Portfolio Performance for the 6 Months to August 22 2019

The portfolio produced a positive net return of +46.2% for the 6 months to 22/8/19 taking the annualised net return since inception to +44.8%. As I’ve added a new international stock, the performance figures are now also reported net of gains or losses arising from changes in currencies.

The standout stock was Afterpay (ASX: APT), which rose +43.5% in the 6 months and has driven the returns. 3 new positions were also added being Electro Optic Systems (ASX: EOS), Blackwall (ASX: BWF), and Pinduoduo (NASDAQ: PDD). EOS was added at a net average price of $3.29 (up +41.2%), BWF was added at a net average price of $0.84 (up +17.5%), and PDD was added at a net average price of AUD$33.13 (up +36.7%).

As usual, the information below isn't intended to be read as investment cases. Rather, they are just thoughts of mine I want to put down. 

Afterpay

There have been numerous key events within the last 6 months including: the launch of Clearpay in the UK, AUSTRAC, a $300m capital raise and founder sell down, key retailer wins and customer growth acceleration in the US, Visa’s entry into the Buy-Now, Pay-Later (BNPL) space, the introduction of Klarna’s ghost card, CBA’s USD$100m investment in Klarna and their announcement that they’ll be coming to Australia, and the list goes on. I believe the AUSTRAC investigation and Visa’s announcement to enter the BNPL space together have been the chief drivers of the volatility experienced over the last 6 months. AUSTRAC’s investigation has meant that Afterpay is subject to an audit in respect of its Anti-Money Laundering (AML) and Counter Terrorism Financing (CTF) compliance. The actual outcome of this is unknown but given the direct worst case scenario is a sanction of $21m per contravention of the Act ($42m in total for 2 breaches), I’m comfortable with bearing this risk. The big unknown from my perspective is that if they were in breach, what other ramifications could that lead to beyond the direct maximum financial sanction. In other words, would this put Afterpay back insight of ASIC and if so, what could that lead to?

In terms of competition, I’m still of the view that the competition especially in the US is exaggerated. The term Buy-Now, Pay-Later gets thrown around as an umbrella term and many of these “me-toos” are in fact very different to Afterpay. Many will charge either an account fee, interest, other charges, or some combination thereof. Most (if not all) don’t have the simplicity and transparency of the Afterpay business model – which in my opinion has been one of the major drivers of its success. Google Trends data below shows the relative popularity in search terms of Afterpay and some key competitors in the US. As can be seen, Afterpay remains the clear leader. This is in light of Klarna’s recent big marketing campaign “Shop Like a Queen”. The campaign promoted the ghost card which allows shoppers to use the service on any site (or so they claim). What this effectively means is that they are providing the service for free. When I first read about the ghost card from Klarna’s press release, I was very skeptical of this. My interpretation of it was that because they couldn’t compete directly with Afterpay in the US, they had to offer their service for free to gain traction. Fast forward a few months, and I think another reason for launching the ghost card was to artificially boost their customer growth numbers for the purpose of their recent USD$460m capital raise. At some point, they will have to monetise the userbase. Given that Klarna is a bank, my inclination is that they will in some form monetise the user base directly and perhaps charge a reduced merchant fee. This reactive move by Klarna in my opinion is a testament to the strength of Afterpay’s management team and the strong brand they have developed. 

Similarly, as can be seen in the Google Trends chart below, within a matter of months, there has been a strong convergence between Clearpay (Afterpay’s brand name in the UK) and Klarna. I think it’s important to bear in mind that this was achieved with less than 100 active merchants at the reporting date (the average would be much lower). This compares to Klarna who have been in the market for several years and have many more merchants than Clearpay.  To me, this is one of the strongest signals of the strength of the business and Afterpay’s ability to expand into new markets. Over time, this will become apparent in the financials. 

Many brokers have assumed linear customer growth in the US. For example, at the time of writing, a recent broker report shows that they assume the US business adds a net of ~2.5m customers per year in both FY20 and FY21. But this is not how this business works, rather, growth is exponential (not linear). The most recent US Press Release proves this nicely, with customers up ~250,000 per month in the US between Jun-Jul 2019 vs ~130,000 per month between Jan-Feb 2019. Therefore, I believe there is substantial upside risk to the customer numbers in many of these broker reports. Over time, as I believe they will continue to grow the customer numbers, the brokers will be forced to upgrade leading to a re-rate.  

The direct key drivers of revenue growth being number of active users, frequency of purchase, average order value and the merchant margin are all tracking along nicely, and I am extremely pleased with the progress. While I continue to monitor the market acutely, with each passing day, I grow more confident that this business will become a household name across the globe and that the best years are still ahead of us. 

Electro Optic Systems

EOS operates in the space and defence markets. They make advanced weapon systems predominantly for the military and develop tracking systems for orbiting satellites and space debris.

The company’s core competency is the development of Remote Weapon Systems (RWS). RWS are essentially weapons that can be attached to various vehicles allowing the weapons to be used remotely – i.e. the gunner isn’t manned on the gun, rather, it’s operated nearby or within the vehicle. The weapons business has an order backlog of over $600m and is tendering for projects which in combination are worth more than $2.5bn with existing customers. Only a small amount of that $2.5bn has to land in order for future earnings upgrades. 

The space business currently generates minimal revenues, but this has potential to be a substantial part of the business over time. Management estimates the market to be worth over $2bn over the next 10 years. The theme behind the space business is appealing. There is currently $900bn of space assets (and growing). EOS’ space technology allows satellietes to track debris and avoid collision which is an increasing threat and legacy based detection is increasingly becoming insufficient. EOS has been in the research side of the space market for over 20 years. They have developed advanced technology which is potentially now at “mass commercialisation”. For example, space communication is mainly by microwave technology which is limited to a bandwidth of about 500GHz. This is expected to hit capacity within a few years, leading to a need for higher bandwidth. The EOS satellite is the only optical communication satellite capable of testing transmit-receive bandwidth of 20THz in space (Evans & Partners, 2019). The company’s advanced technology places it well ahead of the competition. My numbers don’t factor in much upside in this side of the business, but once again, if only a small amount of the market is landed, there is potential for earnings upgrades down the track. The margins in this division are high, and so as this division grows, margins are expected to expand over time.

What initially attracted me to this business was simple; the business was forecast to grow revenues in excess of 40% in FY20, and was trading at about 11x earnings (after adjusting for unrestricted net cash). It was simply just too cheap. A recent upgrade to earnings (and the subsequent rise in the stock price) means that the company now trades at just under an FY21 EV/EBITDA of 9x. On face value, this may seem cheap as it’s got a secured revenue stream with real potential for meaningful upgrades down the track. However, at the end of the day, it’s still a contracting business and so a multiple re-rate much further than this seems unlikely. Rather, the main driver will have to come from the company landing contracts and growing its space division (and therefore margins). Both drivers I believe are achievable and, in my opinion, the risk-reward remains compelling. 

Blackwall

Blackwall is a property funds management company that operates 3 distinct but complimentary businesses. Blackwall Asset Management is a development and management business that acquires commercial real estate for incremental returns. Wotso Worksapce is a co-working business that earns the bulk of its revenue by leasing out desks. The investment segment (~$30m) holds a strategic ~$16.2m in Blackwall Property Trust (ASX: BWR), with the balance deployed opportunistically to further enhance the other 2 operating businesses. 

While the funds management and investment business together contribute towards a large part of the NTA and revenues, the expansion of Wotso is where I believe the bulk of the uplift will come from. Management have indicated that the total network will have 6,700 desks in by FY19, up from 1,400 in FY16. The bulk of the sites are yet to reach maturity (generally after 3 years), meaning that latent revenue remains with overall occupancy estimated to be at ~50%, compared to the average of ~95% for mature sites. Upon maturity, revenue per desk is estimated at $4,750 with an EBITDA margin of 20-35%. In other words, there is potential for $25-30m of revenue using current desk rates. However, given the strong surge in supply, I’ve brought down the average rate per desk and occupancy rates, as despite having some immunity (expansion is CBD focused, whereas Wotso’s  are in the suburbs), I believe there will be rate pressure across the board and maintaining the 95% gets more challenging. I’m a believer that the co-working market will continue to grow in popularity. Moreover, co-working represents less than ~2.5% of assets in Sydney and Melbourne which compares to ~7% in New York, providing further upside via increased penetration rates.

The recent sale of the Bakehouse Quarter in Strathfield also means that with the cash infusion of $110m in total (split across BWR and BWF), the expansion of Wotso is likely to continue and so too will the recurring management fees from asset management.

With NTA of ~$0.49 per share (which isn’t needed to operate the two other businesses), the geographical expansion of Wotso, increase in utilisation rates over time as newer Wotso sites mature, and the sale of the Bakehouse Quarter and the associated uplift in cash and NTA, I believe there is strong potential for the shares to move higher from here.  

I will introduce Pinduoduo in another post.

Thank you for reading.

Performance figures are annualised and the figures are quoted net of fees and expenses, gains/(losses) from changes in foreign currencies, but before taxes. All positions are long positions. Inception date is 22/02/2014. This article is general advice and is not intended to be personal advice. Before making any decisions, consult a licensed professional.

Afterpay Has Potentially Reached A Tipping Point In The US

My analysis and channel checks suggest to me that Afterpay has reached a significant tipping point in the US after only 11 months of operating in the country. While the platform now has thousands of retailers on it, several hundred of them are of a size that suggests to me that over the next 6-12 months, there will be some serious growth in this business. I am of the view that the annualised underlying sales rate in the US could see half on half (2H19 vs 1H19) growth rates in the triple digits, despite the first half having the benefit of Christmas, but offset by the benefit of increased awareness through time.  

My research also suggests to me that we are within weeks of the UK launch. I am hopeful that they give a business update when they launch the UK operations, although I won’t be totally surprised if they don’t.

Afterpay have taken the buy now, pay later model global and are the face of the industry. When people hear the term buy now, pay later, Afterpay is the first thing that comes to most of their minds. I’ve read numerous posts in the US about the buy now, pay later market, and Afterpay gets referenced first or is the only company to be mentioned when that term gets mentioned. Of course, there will be times where this isn’t the case, but it is the exception, rather than the rule based on my research.

Most people who have heard of Afterpay, have also heard of the term buy now, pay later. Many of these same people also understand that Afterpay is interest-free. “Competitors” will throw the buy now, pay later term around as a blanket term, in the attempt to persuade people to thinking that their product is akin to Afterpay. The problem is, many of these competitors end up charging the customer in some major way, whether it be Zip, Paypal Credit, Klara, Affirm, or whoever else, none of them are identical to Afterpay in terms of simplicity, transparency and cost to the end user.

Klarna have gone so far as to copy almost every single aspect of Afterpay’s marketing model to the point where they also say “Klarna it” as one of their marketing phrases. Snoop Dogg has also recently invested in the company and is now the face of it. But what has this done to dent Afterpay’s growth in the US? Little in my opinion. Putting customer related numbers aside, one of the easiest ways to see who the real competitors are (if they do exist) is to look at which retailers are signing up with them. After only 11 months of operations, Afterpay have signed up some of the biggest brands in the world including: Forever21, Urban Outfitters, Revolve, Steve Madden, boohoo, Skechers, Kylie Cosmetics, Designer Shoe Warehouse, Colour Pop Cosmetics, Dose of Colors, Morphe Brushes, and Ray-Ban just to name a few. Who have the “competitors” signed up? That’s what you’ve got to ask yourself. Time will tell but unfortunately, I think Snoop has backed the wrong dog.

This article is general advice and is not intended to be personal advice. Before making any decisions, consult a licensed professional.

Portfolio Performance for the 12 Months to February 22 2019

The previous year (ending 22 February 2019) has been by far the best year for the fund. Pleasingly, the fund returned +86.6% for the year taking the annualised return since inception to +39.3%.

The funds large position in Afterpay (ASX: APT) has surged substantially, rising from $7.53 from the beginning of the year to $17.20, or a rise of +128.4% over the year and has largely driven the returns of the fund. Although the below might read like a partial investment thesis, that’s not the intention. It’s just some thoughts of mine that I wanted to put forward.  

Late last calendar year, I made the decision and sold the vast majority of my holdings and progressively accumulated more stock in Afterpay. After the stock more than halved from the peak to the trough on the back of regulatory risk, a global sell off in tech stocks, and some adverse journalism, I saw an opportunity and took a big swing and progressively accumulated stock between $10.80 and $14.00. I’ve been following the company religiously for over 1 year now, and I am convinced Afterpay will be a global success and the stock in my opinion offers impressive risk-adjusted returns. This company is on track to be amongst one the fastest companies in the world to reach annual revenue of $1bn ever. To put that into context, it took Dropbox just a little bit over 8 years to reach an annualised revenue run-rate of $1bn, and they claim they were the fastest SaaS business to reach that milestone. Although Afterpay is not a Saas business, they are on track for similar success based on actual revenue and not the run-rate. A visual representation of some fast-growing SaaS businesses is below.

Using SimilarWeb, I’ve been tracking website traffic to Afterpay and also website traffic from Afterpay’s platform to various large retailers in the US to get insight into the early momentum in the US. The indicators are extremely positive with Afterpay showing early success in terms of website traffic and customer referrals. For example, in January 2019, the website with the highest referral rate was to Urbanoutfitters in the US, outstripping any other site in Australia. This is an important early indicator given the US business is less than a year old but has been in Australia for ~5 years. Other measures such as Google Trends and app reviews also confirm this strong early momentum and what appears to be growing by the month despite retail seasonality. For example, February 2019 in my opinion is shaping up to be the biggest month in the US in terms of customer additions, outstripping the typically stronger months of November and December. In fact, as the shares halved before my eyes, watching the popularity of the product in the US surge using these 3 measures is what kept me sane.   

While Afterpay’s value proposition to most retailers is clear, a major competitive advantage is how Afterpay’s platform is leading to strong customer referrals to businesses on the platform. Afterpay is now the second largest referrer of business to retailers in Australia after Google. This isn’t a point many people harp on about, but I see this as a major advantage. Afterpay’s strengthening moat will largely depend on their ability to unlock the true potential of these referrals and harness the true power of their platform in the long-term. The uplift in average basket values are nice, but long-term, the value isn’t just in that. It goes much further than just a transaction.

Afterpay’s product in my opinion is self-regulating. This is by design of the product. You can only continue to use the product if you are not currently late on a payment or are under the limit of $2,000. The fact that you cannot use the product if you are late (and need to make up for lost payments until you can begin using it again) weeds out lower quality customers. This is important as Afterpay continues to expand geographically because when you enter a new market which has no incumbents, this process takes time to play out and ideally, you want to be the first one to start so that the later entrants are left with the lower quality customers. In buoyant times the importance of this is masked, but when shit hits the fan, you should see the power of having a higher quality customer base in lower bad debts relative to competitors. As the customer base matures, you end up with a more profitable and less risky customer base. Moreover, as the number of customers and merchants grow, it creates a self-fulfilling cycle as the marginal customer will look for the provider with the largest (and/or most suited) retail network, and while merchant fees are important, the marginal retailer will look for the provider with the largest (and/or most suited) customer base.  

Putting aside where we sit in the current economic cycle, the short repayment cycle helps determine the credit riskiness of the customer base relatively quickly. As the average customer is paying back within ~30 days, Afterpay get a pretty good grasp of their customer base within a matter of months. I’ve spoken to someone who models credit risk for a bank who also confirmed this. It takes banks much longer to figure out how risky a new and first-time credit user really is as the repayment cycles tend to be much longer and loan sizes are typically larger. 

Afterpay is unique because it has a very low Customer Acquisition Cost (CAC). At a basic level, in FY18, the company added 1.5m customers but only spent $5.8m in marketing, equating to a CAC of only $3.9. Bear in mind that when comparing this to other companies, the CAC cannot be viewed in isolation, as it needs to be viewed alongside other metrics such as Average Revenue Per User (ARPU) and EBITDA per customer.  

Afterpay are pricing their product lower in the US to gain faster and more effective traction. I don’t have an issue with this as many of the brands who are paying a lower rate in the US are paying a higher rate in Australia as they see the value in it. I think it’s only a matter of time for the results to shine through in the US market (like it has in Australia) and as a result pricing might revert closer toward the 4% it is in Australia on average. As competitive pressures rise, this might offset the pricing power, but in my model, I assume a long-term rate quite a bit lower than 4% and it still makes economic sense based on my assumptions. It’s interesting to note that Visa & Mastercard are lifting some of their fees in the US (however I’m not certain whether it applies to online transactions just yet). If applied to online transactions, this move would improve the relative affordability and value proposition of Afterpay to credit cards as an alternate payment method.

Afterpay is set to begin its operations in the UK in CY19. The UK launch will benefit from their existing operations in Australia and the US, as many of the global brands in these two countries have operations in the UK and so I believe they won’t be starting from the beginning. Moreover, the acquisition in the UK will give them a customer base to leverage off as well. Carl Scheible will lead the UK team who was an ex VP & MD of Paypal UK & Ireland and spent over 8 years at the company.

To date, Afterpay have executed almost flawlessly. I commend every single employee on their efforts to date. However, nothing is perfect and it too has its share of negatives. 3M has a history of innovation and delivering quality products. They are “famous” for going straight to the customer to improve their products by reviewing complaints made to the company as a key way to improve. I’ve done something similar by reviewing the common negative reviews in the businesses US operations. While not backed statistically, my experience suggests to me that the two common flaws (that are not user induced) are some people are having issues setting up their account (and this has occurred enough times for me to believe it’s not user error) and a lack of customer service. I don’t have the details as to why the former is occurring and so cannot comment on that one but the latter was and to some extent continues to occur in Australia. The reason is that because they are growing so quickly, they simply are not hiring people fast enough. I hope sooner rather than later, they are in a position to sort this out. Another consumer related issue is that getting a refund for the most part can be extremely difficult. So, while not perfect, the management team are doing a great job when you factor in how fast they are growing.

I believe CY19 will see Afterpay introduce adjacent revenue streams, enter a new vertical and launch into Canada. I also believe a NASDAQ listing is on the cards by FY20-21. The potential dual listing is on the back of the theory that they don’t have the balance sheet to fund companies such as Nike in the US. While the US debt facility of up to ~US$300m will facilitate in excess of $4.0bn of sales per year, they will eventually need to diversify their funding sources and raise fresh equity which may be completed in the US.

Some other positive contributions in the year came from Infomedia (ASX: IFM), Netwealth (ASX: NWL) and Redhill Education (ASX: RDH).

I’ve copped a lot of crap from holding this stock but it’s been well worth it. Almost nothing is without risk, and Afterpay has its fair share of risks (which I’ve decided not to include here in this post), but as Stanley Druckenmiller once said “I’ve learned many things from [George Soros], but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity.” Until I find a clear reason not to be owning this stock, I believe I’ve found that opportunity and I’ve put my money where my mouth is. Time will tell.

All the best!  

Performance figures are annualised and the figures are quoted net of fees and expenses but before taxes. All positions are long positions. Inception date is 22/02/2014. This article is general advice and is not intended to be personal advice. Before making any decisions, consult a licensed professional.