9/8/2022
KDM Capital 2022 Q3 Commentary
The first six months of 2022 witnessed the worst start to a year for the S&P 500 since 1970. It was the third worst start to a year ever! There's no shortage of dire, civilization-ending, world-collapsing headlines. Indeed, we are besieged by a litany of woes. However, within this cataclysmic tableau, there's one fact we've all come to know and understand; the world is becoming more digital and faster than we realize. Digitization is making an increasing amount of information available at all times. The irony is that increased access to information diminishes our space for deep, concentrated thinking.
This ceaseless streaming of media increases the cost of paying for a more digital world by decreasing our frequency of contemplation. Unfortunately, daily price quotes on companies we own only add to the noise. I think it's important to step away from the incessant streaming of data and consider what it means to own equity in an enterprise. In the paragraphs below, I write about potential analogs to today's market, how imagination is essential to long-term success, and why I like our positioning. I also spend a few words diving deeper into Shopify's business. But before I get to all that, I'd like to express appreciation to all my clients. Working with like-minded investors who understand the value of having a long-term perspective makes me confident that we will successfully navigate these tumultuous times together.
Inflation will slow down, the Fed will pivot, and investors will rotate back into stocks. Like noted investor Ron Barron recently wrote, 'This is a HUGE once-in-a-generation BUYING opportunity.' (All cap words are his emphasis, not mine"). I couldn't agree more.
We've seen this before…. hopefully.
In 1994 the Federal Reserve raised interest rates five times. Three twenty-five basis point increases, two 50-point raises, and one 75 basis point increase. It was an aggressive, jarring cycle that deflated risk assets and created an abundance of negative sentiment on Wall Street. It also caused declines in the S&P 500 and Nasdaq of 9% and 16%, respectively. But another development was simultaneously occurring, and investors weren't sure what to make of it; the internet. The 1994 Fed hiking cycle, coupled with the rise of new, dominant technology, is analogous to our current environment. Once the Fed completed its cycle, markets began to focus on the potential and opportunity of what the internet could truly produce. As a result, from 1995-1999 the Nasdaq 100 returns were as follows: 42.54%, 42.54%, 20.93%, 85.30% and 101%. $1,000 invested on 12/31/1993 in the Nasdaq 100 would have grown to $9,332 on 12/31/1999. That's a roughly 55% annualized rate of return! Today believe the AI economy is sure to supplant the mobile economy (internet 2.0), which supplanted the first iteration of the internet. Eventually, investors will begin looking past CPI data, rising rates, and all things Fed. They'll start to focus on the growth opportunities of the AI economy. And once that happens, stocks could surge, like the mid-90s. To be sure, companies are more cautious as the Fed slows the economy, which will weigh on stocks and keep prices depressed in the short term. But the relentless advancement of technology continues unabated.
Imagination
Most view the markets as a quantitative endeavor overlayed with perhaps the most volatile element on earth: human emotion. The combination of these two inputs makes investing very difficult. I think this viewpoint is reasonable. After all, what do stock prices reflect, if not the net present value of future cash flows? Inputs such as earnings, revenues, free cash flows, etc., are all used to try and establish what a stock should be worth. But I believe imagination is one important factor often overlooked in such bearish times. And imagination is the first factor to be cleaved away from our investment process when markets are challenging, and sentiment (emotion) is so profoundly damaged. During these moments, it is hard to imagine structural tailwinds that will elevate stocks to new highs. The future is always in motion, and no one knows where it will end up. The best we can do is to guess which direction it is headed. It's always challenging to imagine what will be. Inertia makes it comfortable to ponder what is. But real opportunity lies in imagining what's to come. That's where fortunes are made, in the transition.
The world is transitioning to an all-digital architecture encompassing the cloud, metaverse, blockchain technology, and decentralized finance, all of which are underpinned by explosive investments in artificial intelligence and machine learning. PwC estimates that the AI economy could add $15 trillion to GDP by 2030. Today the mobile economy (internet 2.0) adds about $4.4 trillion. And yet the mobile economy has seen the creation of several companies with trillion dollar plus market caps, such as Apple, Google, Microsoft, and Amazon. By lowering costs and increasing productivity, AI will touch every aspect of industry and commerce, including consumer, enterprise, and small to medium-sized businesses, and will do so by disrupting every vertical, similar to cloud. That's why I believe Nvidia and Tesla, leaders in the development and usage of AI, can become the largest companies in the world by market cap over the next five to ten years. The convergence of more robust network capabilities, wider consumer adaption of technology, and more powerful computing chips will lead to larger addressable markets and more scalability for companies with the early mover advantage setting up' winner take most' outcomes.
Positioning
Inputs matter when it comes to making investments. But the most significant effect on output, i.e., returns, is driven by a strategy philosophy. Strategically our portfolios are well positioned to have tremendous gains as the world moves further into the digital realm. Companies today are laying the groundwork for realities asyet unborn. How do you value such undertakings? Take, for example, Roblox. For July, the company reported 58,500,000 Daily Active Users, an all-time high. Hours engaged were 4.7 billion, up 25% year-over-year, an all-time high. The company says, "We are now at peak numbers globally for users and hours. The absolute level of users and engagement hours in July exceeded those of any prior month even during the peak lockdown periods with the pandemic".
With 75% gross margins, trailing twelve-month (TTM) revenue growth of 57%, $2bb of net cash in the bank, and EBITDA turning positive on a TTM basis, this seems like a promising company to invest in, especially if one believes that more time, not less, will be spent in simulated worlds. More time spent equals more commerce to be done, which can become enormously valuable, yet the stock is down 75% from its high.There is a reason Microsoft is attempting to purchase Activision Blizzard for $69 billion. Satya Nadella, Microsoft CEO, stated, "We need to support as many metaverse platforms as well as a robust ecosystem of content, commerce, and applications. Their corporate strategy is coalescing around cloud, content, and creators (Roblox currently has about 2.7mm creators and developers on its platform). Microsoft isn't the only large enterprise acquiring gaming companies. Sony, Tencent, Netease, and Take-Two Interactive are spending billions to sure up their content offerings. The combination of social, commerce, mobile, and high user engagement is why gaming can potentially function as a bridge to more immersive, simulated worlds. And this is only the beginning. As the worlds become more open and interoperable, they will scale exponentially. And the social aspect is only half the story. Enterprises, too, will have many valuable applications for developments in the metaverse. Jensen Huang, CEO of Nvidia, said, "Anything that is built will be visualized. Anything that moves will be autonomous. Anything autonomous will be simulated".
Shop(ify) till you drop
Shopify is a cloud-based, software-as-a-service commerce platform allowing merchants to start, grow and build their business online. Merchants can create an online store and sell on social media sites, seller marketplaces, blogs, other websites, and through email. They offer plans starting as little as $9/ month for smaller merchants up to $2,000/month for enterprise customers. The company's flywheel has also grown to provide lending, logistics, BNPL (Buy now, pay later), and payment processing. Shopify stock has experienced significant value destruction in 2022. Currently, it's quoted for roughly $30 per share, down from $176. As hard as it is to write that, it's even harder to believe. In 2018 the gross merchandise volume (GMV) on its platform was $41 billion. By the end of 2021, it was $175 billion, almost half of Amazon's GMV.
At the end of 2018, the company had 820,000 merchants on its platform. Today, it has roughly 2.7 million. In addition, Shopify reported $1bb in revenues for 2018. By 2021, revenue rose to $4.6bb, with projections of hitting $6.9 billion in 2023. Although the company does not operate outside the rest of the economy, it's still growing faster than retail. The covid pandemic pulled forward demand for online shopping, and that has caused forecasting issues for many in this space. To be sure, macro headwinds have led to a slowdown in growth which has compressed margins. In addition, the company miscalculated eCommerce trends staying elevated in a normalizing, 'post-pandemic' world. In turn, they have announced a 10% workforce reduction and cutting back on growth initiatives as management' rights the ship'. With about $6bb in net cash, they have enough balance sheet prowess to weather short-term headwinds. However, behind the scenes, improvements in everything from digital payments to supply chain and fulfillment capabilities improve the customer experience—further driving changes in consumer behavior.According to Allied Market Research, global digital commerce is expected to hit $17 trillion in sales by 2030, for a 15.1% CAGR. That's a massive tailwind for Shopify.
In a recent note to clients, Morgan Stanley wrote, "One of the top differentiating factors for e-commerce platforms could be supply chain and fulfillment capabilities, which could empower better customer servicing.'
Since 2018, Shopify has made considerable strides in fulfillment, which is key to reaccelerating top-line growth. It acquired Delivrr earlier this year and signed a deal with Flexport, which allows merchants to ship inventory at a pallet level on pre-booked container ships. That resonates with merchants who have experienced shipping issues due to the pandemic. Delivrr uses technology based on machine learning and predictive analysis. It predicts where and what quantities of inventory are needed in the company's distribution locations. By acquiring Delivrr and partnering with Flexport, they have created an asset-light fulfillment business that positions Shopify to provide 1-day or same-day delivery with end-to-end logistic capabilities. Shopify is committed to helping merchants with their end-to-end supply chain needs. They've even built a fulfillment solution integrated into Amazon's online store. Beyond focusing on their delivery network, they also have a terrific distribution network. The company has signed partnership agreements with likes of TikTok, which allows merchants to promote products directly into TikTok feeds, and JD.com. That partnership agreement grants Shopify merchants access to JD.com's 550 million active users in China. These deals are significant because social commerce is projected to hit $500 billion in China alone by 2024. In the US, it's estimated that social commerce sales will hit $67 billion by 2024. They also have app integration partnerships with Instagram, Youtube, and Twitter. These partnerships make it easier for merchants on the Shop platform to sync their product catalog into the app, facilitating higher GMV. Deal by deal, partnership by partnership, the creator, direct-to-consumer, and connected economy continue to take shape. Shopify stands to benefit enormously from this evolution.
Beyond the push into social commerce, the company is also making headway in the enterprise space with Shopify Plus. Shop plus is building around larger customers. It costs $2000 per month to access, which also comes with a revenue share in fees for sales greater than $800,000 per year. Shopify Plus also uses an AI tool called Shopify Audience to optimize and improve ad spending for Merchants. Lists are created by Audience and exported to Facebook and Instagram. The idea is to accelerate new customer acquisition. Shopify Plus is gaining traction with larger enterprises such as Heinz UK, Staples Canada, and All-Birds. The Shopify Plus business has seen growth of 33% year over year vs. 16% for all of Shopify. To be sure, there is tough competition. Salesforce, Adobe, SAP, and others are vying for the enterprise platform market. However, the Shopify platform costs less than the competition and has faster deployment times, allowing it to attract more merchants than its rivals.
Lastly, the Merchant Solutions business is another critical component of long-term success. Beyond improving its logistics capabilities, Shop also has seen increased spending from merchants on products such as Shopify Payment, Shopify Capital, and Shopify Markets. Customer uptake for merchant-centric products is growing, and it shows in the growing annual product spend of Shopify's annual customer cohorts.
The company's growing merchants base, improving customer monetization, visionary management, and structural tailwinds are but a few reasons to be a stakeholder in Shopify.
Final Thoughts
While the next few months may continue to be difficult, I believe the next few years could be marked with extraordinary growth. KDM is genuinely investing for the long-term in firms run by management teams who are making strategic growth decisions, the fruits of which may not be apparent for several years. I'm confident that, over time, our results will prove satisfactory. If KDM is to have an advantage over others, it will come from our capital allocation skills and the patience of our investor base. We expect to deliver superior returns by looking further out than short-term investors and tuning out day-to-day noise.
Again, we would like to thank you for your confidence, value your support and welcome any questions or thoughts you may have.
Sincerely,
Andre McClure
