[QS] Why Do Markets Love SaaS Companies?

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

If you’ve ever analyzed enterprise software companies, you’ve heard of SaaS. (Or PaaS, or IaaS). Actually, even if the company you’re analyzing isn’t an enterprise software company, you’ve probably heard the management team claim they have a SaaS product.

So what is it? SaaS stands for Software as a Service. What this essentially means is that the software is all or partially cloud based (computations are run on a data center somewhere far away) and the user runs the application on a web browser or downloads the client onto their computer. Customers are billed on a per license, per month basis in a subscription format.

This arrangement benefits both the software companies and their customers.

Customers benefit by:

  1. Always having the latest version of the software and never needing to pay up for next year’s upgraded version,
  2. Not having to pay the upfront cost of buying the entire software license ($249 for Office 2019 vs. $6.99/month for Office 365 home),
  3. And having predictable and consistent cash flows.

Software companies benefit by:

  1. Expanding the pool of customers that can purchase the software,
  2. Getting more accurate user metrics and lowering piracy,
  3. And also having predictable and consistent cash flows.

And what’s with all the hype? There has been a massive move towards enterprise SaaS over the past 10 years. And one of the reason that SaaS companies have seen their stock prices massively outperform the market is that the cash flow generation is even more impressive than revenue or EPS growth.

Let’s take a simple example.

A typical software license sale of $100k + 10% annual service charge leads to revenues of $150k over a 5 year period ($100k + $10k x 5). A SaaS version of of that software may go for $3000/month, which leads to revenues of $180k ($3000 x 12 x 5). If you look at cumulatively revenues by year, the traditional license model has a large bump in year 1 and the growth tapers off. In contrast, the SaaS model has steady increase every year and overtakes the license model over time.

Of course in the traditional license model, there will be a renewal many years later (between years 7 -10) and there will also be a spike up in revenues from that customers. But you have to remember that there will have to be another sales process with the renewal which increases expenses. In the SaaS model, because there isn’t a follow-up sale, there is not spike up in expenses.

So back to those impressive growth rates. Fast growing SaaS companies are growing revenues between 20%-40% annually. That actually means that cash flows are actually growing 50+%, due to the slow ramp in cash flows and the way billing is done.

Bonus. So an interesting market phenomenon is when software companies transition from a license model to SaaS. There have been a handful and their stock prices are very impressive to say the least. Below are each of the company’s total returns vs. that of the S&P500. Owning a basket of these stocks would have beat any of the top fund managers over the past 5 to 10 years.

Happy investing everyone!

Retirement Account(s) Strategy Part 3

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Since its 2020, it’s time to revisit retirement account options and figure out how to maximize the benefits. Since 2019, the maximum contribution limit for IRAs and Roth IRAs is $6,000. The income limits have increased a little from 2019 to 2020. Below is a nice summary table from Nerd Wallet.

In the last retirement account post, we went over the non-deductible contributions to a traditional IRA and then subsequently rolling it over to a Roth IRA. This allows people that cross over the income limit to backdoor into a Roth IRA.

Doing further research on retirement accounts, I found that you shouldn’t overlook the contribution options of a 401(k). I caveat the following paragraphs by stating that every 401(k) plan is different and has different rules according to its plan sponsor. Also remember that every 401(k) plan has a different set of investment funds or vehicles to which you can invest your assets.

There are three contributions methods for a 401(k): pre-tax, Roth 401(k), and post-tax. I think when most people think of 401(k) contributions, they think of pre-tax. But there are these other two options that also make a lot of sense.

Pre-tax is what it sounds like. You get a tax break on the dollars you put into your 401(k) each year up to $19,500 in 2020, up from $19,000 in 2019. If you’re over 50 you can also contribute another $6,500. All contributions and gains are tax deferred until withdrawal.

For the Roth 401(k) there is the same contribution limit of $19,500 (+$6,500 if you’r over 50) in 2020. However, all contributions and gains are not taxed at withdrawal. These contributions are the same as a Roth IRA contribution, however there is no income limit and the maximum amount is much higher per year!

Post-tax contributions are a little different. All contributions are not taxed at withdrawal, since you’ve already paid taxes at the beginning, but the gains are taxed. So why would anyone make a post-tax contribution vs. a Roth 401(k) contribution? The answer is that the post-tax contribution limit is much higher than $19,500.

Theoretically you can contribute up to $56,000 with the after-tax contribution, meaning an extra $36,500 to your 401(k). However, it depends on each plan as certain plans may have limitations based on a percentage of your income.

Super Roth IRA Rollover. So back to the backdoor conversion into a Roth IRA via a non-deductible IRA contribution. The post-tax contribution to your 401(k) may be an even more super charged version of this. Because the contributions are not taxed (but the gains are), you could theoretically convert your contributions into a Roth IRA, tax free. And even better than the non-deductible IRA route, your annual contributions via post-tax dollars can be much larger than $6,000.

The drawback is that you can’t withdraw partially from a 401(k) — please correct me if my understanding of this is incorrect. And you can’t withdraw while you’re still at your employer. So you’d have to wait until retirement or until you change jobs to convert your 401(k) plan into a Roth IRA.

Even with all the potential drawbacks, being able to invest $19,500 annually via Roth 401(k) contributions and then another $36,500 via post-tax contributions, only to be rolled over into a Roth IRA eventually sounds very appealing.

Happy investing everyone!

(DV) Top Small Cap Stock Returns of the 1990s

Our 13th YouTube video explores the Top Small Cap Stock Returns of the 1990s, cumulatively.

If you want to subscribe to our YouTube channel, please click here.

Interesting takeaways from this video:
(1) Small cap returns were much more across the board vs. large cap,
(2) Tech did benefit from the bubble, but was limited to a few stocks,
(3) Healthcare did well led by Amgen and Medtronic,
(4) Sun Microsystems had such a massive run in the 90s, only to be acquired for $7.4B in 2009 by Oracle.

We might take a break from the bar chart race videos for a while. Hopefully with a little luck, we’ll be putting out more customized videos going forward.

As always, we appreciate any feedback to the video or the channel.

(QS) Stericycle [SRCL]

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

In this next post in our quality series (QS), we’ll cover a company that was once viewed as a quality company but subsequently fell from grace. From 2000 to 2015, this company increased revenues by 15% annually, growing from $323 million to $3.5 billion.

The company consistently made acquisitions that turned out to be very accretive to earnings and used any free cash flow to acquire smaller competitors, rolling up the industry. From 2000-2014, the company spent $2.4 billion in cash for acquisitions, allowing the company to become 20x larger than the 2nd largest competitor. This company is Stericyle.

Stericycle specializes in the regulated waste management business for the medical industry. This means picking up and disposing of hazardous waste and used medical instruments from hospitals and doctor’s offices.

Why is it quality? The idea behind the moat of the business and the roll-up model is economies of scale. The regulated waste management company that has the highest density in a given location (city, state) is able to spread the fixed costs (incinerators, autoclaves, buildings, computer systems, transport vehicles, etc.) over a larger base of customers and revenues. Furthermore, increased density will allow for more efficient driver routes for the drop off and pick up process.

As Stericyle became the largest player in the space, it also started to do something that most investors at the surface thought validated the company’s moat. The company started to exercise annual price increases because it had “pricing power” in markets that it dominated. Price increases are normal in many subscription and service type businesses. Anyone with a child in preschool or daycare knows that annual price increases of 5-10% are normal.

Why did it fall from grace? There were two main issues with the annual price increases that investors found out about the hard way in 2016 and beyond. The first was that by the end of 2014-2105, the price increases had become such a large part of the annual revenue growth as markets were becoming saturated and its end customers were consolidating. Big hospital networks had more leverage when negotiating prices vs. individual doctor’s offices. And the smaller doctor’s offices were being absorbed into larger networks.

The second and more glaring issue was that many of the annual price increases were done without notifying the clients. What once started as a small expense line item 10 years ago, became much larger due to compounding price increases and customers started to investigate how and why it was increasing each year. An example that was revealed during one of the lawsuits against the company was a about a government customer that experienced price increases of 18% every 9 months.

As the company’s end markets were slowing and price increases were harder to come by, Stericycle made a large acquisition of a paper shredding service company for $2.3 billion. The rationale was that driver utilization will increase as paper shredding can be complemented with medical waste. However, the integration was much more difficult than originally projected and the benefits of picking up paper and medical waste were minimal. In fact, it caused many delays as the driver wasn’t efficient in carrying different types of products.

So what happened to the stock? If we look at a 20 year chart of the stock price and the P/E ratio, things peaked in 2015. That’s when the market started to see the weaker earnings reports for issues discussed above. Each time the company reported poor earnings, the market thought it was a temporary blip, but the company continued to disappoint over the next three years.

But what’s probably the most interesting is that the P/E ratio started to precipitously decline and investors looking for a “bargain” started to step in, only to see the multiple decline even further.

I’m still unsure if Stericycle ever was a high quality company due to its business model and end markets, even though it was making accretive acquisitions prior to 2015. In addition, we can’t parse out price increases vs. volume increases. But what I can say with much confidence is that once the market perception (and the fundamentals) of the quality level of the company was in free fall, there’s no reason to step in and buy the stock. Because as a company goes from higher quality to lower quality, there’s no way of telling where the bottom is for the stock or the multiple.

Happy investing everyone!

(DV) Top Large Cap Stock Returns of the 1990s

Our 12th YouTube video explores the Top Large Cap Stock Returns of the 1990s, cumulatively.

If you want to subscribe to our YouTube channel, please click here.

Interesting takeaways from this video:
(1) Tech performed well all throughout the decade leading up to the dotcom bubble,
(2) Consumer stocks did well, even those categorized as staples,
(3) There was a temporary spike in Energy during the Gulf War,
(4) Even though GE was touted to be the best run company in the 90s there were 10 stocks that performed much better.

In our next video, we’ll continue to explore the best returns of stocks in the 1990s. As always, we appreciate any feedback to the video or the channel.

Other People's Money

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Premise for this post: you have a business or idea that you think can grow into something big one day. But you have no capital and no friends/family money that you can tap into. So what type of capital should you raise?

Well, it depends on the type of business. If you have a stable, cash flow generating business, go with debt. It’s implied that the likelihood of your cash flow increasing with the new capital is very high.

An example would be a CPA firm that is looking to acquire a rival firm. You can make simple pro forma calculations to project how much your revenue and profit would increase from the new client base, which would allow you to pay down the new debt in a timeline that you lay out.

Here are things to consider when taking on debt:

  1. Cost of debt should be lower than the Return on Capital at the minimum
  2. A sensitivity analysis should be done on the Return on Capital calculation because there are always unforeseen circumstances
  3. Make sure that your business is defensible as you think, meaning the likelihood of the cash flows is very high

If you don’t have great visibility on increasing cash flows or even generating any cash flows in the future, go with equity. That’s because the equity investors are sharing some of the risk to participate in some of the profits. If your business/idea goes to zero, you don’t owe these equity investors a dime.

That being said, it also means that investors won’t be interested unless there is massive growth ahead for your business/idea. The amount of work they need to do to conduct due diligence on your business/idea has to be worth it for them.

An example would be any software or service company that has a large market opportunity. Think of Amazon in the late nineties. There was (and still is) a huge market opportunity for online commerce so that slowly building Amazon through debt and future cash flows would have been a mistake.

Here are things to consider when taking on equity:

  1. Even though the new equity investor would typically be a minority investor, be careful of certain protections specifically for them. There are so many stories of start-ups that go bust, but the venture capital investors had protections that allow them to recoup all their money, leaving the employees and sometimes founders left in the dust with nothing.
  2. Equity investors have voting rights and if the founder dilutes himself/herself enough, they have the power to collectively boot you from your own company.
  3. Valuations matter for equity capital. If you give up too much of your equity for the initial capital infusion, you may limit your upside.

Happy investing everyone!

(DV) Top Small Cap Stock Returns of the 2000s

Our 11th YouTube video explores the Top Small Cap Stock Returns of the 2000s, cumulatively.

If you want to subscribe to our YouTube channel, please click here.

Interesting takeaways from this video:
(1) Similar to large cap stocks, tech returns dominated the early 2000s,
(2) Because most housing related stocks were small cap, they dominated returns in 2003-2007,
(3) Tech stocks were in a bear market after the dotcom crash,
(4) Energy stocks were the big winners past 2008.

In our next video, we’ll explore the best returns of stocks in the 1990s. As always, we appreciate any feedback to the video or the channel.

Tesla Stock?

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

Image result for elon tesla

This week has been a wild ride for Tesla shareholders, to say the least. On Monday, the stock was up 20% and on Tuesday, it reached a peak of $968 prior to dropping into the close, but still closing up another 13.7%. You just don’t see volatility like that for a stock with a market cap over $100B.

For context, the stock started at $418 at the beginning of this year and was as low as $188 last May. The rest of the week wasn’t as good for shareholders. Wednesday the stock was down 17%, Thursday up 2% and Friday essentially flat.

So what are the bulls saying? There was good news coming out of China as Tesla is building a factory in Shanghai to sell directly into the China market. And of course there were reports that demand for the Model 3 was very strong, even though production even hasn’t started yet. China’s auto market is already larger than the U.S. in the number of vehicles sold each year and Tesla is just getting started in that market.

There have also been big projections given for the model Y, which is currently set to be released in 2021. The bulls are hoping that demand for the model Y is just as large if not larger than the model 3.

The bulls are look towards an end game scenario in which Tesla is the dominant electric vehicle manufacturer and everything battery/solar provider into the electric vehicle/home ecosystem.

Furthermore, because there is a lot of momentum in the stock, people are piling on. In fact, the top suggested Google search for “Should I” was “Should I buy tesla stock”. And there are plenty of people on social media talking about how they’ve made money off of the big move in Tesla.

What are the bears saying? Generally, the bears are saying 3 things about the stock price moves. First they’re saying that it’s a bubble that can’t be sustained. I found this chart comparing Tesla’s stock price run up to the famous South Sea Company bubble. As you can see below, it didn’t end well for South Sea Company investors.

The second round of arguments against the company is that the fundamentals can’t support a stock price that high. Tesla only delivered 367k cars in 2019. If you compare that to GM and Ford, which have a combined lower market cap ($79B vs. $137B), GM delivered 7.7M vehicles and Ford 5.4M vehicles in 2019.

Furthermore, the Tesla bears point to slowing down of unit growth rates when tax credit incentives are removed. These arguments are all valid but whether the stock is at $200 or $700, they are all the same.

The third argument is that Tesla is a fraud. Bears point to the failed acquisition of Solar City, unsuspected charges for software upgrades that haven’t been delivered yet (full self driving), unintended acceleration cases that have caused serious accidents, etc.

So what’s there to know? I think when a stock gets into frothy territory like it is now, it can go either way. Just because a stock has become very “expensive” relative to its history doesn’t mean that it’s going to come down anytime soon. In fact, I would argue that it’s more likely to go up than down because people continue to pile onto the trade, especially uninformed retail investors who are trying to make a quick buck.

Having said that, it can just as easily crash if the stock drops much lower as holders of the stock have “weak” hands. There isn’t the large institutional investor that believes so firmly in the company’s fundamentals to step in and buy a bunch of shares at $500-$600.

Takeaway. I think the main takeaway should be that you should just watch for entertainment purposes vs. play when see you stock moves like this. First, the gains, while they can be massive, can just be as massive on the loss side. Second, even if you are lucky enough to achieve massive gains, you have to pay short term capital gains taxes. And lastly, the amount of stress that you’ll have to deal with from holding onto a stock that has gone up 200% just isn’t worth it.

That’s why I’m a big proponent of acquiring quality and high quality companies at reasonable prices. You can sleep better at night and compound returns for the long run.

Happy investing!

(DV) Top Large Cap Stock Returns of the 2000s

Our 10th YouTube video explores the Top Large Cap Stock Returns of the 2000s, cumulatively.

If you want to subscribe to our YouTube channel, please click here.

Interesting takeaways from this video:
(1) The dotcom bubble boosted tech returns massively before the crash,
(2) Healthcare did really well post dotcom bubble bursting, especially United Health,
(3) Energy did really well in 2008,
(4) Surprisingly, Financials didn’t have the best returns prior to the 2008 market crash.

In our next video, we’ll explore the best returns of small cap stocks in the 2000s. As always, we appreciate any feedback to the video or the channel.

(QS) Disney [DIS]

Disclaimer: This post should not be taken as investment advice. It just represents the opinions and perspectives of someone who’s been in finance over two decades.

In this part of our quality series, we will go over a company that went from HQ to Q to HQ again. That company is Disney from 2010-2015, then 2015-2018, and then 2019 onward.

If you need a recap of what has been discussed so far, here are part 1, part 2, part 3, part 4, and part 5.

I’m sure you remember by now but just as a refresher, a quality company has a defensible moat which allows it to generate excess cash flows. Disney fits that criteria. The company has the best IP of any media/entertainment company (Marvel, Pixar, Starwars, etc.) and leverages that IP through all of the media channels (TV networks, Movies, Theme Parks, Consumer Products).

Financially, Disney generates $70B in revenues each year, of which they take $6B-$10B in operating cash flow. Returns on capital have been 10%-15% consistently. Disney has grown revenues each year since 2000, with the exception of 2010 when they shrank by 4.5%.

So is it a high quality company? From 2010 to 2015, Disney was a high quality company. They had just finished acquiring Marvel for $4.2B. With the Marvel franchise under the Disney umbrella, many studio hits would be released, some of which would set box office records. The company still continues to benefit from the Marvel universe IP, as it expands its parks to include Avengers Campuses.

ESPN adoption was steadily growing as cable penetration into households continued to increase each year. Cable networks get a per subscriber fee from their distribution partners, such as traditional cable companies (Comcast, Charter), satellite companies (Dish, DirecTV), wireline providers (AT&T, Verizon) and now OTT providers (YouTubeTV, SlingTV, HuluTV). This segment continued to grow and become a larger portion of the overall company’s earnings.

To reference how important ESPN was to Disney, in 2015, the network contributed 31% of revenues to the company and 51% of operating income, due to the high margins in cable networks.

Why did it go from high quality to quality? What was once a gem at the company started to detract from growth rates. The streaming video effect was taking hold and households were cancelling enough of their cable video subscriptions to make the subscriber count go negative for ESPN.

Essentially half of the earnings power of the business was facing industry headwinds. There were talking heads on TV that thought no one would cancel ESPN due to its focus on sports and live content, but the subscriber count kept declining.

This phenomenon is still happening at the company and for all cable networks, but Disney was able to shift the company in a new direction with its venture into direct to consumer streaming video.

So what happened in 2019? Disney acquired BamTech in 2017 to lay the foundation for its streaming technology and subsequently launched ESPN+ in 2018. The content on the service wasn’t as good as regular ESPN (due to programming deals), but it did produce some original content that was complementary to live sports. Subscriber count for the service is now over 7M.

The big game changer happened in early 2019 when the company announced details around its Disney+ launch. The company planned to aggressively invest in new and original content that would only be available Disney+ and pricing was very favorable to attract subscribers. Disney+ had over 10M subscribers after its first weekend after launch and has over 26M subscribers today.

The stock chart below shows that from 2010-2015, Disney’s intrinsic value compounded at a strong rate. The there was a lull from 2015 to 2019 as the company had to stem the losses coming from ESPN. The spike in 2019, happened after the details of the Disney+ streaming service was announced.

Since Disney is now back to being a high quality company, intrinsic value for the company should compound each year, especially as the streaming services gain traction internationally. The multiple for the stock follows the market’s perception of the quality level of the company.

Happy investing everyone!