAM is rather too high. Morningstar estimates Lyft’s total addressable market, including taxis and ride-sharing as well as bike- and scooter-sharing world-wide, to be around $500B by 2023 and growing at 24% a year from 2018. This translates to over $200B market size in 2019. Other research reports peg the shared mobility market size at $164B and $79B in 2019 with growth rates of 25% and 15% over the next 5-10 years.
Story – Addressable Market Size: With this huge variance in market sizes, I resort to the $120B market size in the year 2019 used by Prof. Damodaran. Prof. goes on to say “That is, of course, well below the size of the transportation market, but the $1.2 trillion that Lyft provides for that market includes what people spend on acquiring cars and does not reflect that they would pay for just transportation services“. Moreover, following Prof.’s league, I make the assumption that the market size will double in 10 years. This translates to a CAGR of 7.2% (remember rule of 72?). I won’t blame you if you accuse me of being conservative since almost all research firms have predicted growth rates in excess of 15% over the next 5-10 years.
Fact – Addressable Market Share: In 2019, Lyft had revenue of $3.6B representing a market share of 15% considering Lyft collects 20% of what it bills to Riders.
($3.6B/20%)/$120B = 15%
Bear in mind that Lyft does not reveal revenue % of gross billing. Our estimate of 20% is based of Uber Mobility, which has this in the 20-25% range
Story – Addressable Market Share: With the expanding use cases following the foray into car rentals, bike and scooters and the fact that ride hailing has revolutionized the way we commute, I believe they will be a able to capture 30% of the US and Canada market by 2025 (from 15% in 2019) and increase it to 40% share by 2030. As more players enter the scene, I believe their share will decline to 35% by 2035. Essentially, I am laying the groundwork for my DCF by assuming 3 phases – In the first phase, mobility levels recover by 2022 and then pick up momentum to double market share from pre-COVID levels. Growth continues in the second phase which is followed by a phase of stability or moderating growth in which competition becomes more pronounced resulting in market share decline to 35% by 2035.
Using the above facts and my stories, I can now project out revenue per rider over the next 15 years from $164 at the end of 2020 to ~2x by 2025 and 3x by 2035.
b. Cost of Servicing (Cost of Revenue + Ops and Support) each rider
Fact: Cost of Revenue is direct operating expense and Ops and Support is non-direct operating expense. Infact, R&D, Sales and Marketing and General Admin expense also make up non-direct operating expenses. Operating profit (or EBIT) is the profit left after removing both direct and non-direct expenses from Revenue. For any young growth and money losing firm, you live with the hope that eventually economies of scale will kick and result in faster declining non-direct operating expenses (in % terms) with scale.
Uber mobility reported an adjusted EBITDA of 24.4% by Q4 of 2019. Uber has long term target of reaching 45% EBITDA margin in its mobility business. Although, Lyft has not given any targets for operating profitability, they have been constantly vocal about become op. profitable on an adjusted basis by Q4 of 2021. Adjusted income does not include stock based compensation and historical insurance payouts (companies are known to stretch โadjustedโ to suit their needs).
Story: In my valuation, I do not stretch โadjustedโ and restrict it to exclude only stock based compensation (I donโt ignore them in my valuation. Just hang on for a bit). This reflects in my assumption of a positive annual adjusted operating margin beginning 2023 (and not 2022 as guided by Lyft). In my bull, base and bear cases, I hit an adjusted EBIT margin of 25%, 20% and 15% by 2025. In setting both short term (2025) and long term (2030) margin targets, I have taken Uber mobility as my guiding light. I build in my hope that economics of scale kick in resulting in faster declining non-direct than direct operating expenses as the firm scales. The cost structure for the three cases projections have been presented below:
Although, I present the entire cost structure projections in the exhibit, I only consider Cost of Revenue and Ops and Support expense as Cost to Serve. The rest of the cost heads are factored in valuing new riders and estimating corporate drag as we will see in subsequent sections of this post.
c. Re-investments required for each rider
Reinvestments required = Change in Revenue / Sales to Invested Capital, where Sales to Invested Capital is also called Capital Efficiency
Invested Capital = Working Capital + PPE + goodwill + intangibles + Research Asset (obtained by capitalizing R&D)
On capitalizing historical R&D expenses, I computed a Sales to Invested Capital ratio of 2.9 for Lyft based on 2019 numbers using the above two equations
To project out Reinvestments, I need the Sales to Invested Capital ratio (and in turn the Invested Capital) for future years.
I capitalize the projected R&D numbers to estimate the value of the research asset for each year 15 years out. I extrapolate the research asset growth rate to estimate the total Invested Capital for each year 15 years out.
I then project out Sales to Invested Capital ratios and use them to estimate Reinvestments.
d. Annual Renewal Probability
Story: There is no data on annual retention. As per popular belief by 2023, COVID should be completely behind us. 2021 and 2022 should be a phase when mobility levels recover – active 2019 riders who stayed at home will return by 2021 and 2022. In 2021, I believe that almost all riders that used Lyft amidst the pandemic (in 2020) will stay active on Lyft. In 2022, as recovery picks up momentum, I assume that 95% of the riders from prior year will stay active on Lyft.
Now, assuming an annual renewal probability of 95% (each year from 2023 to 2035), 54% (=95%^12) of active riders from 2023 will continue using Lyft in 2035. Assuming an annual renewal probability of 90%, only 28% (=90%^12) of active riders from 2023 will continue using Lyft in 2035. I take a judgment call. I believe that the value should be in the middle i.e. 40% of active riders from 2023 will be actively using Lyft in 2035. The 40% translates to an annual retention probability of ~92.7% (=40%^1/12) from 2023 to 2035.
I use the annual renewal probability to discount value of existing riders. This bakes in the wisdom that we donโt assume that all active riders today will be still riding on Lyft 10-15 years out.
We now have all the inputs we need to forecast the life time value of a rider. I use a terminal growth rate of 2% (with the expectation that US T bond rates will increase from 0.9% now) to estimate terminal value and discount the future cash flows to the present using a cost of capital of ~7.5%
2. Value of New Riders
Value added by a New Rider = Value of a Rider - Cost of acquiring a Rider
Value of a Rider in the base year is the life time rider value we estimated in section 1 above. Every year the rider value is modeled to increase with the inflation rate.
For estimating cost of acquiring a new rider, we make a simplistic assumption that all the sales and marketing expenses is done on acquiring more riders. We arrive at the per rider acquisition cost by dividing the projected sales and marketing expense each year by the new riders added each year (sales and marketing expense projection present in the cost structure exhibit in section 1. Remember this is a non-direct op expense and their decline is key to achieving economies of scale).
New riders added in year n = Total riders in year n - (annual retention probability * total riders in year n-1)
We already have the annual retention probability. To estimate the total riders in each year, we need to define the addressable market for the number of riders as well. We assume that 37% of the US and Canada population is addressable (rationale behind this assumption presented in appendix). Although, the derivation is for US, but we extrapolate the addressable % to the 37M population of Canada as well). Lyft had 22.9M active riders by the end of 2019. This represents 17% rider share. We further assume rider share increases from 17% (in 2019) to 24% in 2025 and 30% in 2030. With this assumption, we arrive at 34M riders in 2025 and 44M in 2030 from 22.9M in 2019. We have baked in the COVID impact, by assuming that riders return to the platform gradually from 14.4M (63% of the riders in 2019) in 2020 to 20M in 2021 (which is below the 2019 ridership)
We now have the inputs for the variables we need to estimate the value added by new riders each year. We discount the future values to the present using a higher cost of capital 8.5% reflecting higher risk owing to cash flows from riders not on the platform yet.
3. Value of Corporate Drag
Expenses which do not directly relate to the existing and new users to extent possible fall under corporate drag. We have classified general and admin and stock compensation expenses as corporate drag. These are non direct operating expense and hence as we said earlier we expect them to decline in % terms over time as the firm scales.
We project out these expenses into the future and discount them to the present to estimate the value of corporate drag. (projections present in cost structure exhibit in section 1)
Putting it all together
In the bull, base and bare cases, I have used diff margin targets, but I have stuck to the same story presented in this writing above.
My sense of the value in the firm is centered on the base case scenario, which makes Lyft fairly valued as of this writing (12/13/2020). Lyft traded at $46.87 at close on 12/11/2020.
In the three cases, there is little variance in user lifetime value. Major difference in equity value is due to the value by new riders and the corporate drag, both of which are primarily dependant upon non-direct operating expenses. For any young growth and money losing firm, it’s hard to rely on limited history and make projections. The business model thrives on the hope that as the firm grows it will realize economies of scale resulting in declining non-direct operating expenses (as a % of revenue; in absolute terms it will rise). This valuation is built around that hope. I have presented facts supporting my story to the extent possible. I have taken quite a few judgement calls based on my story for Lyft. Your assessment can be very well different from mine. The value that Lyft offers depends upon your story.
Costco Wholesale Corporation (Costco) has a solid business model with a predictable stream of subscription revenue, which constitutes 90% of the net profit.
In the video (embedded below), I have projected out Costco’s financial statements and valued its equity. Although, Costco trades at a P/E of ~36 (amongst the highest in the retail business it operates in), I have found it to be fairly valued.
I have embedded the base excel (without the projections). Please feel free to download and try to model the financial statements and value Costco’s equity if you’d like. Do write to me if you have any questions.
Facebook earns close to 99% of its revenue by advertising. Marketers pay for ad products based on the number of impressions delivered or the number of clicks done by users. The business continues to impress me given that my friends, family and colleagues are so hooked to the platform and most of them (albeit to varying degrees) can’t wait to give the lurking marketers access to their personal information at the expense of getting connected and endorsed (for posting their views/sharing pics etc etc you know it) with their network. I will cast aside my prejudice and value Facebook in this post.
First some facts
As of Sept’19, the platform reported to have 2.4 billion monthly active users world wide, which is 32% of the world population. FB earned an average of $28 per user over the the last 12 months (as of Sept’19). This translates to 4x growth in per user revenue since 2013 and ~3x since 2014. The platform draws $130 per user from US and Canada, followed by $41 per user from Europe (which includes Russia and Turkey), $12 from Asia and $8 from Rest of the world (which includes Africa, Latin America and Middle East). Although, US and Canada have the highest per user revenue, they account for only 10% of the user base.
The user base as a percentage of world population has increased from 17% in 2013, 19% in 2014 to 32% in 2019
Moreover, FB makes $11.6 as pre-tax operating profit on a revenue of $28 per user. This translates to a pre-tax operating margin of ~42% after capitalizing R&D expenses.
Valuation
Before jumping into valuation, let’s do a quick refresher on how a company is valued. Value of a firm is the present value of its projected Free Cash Flows (FCF). FCF is the the portion of net operating profit after tax that is left after meeting the firm’s reinvestment needs. So to value a firm, one needs to project operating profit (i.e. revenue x margin%) and reinvestments 5-10 years out (and discount them to present using the firm’s cost of capital).
Facebook story is that of an active user growth play. I go on to value FB under 3 scenarios using different revenue projections based on combinations of user base (as a %age of world population) and average revenue per user (ARPU). In all the 3 scenarios, I take the same margin, reinvestment cost of capital and return assumptions as follows –
Margin: I assume that the current margin will drop from 42.05% to 40% over the next 10 years. Your estimate of future margins may be higher or lower, but I believe the status quo will more or less continue which is reflected in the 2% margin drop that I have assumed.
Reinvestment: Again, I believe the existing state of operations will continue leading to the firm operating at current capital efficiency of 1.31 (i.e. FB generate $1.31 in revenue for every dollar invested) 10 years out. Capital efficiency ratio is used estimate reinvestments (Reinvestment = Change in Revenue / Cap Eff).
Cost of Capital: I have used 8.3% as the cost of capital which gradually reduces to 8% over the 10 year period.
Return on Invested Capital: Given the unwavering user engagement the platform has demonstrated, I believe that marketers will not pull out anytime soon and the platform will continue to increase the size of the digital marketing universe. The firm will continue to have competitive advantage and create value beyond year 10. With this belief, I assume an ROIC greater than the cost of capital beyond year 10.
1. Sane Scenario – I project user growth with the belief that FB’s active user base reaches 35% of the world population over the next 5 years from 32% today. This leads to the addition of 400 million new active users over the next 5 years which is under 40% of the new users addition over the last 5 years. Moreover, I make ARPU growth rate projections with the belief that ARPU will increase by ~1.75x in the next 5 years. (Overall ARPU has increased ~3x from $10 to $28 over the last 5 years). A combination of this ARPU and MAU growth (ARPU x Active Users = Revenue) leads to an implied revenue CAGR of 16% over the next 5 years, which is 40% of the growth over the last 5 years.
Using the above revenue growth (also operating margin, same capital efficiency and cost of capital) assumptions, the value of equity in common stock I estimate is $657 billion which is over 10% of its market cap as on 12/31/19. The intrinsic share value that I get is ~$225 as against its current trading price of ~$205 Model credits – Dean of Valuation Prof. Aswath Damodaran
2. Upbeat Scenario – Letting my prejudice towards the platform flow in, I project user growth with the belief that FB’s active user base reaches 40% of the world population over the next 5 years from 32% today. This leads to the addition of 790 million new active users over the next 5 years which is under 75% of the new users addition over the last 5 years. Moreover, I make ARPU growth rate projections with the belief that ARPU will increase by ~2x in the next 5 years. (Overall ARPU has increased ~3x from $10 to $28 over the last 5 years). A combination of this ARPU and MAU growth leads to an implied revenue CAGR of 20% over the next 5 years, which is half of the growth over the last 5 years.
Using the above revenue growth projections, the value of equity in common stock I estimate is ~$722 billion which is over 20% of its market cap as on 12/31/19. The intrinsic share value that I get is ~$247 as against its current trading price of ~$205
3. Downbeat Scenario – In the event that FB’s active user base increases at the same rate as the world population i.e. active user base remains at 32% over the next 5 years and ARPU grows ~1.6x, this yields a revenue CAGR of 12 % over the next 5 years.
The value of equity in common stock I get using revenue CAGR of 12% is ~$542 million, which translates to an intrinsic share value of ~$186 making the share overvalued by 9%
Conclusion
Not letting my prejudice overpower, my story of Facebook is centered on the “Sane” scenario, which makes the platform undervalued by 10% as of this writing. For long, I have made this business earn of me as an active user of the platform, now I will be looking to own a few shares if the price offers more than 10% of the value I have estimated in my story. Your story may be more “upbeat” or “downbeat”. The value that FB offers depends upon your story.
Thank you for reading!
Gautam
Disclaimer โ Currently, I do not own any stock of this company. This analysis should not be misconstrued as a buy / sell recommendation. Readers are advised to do their own analysis. Moreover, any opinion expressed in this blog post is solely my own and does not represent views of my employer
