Coho Capital Letter: Value Investing in Tech, Alibaba, Facebook, Google, Visa, S&P

Coho Capital Annual Letter, January 31, 2017

Performance:

• Return of 6.3% in 2016 compared to 12% in the S&P
  • Portfolio did not participate in the post-election rally
  • Over the last 5 years, Coho returned 20.2% per year relative to 14.7% for S&P

Value Investing in Technology & Self-reinforcing Business Models:

• Value investors are often quick to dismiss investments in technology companies for fear that competitive moats are ephemeral
• Our contention is that software focused business models possess more durable moats than when hardware ruled the roost
• Many value investors view technology through a hardware-centric lens, a view premised upon the manufacturing of non-essential gadgets with shrinking margins
  • After a brief window to make money, bankruptcy is all but assured once someone invents a better mousetrap
• Software-centric business models are some of the most compelling in all of business; light capex, infinitely scalable, high switching costs, and naturally conducive toward network effects
  • Many of the qualities one sees in a self-reinforcing business
  • Want to own these types of business and the market is offering them at attractive prices because too many market participants remain focused on a hardware-centric notion of technology
• In normal markets you can have Pepsi and Coke, In technology markets in the long run, you tend to only have one with 90% market share (generally winner-take-all markets)
  • Dominance of Facebook and Google is astonishing: together, have 64% share of digital ad market; despite their dominance, Google is capturing 60% of all digital advertising growth and Facebook the remainder at 40% (all other marketers and ad tech platforms are losing share)
• Google is a great example of a self-reinforcing business model
  • Every individual search refines future search results; feedback loop continually strengthens the efficacy of search products while widening its competitive moat
  • Compare this virtuous circle with the vicious cycle of a mining business: mining company mines surface level ore first, but upon depletion must drill further into the earth incurring greater costs the longer it is in business – business structurally gets weaker over time

Alibaba:

• Dominates world’s largest e-commerce market with 49% share compared to Amazon’s 20% share of the US online retail market; approximately 73% of all online retain transactions in China utilize Alibaba’s online payment platform; profit margins of 44% compared to 0.5% for Amazon
• Has a lot of things we desire in a business: network effects, switching costs, scalability, latent pricing power
• Grew sales 54% y-o-y in the most recent quarter and counts 493 million monthly active users across its three platforms
• Supplanting of brick and mortar by e-commerce is happening more quickly in China than US due to less robust physical retail infrastructure; Chinese e-commerce sales grew 36% last year to ~$900B and now roughly 18% of aggregate retail sales (compared to 12% in the US)
  • With 80% share of Chinese e-commerce, fair to think of Alibaba as a toll on online Chinese consumption
  • BCG predicting 20% CAGR in online spending over the next four years
• Multiple business units reinforce each other, creating a business ecosystem that grows more valuable with each additional user and transcation
  • Provides a platform for onboarding new services such as online payment, mobile operating system, map service supplier, online grocer, group shopping, cloud computing, video hosting and streaming and others
• Massive platform of users opens multiple pathways to monetize user data; opportunities to cross-sell additional products and services to its large and growing base of customers
• Despite its dominant position and compelling growth opportunities, does not have a demanding valuation
  • Core business should trade at least 25x forward earnings given its inherent operating leverage and projected sales growth of over 28% over the next few years – this results in stock price of $114
  • Add $15/share for investments and stake in Ant Financial – gets you to $129 (27% higher than today’s quotation)
  • Expect emergent businesses such as Alicloud and digital entertainment to be material contributors to future economic returns providing downside support
• After Amazon, Alibaba is our second largest position

Facebook:

• 8 billion users with 1.2 billion of those users (1/6^th of humanity) using the service daily; over a billion people use its messaging platform WhatsApp; Facebook Messenger also surpassed one billion users last year; Instagram has grown to 600 million users last year
• Incremental margins of 70% and revenue of over $3 million per employee, monopoly-like profit engine; think still early in its monetization opportunity with inherent operating leverage and multiple pathways to drive profits through software enhancements and enhanced data utilization
• Akin to multi-level marketing company, yet it does not have to peddle product
  • Instead of product, sells advertising and media feeds; users freely turn over data every time they use the site, creating a rich stream of data to mine for profits
  • Great margins considering it’s the world’s largest media distribution platform and does not pay for any of its content
• Despite reach, monetization efforts are nascent; in a global advertising market of $700B, Facebook has less than 4% share; expect to see dramatic acceleration
  • Social network ads account for 3.6% of internet traffic to retailer sites over the holidays, approximately 10x the 0.25% share garnered last year
• Network effect: the greater the number of users, the greater its utility for all users; virtuous aspect to its operations; the more data we provide its software algorithms, the smarter it gets in tailoring news and advertising
• Facebook effectively becomes a mobile operating system: why open separate apps, when you can order Uber, play games, exchange photos, stream videos, and make payments all through the same software interface?
• With the Street focused on slowing ad loads as well as bungled advertising metrics, this business can be purchased for less than 20x forward earnings

Alphabet (Google):

• Those with the most used platform win due to exponentially lower costs as platform users scale; this again is a core differentiation between a hardware-centric tech marketplace and software-centric marketplace
• Over 3B searches a day; 78% share of global desktop search and over 90% share in mobile search; every search refines search results and improves search optimization
  • After years of effort and billions spent by MSFT, AMZN, and others, no acceptable substitute for Google
  • Further, sealed off potential breaches by establishing dominance in browsers (Chrome has over 50% share in desktop browsers) and mobile operating systems (Android has 78% share)
• Apart from search, has six separate products with over a billion users including YouTube, Gmail, Google Maps, Google Play Store, Android and Chrome
• Ability to mine data across its properties makes it the most effective advertising channel in the world
  • Expects digital advertising to grow at a 40% annual clip over the next 5 years
• After netting out cash, currently trades for 17x 2017 earnings, below the S&P 500 multiple of 18x
  • This is well below other dominant companies with durable franchises and cheap relative to Google’s 20% growth
  • If one considers that YouTube, GCP and Other Bets are still in investment mode, valuation metrics become even more favorable; if YouTube were valued like a cable network, would be worth $300 a share; GCP could be worth as much as $100 per share
  • Adjusting for value of YouTube and GCP brings Google’s multiple to less than 11x earnings; multiple moves to 8x if you adjust for net cash

Visa:

• Apart from Google, Visa is the best business model we have ever seen; royalty on global spending
• Ultimate network effects business with retailers dependent on the vendor with the most users and users wedded to the vendor with the most points of purchase; Visa accounts for nearly half of all credit card transactions
• Despite its dominance, expect to experience sustained double digit earnings growth; 85% of global transactions still conducted by cash and check
  • Enhanced competition among credit card issuers has resulted in a dramatic rise in card rewards with six largest issuers offering over $100B worth of rewards over the past 6 years
  • Proliferation of digital payment options should drive increased volumes for years
• Paradoxically, growth of mobile payments has weighed on Visa’s valuation as many view payment by mobile as a threat to Visa’s business model
  • Most mobile payment networks utilize Visa’s and MasterCard’s network
  • It is easier for Apple to partner with Visa and its relationship with 17,000+ financial institutions and 44 million merchants than it is to traverse the regulatory quagmire of establishing a financial network on its own
• As a software based business, can grow with only minimal increased capital investment; incremental margins inflect higher due to operating leverage
• Apart from long-term trends, there are two medium-term trends which will bolster shares: Visa Europe and increased uptake in India
  • Visa Europe: expect surprise on the upside and offer multi-year earnings catalyst; credit card penetration in Europe is low at 40% relative to 55% in the US; Europe offers low-hanging fruit for margin optimization as fee structure in Europe is well below network average at $0.055/tx vs. $0.21/tx in rest of the world
  • India: Prime Minister Modi’s decision to remove high value currency notes from circulation should accelerate electronic payments in the country; India’s war on cash effectively took out 86% of cash in circulation in an economy that is 90% cash reliant; think migration to electronic payment is inevitable
• Currently priced at 22x earnings, in line with historical average; think analysts are not properly modeling the opportunity for pricing power in Europe; Visa is emblematic of what we want from all our holdings – a company that does the compounding for you

S&P Global:

• Together with Moody’s, S&P is a government sanctioned duopoly with each company controlling 40% of the market for credit ratings
  • Credit ratings is attractive with strong pricing power, recurring revenues, and high margins; pricing power not just from lack of competition but from favorable economics created by credit affirmation
• Earnings drivers for the credit ratings business over the next five years: debt maturity schedules of over $2 trillion a year in debt will need to be refinanced over the next five years; increased capital requirements on behalf of European banks has attenuated bank loan issuance; emerging markets continue to represent a compelling opportunity for increased debt issuance; public finance and infrastructure spending represent growth opportunity
• Outside of ratings business, possesses a collection of excellent businesses including a dominant index franchise (S&P 500, Dow Jones), market data subscription services (CapIQ, Platts, SNL)
  • Asset-light, highly scalable, feature recurring revenues and exhibit strong pricing power
• Significant future earnings growth in subsidiaries that are underappreciated by the market
  • 68% share of India’s leading credit rating agency, CRISIL

Image Source: Alizila