Hayden Capital 2Q17 Letter – Earnings Growth, Analytical Edge, Amazon, JD.com

Smart Money

Hayden Capital 2Q17 Letter, July 31, 2017

  • Gains 12.6% during Q2 2017, bringing YTD returns to 13.7%

Earnings Growth = ROIC x Reinvestment Rate

  • Stock Return = [Dividend / Stock Buyback] + [Earnings Growth] + [Multiple Expansion / Contraction]
  • Long-term value creating projects are not created overnight – there’s often years of R&D, investment, implementation, and customer adoption, before investors will see the tangible results of these efforts
  • Most investors are like over-active children – easily bored, and without the patience to stick around before moving on to the next hot stock
    • Due to this dynamic, most market participants primarily rely upon multiple expansion for their stock returns
  • While our portfolio certainly benefits from multiple expansion, I view multiple expansion as a “bonus” and is never the crux of our thesis
  • To evaluate the potential for earnings growth, I focus on ROIC x Reinvestment Rate
    • ROIC is the return a company can earn on each dollar it reinvests back into the business
    • If return is sufficiently higher than what investors can achieve elsewhere, money should be used for new projects that expand the company’s operations
    • Thus, the higher the incremental ROIC, the higher I look for the reinvestment rate to be
  • What we should care about is the returns on future projects, not those that took place years ago
    • Industry dynamics change and so does the opportunity set for companies
  • So the natural question is, how can we be forward-looking instead of backward looking? Can we collect the data necessary to estimate what the future return on projects will be?

Gaining an Informational & Analytical Edge

  • Idea is if we can have a framework which we believe a company’s opportunities will fall under, we can test the validity of this framework by looking at specific projects which we believe are representative of its economics
  • Let’s assume an e-commerce company has recently announced its plans to build 100 new warehouses across the country. If we owned 100% of the business, we would naturally have the option of either saving the cash and putting it into our pockets, or building out these warehouses. We want to know which is the better option – it is no different as a public markets investor
    • Thus as investors, the most important thing we want to know is what type of return can we expect, from investing money into this project
    • If the return’s lower than I could get in other similar risk investments, I would rather have the cash in my pocket to invest elsewhere
  • It’s likely we would not have the time or resources to evaluate all 100 warehouses individually – however, we could single out 5 -10 of these warehouses and run the analysis on those. If our analysis starts indicating paltry returns of 2% project ROIC’s for example, we should be much more hesitant to hand over hard-earned capital to the company and/or this management team
  • In practice, let’s assume that one of the warehouses is being built in Rochester. This warehouse is meant to replace another one 300 miles further, in order to cut the distance to the customer in half and deliver goods quicker to households in the region
    • Call the Rochester Chamber of Commerce to get the public filings for this project – firm will need to report how many jobs will be created, the average salary per employee, how much tax revenue it will generate, how large the property will be, etc
    • By talking to industry experts, can also determine how large of a region this size of warehouse can cover – if on average 5% of households use this company’s services, this would imply a coverage of 50,000 households
    • In analyzing the prior financials, were able to back out that on average it previously costed $7 to ship a package to a customer. Using a rule of thumb of last mile shipping making up 50% of total logistics costs, can estimate that it used to cost $3.50 to deliver from the warehouse to the doorstep. By cutting the warehouse distance in half, this should drop to ~$1.75 per package
    • Average customer orders 5x per year – by saving $1.75 per package, this would equate to a total savings of $437,500 by building the warehouse
    • If the warehouse costs $2,000,000 to build, then this would equate to an attractive 22% return on capital deployed
  • This example is overly simplistic and depends upon having a high confidence in our numbers – nevertheless, it is a useful illustration of how this “data-point analysis” can help us see around corners and determine where a company’s earnings growth is heading
  • Having an informational edge is harder in today’s sea of news – however, there’s still a lot of useful data-points to be uncovered out there if you look hard enough


  • Announced it would acquire Whole Foods in June – this deal is attractive as their very strong overlap in customer base between Whole Foods and Amazon Prime
  • This overlap creates numerous synergies including collecting more data on the purchasing habits of these types of customers, cross-selling opportunities and a higher likelihood of these customers adopting online grocery shopping
  • While many in the media are focusing on the $13.7Bn purchase price, I find the logistics benefits this deal provides far more interesting
  • My working framework for e-commerce companies is that at its core, these are logistical businesses. If you look at these companies’ financial statements, shipping and fulfillment is typically the largest operating expense
  • Value-add of a retailer is simply taking a product from the manufacturer, and getting it as close to the customer as possible, where they can buy it conveniently – 20 years ago, this was to a brick and mortar store in their town; nowadays, it’s almost as cheap to deliver to the customers’ doorstep
  • If a company has structurally lower costs than its competitors do, it can afford to sell at a lower price, which in turn leads to new customers. This then allows for lower shipping costs due to increased customer density, and the “flywheel” begins again
  • In the world of e-commerce, convenience is primarily measured by how long it takes an item to arrive, after placing the order – the more items you ship, the cheaper the per unit shipping cost will be
  • For e-commerce businesses, shipping and fulfillment costs typically make up ~20% of revenues, with half of this being allocated to of “last mile” – Amazon is no different
  • In the scope of Whole Foods, if online grocery shopping takes off, it will lower the shipping costs for all of Amazon goods since shipping costs are driven by order density – and since Americans buy groceries on average 1.5x per week, this would certainly drive up the density


  • China’s largest business-to-consumer company and expected to achieve over $50bn in sales this year
  • Thesis for the company is consistent with our broader e-commerce framework- where retail is essentially a logistics business, and those with the lowest cost structure will win
  • Company has been rapidly taking market share from Alibaba based upon its promise of faster delivery times, authentic quality products, and great customer service
  • Key to this is JD’s one-of-a-kind logistics network, first built in 2007 – JD has invested billions into its logistics network: this has allowed the creation of initiatives such as the “211 program” where orders placed before 11am are delivered the same day and orders placed after 11pm are delivered by 3pm the next day
  • Alibaba on the other hand still relies upon a partnership of 3rd party carriers to deliver its packages
  • This type of instant gratification is habit-forming and very hard for competitors to replicate – it’s just hard to go back to waiting a week for your laundry detergent when you can have it the same day via Amazon Prime or JD.com
  • JD’s market shares gains has been 3-4% a year, recently reaching 25% of China’s B2C market in 2016 vs. Alibaba’s 57%
    • On top of this, China’s broader e-commerce industry is growing at 19% y/y
  • Vast majority of US-based investors are scared to invest in Chinese companies, due to concerns about fraud, lack of knowledge of the market, Variable Interest Entity structures, macro concerns, etc – there seems to be a large opportunity in US-listed Chinese ADRs
    • On the flip side, Chinese customers who know and use these companies every day are unable to invest, due to capital controls restricting funds from going outside China
    • This creates a favorable dynamic – one where the highest quality Chinese companies are without a natural shareholder base, resulting in very attractive valuations
  • Where else can you find the #2 e-commerce company, serving the world’s largest population, with a highly loyal customer base, huge logistics advantage, and strong industry tailwind, trading at 1x EV/sales (~20x long-term EBIT) and growing at 40% y/y?
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