Contents

1. Introduction

2. Moat Analysis

3. KPI & Financial Snapshot

4. Growth Opportunity

5. Risks

6. Valuation

7. Investment Outlook

1. Introduction

Rubrik is a company that helps organizations keep their data safe and easy to recover if something goes wrong, such as a cyberattack or accidental deletion. In simple terms, Rubrik provides secure backup and recovery solutions, ensuring that files, databases, and entire systems can be quickly restored to their previous state. The company was founded in 2014 and went public via an IPO in April 2024.

Rubrik operates as a Software-as-a-Service (SaaS) data security and management company built around its flagship Rubrik Security Cloud (RSC) platform.

It has evolved from traditional backup and recovery into a comprehensive cyber resilience provider, positioning itself as “securing the world’s data.” Rubrik is recognised as a Gartner Magic Quadrant Leader for six consecutive years, reflecting its strong market position.

The platform helps organizations build resilience against cyberattacks, ransomware, malicious insiders, and operational disruptions. Built on a Zero Trust Data Security model, Rubrik leverages machine learning to safeguard information while enabling fast recovery.

What Rubrik Offers

• Backup and Recovery: Automatically saves copies of data and makes recovery quick and simple.

• Protection from Cyber Threats: Enables recovery from ransomware or hacking without paying attackers.

• Works Everywhere: Supports data across on-premise systems, the cloud, or hybrid environments, all managed through a single dashboard.

• Automation and Ease of Use: Automates complex workflows, reducing manual effort.

• Fast Recovery: Restores files or systems almost instantly, minimizing downtime.

• Security: Encrypts data, ensures backups remain unchanged, and supports compliance requirements.

Think of Rubrik as both a secure digital vault and a rewind button for critical data.

How Rubrik Enables Recovery After a Cyberattack

1. Pre-Attack Preparation: Rubrik continuously backs up and scans data, creating “snapshots.” It proactively scans for threats, tags sensitive files, and monitors access to reduce risks.

2. Cyberattack Occurs: If data is compromised, Rubrik’s immutability ensures backups cannot be altered by attackers, preserving clean copies.

   

3. Identify Clean Recovery Points: The Preemptive Recovery Engine pinpoints safe, uninfected backups created before the attack.

4. Restore Data: With just a few clicks, Rubrik restores data from these clean backups. Recovery time is reduced from weeks to hours or days. IT teams can also test data in a secure “sandbox” to confirm recovery is safe.

5. Business Back Online: Once confirmed, Rubrik streamlines the workflow through automation, restoring files, applications, and systems with minimal disruption. Businesses resume normal operations without paying ransom.

6. Post-Attack Insights: Rubrik continuously analyzes risks and provides insights to strengthen defenses for the future.

In essence, Rubrik acts as an organisation’s “undo button” after a cyberattack, rapidly restoring data and enabling a secure, confident recovery.

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2. Moat Analysis

Rubrik is still in the growth phase of its business, meaning its competitive position is developing. Strong moats typically emerge over time. Below is a summary of key moat components and their trajectory.

1. Switching Costs

Rubrik benefits from moderate but growing switching costs driven by platform integration and data dependencies. Its API-first architecture and unified management interface embed the platform deeply into workflows, making migration complex.

Technical features such as the immutable file system, proprietary data deduplication, and zero trust security architecture add further switching friction. Customer feedback highlights substantial implementation investment, though Rubrik’s fast deployment can make competitors easier to trial.

2. Network Effects

Rubrik benefits from network effects through threat intelligence, ecosystem development, and partner integrations.

• Threat analytics improve as more organisations deploy the platform. The platform learns collectively, enhancing security for all customers.

• Ecosystem integrations with partners like Microsoft Azure, Pure Storage, and major cloud providers increase stickiness and expand platform value.

• Multi-cloud architecture supports AWS, Azure, and Google Cloud, positioning Rubrik well as enterprises adopt hybrid and multi-cloud strategies.

These dynamics create a virtuous cycle, strengthening security and platform value as adoption grows.

3. Cost Advantages

Rubrik positions itself as a premium provider, with cost advantages rooted in total cost of ownership (TCO) reduction rather than low upfront pricing. Forrester case studies show 30–50% TCO savings via license consolidation, reduced admin/support, and lower data centre costs.

Rubrik’s advantage lies in delivering meaningful TCO reductions for enterprises consolidating and automating resilience workflows. For large, complex environments, savings could be in millions of dollars, making the premium pricing a net financial benefit. For smaller setups, however, costs may outweigh benefits.

4. Efficient Scale

Rubrik operates in a large, growing market but has not yet reached the scale required for durable competitive positioning. The market remains fragmented with Cohesity-Veritas and Veeam holding larger shares. Rubrik’s scale advantage is therefore limited, although its growth trajectory points to significant potential.

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3. KPI & Financial Snapshot

Customers with $100K+ in Subscription ARR

Rubrik tracks the number of customers generating at least $100,000 in annual recurring subscription revenue (ARR), a key metric reflecting its ability to land and expand large enterprise clients. These clients are critical for sustained revenue growth in the competitive cybersecurity and data protection market.

As of Q1 FY 2026, Rubrik reported 2,391 customers with $100K+ in Subscription ARR, up 29% YoY. Customers at this level are more likely to expand platform usage, adopt additional modules such as cloud security or anomaly detection, and renew at higher rates. Sustained growth in this KPI demonstrates Rubrik’s relevance and traction among enterprises with stringent data security requirements, where deal sizes, multi-year commitments, and switching costs are higher.

Average Subscription Dollar-Based Net Retention Rate

Rubrik’s NRR consistently exceeds 120%, signalling strong upsell, retention, and expansion within its subscription base. In enterprise SaaS, an NRR above 120% is considered world-class and reflects effective cross-selling, upselling, and limited churn.

The company grows its footprint by:

• Increasing the volume of data protected within existing applications

• Securing additional applications for customers

• Adding more security functionality to existing deployments

In Q1 FY 2026, adoption of additional security functionality contributed over 30% to subscription NRR. High NRR allows more efficient sales spending, as each landed customer becomes increasingly valuable over time. Maintaining 120%+ NRR will become more challenging as net new customer growth slows, requiring continued product innovation and strong customer success.

Revenue

Rubrik’s revenue comes primarily from subscription sales tied to the RSC platform and related solutions, including term-based licenses and standalone SaaS products such as Anomaly Detection and Sensitive Data Monitoring. Subscription revenue represents 95% of total revenue, with professional services, installation, training, consulting, and technical support, making up the remainder.

In Q1 FY 2026, total revenue reached $278 million, up 49% YoY and marking the third consecutive quarter of growth acceleration. Subscription revenue grew 54% to $266 million, while legacy maintenance revenue fell from $6 million to $2 million, reflecting a successful transition from older models.

Operating Margin

Rubrik’s operating margin remains negative as investments in growth outpace current revenue. In Q1 FY 2026, the operating loss was $93 million, representing a -33% margin, down from -387% in Q1 FY 2025, when high IPO-related stock-based compensation inflated expenses.

The negative margin reflects aggressive sales and marketing spend (61% of revenue) and R&D (29% of revenue), despite a healthy gross margin of 78%. Rubrik’s operating loss is therefore a function of strategic investments in product development, innovation, and market expansion.

Free Cash Flow

Despite the negative operating margin, Rubrik generated $33 million in positive free cash flow in Q1 FY 2026, a 13% FCF margin. This improvement reflects better operational efficiency, with the Subscription ARR Contribution Margin rising from -11% to +8% YoY.

The discrepancy between operating margin and FCF largely stems from stock-based compensation (SBC), which currently represents 26% of revenue. SBC serves two purposes: attracting and retaining top talent in a competitive sector, and conserving cash while investing heavily in growth. IPO-related equity award vesting also contributes temporarily to the expense but is expected to moderate as the company scales.

Looking ahead, while post-IPO SBC levels will remain a factor, Rubrik’s FCF margin is expected to expand, and operating margin should turn positive once SBC stabilises.

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4. Growth Opportunity

1. $50 Billion Market

The traditional backup market is $10 billion and growing, while Rubrik’s broader data security and cyber resilience TAM reaches $50 billion. With an ARR of $1.2 billion (2% of TAM), there is significant room to capture market share as spending shifts from legacy backup to integrated platforms.

Rubrik focuses on cyber resilience, now a top priority for CIOs and CISOs, consistently winning deals against legacy and next-gen competitors. Recent examples include a U.S. pharmacy company replacing a legacy vendor and a Japanese industrial firm consolidating multiple cloud backups under Rubrik, citing threat mitigation and cost savings.

The Identity Recovery solution cuts hybrid cloud recovery times from weeks to under an hour, combining identity and data security in one platform. Long-term initiatives like Rubrik Annapurna aim to accelerate secure, scalable GenAI adoption, leveraging Rubrik’s platform to manage and secure business data simultaneously.

Rising ransomware costs, tightening regulations (NIS2, DORA), and expanding cloud/SaaS footprints drive demand for platforms that secure hybrid, multicloud, and Microsoft 365 environments, positioning Rubrik at the intersection of data, security, and AI.

2. Isolated from Risk of In-Housing

While some software vendors face substitution from in-house AI, Rubrik is structurally insulated. Backup relies on immutable, offsite, air-gapped copies, making third-party platforms a necessity for security and compliance (ISO 27040, NIST SP 800-209, NIS2).

Hybrid enterprise workloads across on-premises, multicloud, and SaaS platforms make in-house backup replication complex. Rubrik’s connectors, policy engines, and compliance reporting cannot easily be replicated internally, and independence is critical.

Attackers target both production and backup data. Rubrik’s immutable file system, zero-trust design, and SaaS control plane ensure isolated recovery, restoring trust with regulators and boards. Backup is subtractive risk management, requiring independence, while AI tools are additive. Even with internal AI, enterprises still need trusted third-party backup, which Rubrik provides, integrating AI/ML for detection without substitution risk.

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5. Risks

1. Competition from incumbents and hyperscalers

The backup and data protection market is crowded, with both legacy vendors (Veritas, Dell, Commvault, Veeam) and newer challengers. Cohesity-Veritas holds the largest data protection market share. Many of these players are repositioning around cyber resilience, immutability, and cloud workloads, the same themes driving Rubrik’s growth. Consolidation among incumbents (e.g., Cohesity’s acquisition of Veritas) adds competitive pressure, as larger combined entities can leverage broader resources for R&D, sales, and channel reach.

At the same time, hyperscalers continue expanding their native backup and recovery capabilities. Leveraging massive infrastructure scale, deep pockets, integrated cloud services, and embedded AI, their offerings are attractive to cloud-first customers. While enterprises still value a third-party control plane for independence and regulatory compliance, pricing pressure or bundled offerings from these giants could slow Rubrik’s share gains, particularly if customers are tempted by “good enough” solutions integrated into their existing cloud environments.

2. Execution risk in scaling growth, profitability, and security

Rubrik has expanded beyond core data protection into adjacent areas such as cyber resilience, AI-driven security, and SaaS data protection. While diversification opens growth opportunities, it also increases complexity in product development, go-to-market execution, and customer success management. Scaling sales and marketing while maintaining deal quality remains a challenge. Early issues in co-selling with partners like Microsoft, where flooding partners with all opportunities initially diluted focus and credibility, illustrate this risk.

Despite rapid revenue and ARR growth, Rubrik still faces profitability pressure due to significant spending on R&D, sales and marketing, and strategic acquisitions. If sales efficiency declines, renewals slow, or operating leverage takes longer than expected, financial performance could be impacted. If Rubrik needs to raises capital, the combination of fresh issuance and heavy SBC could significantly dilute shareholders and weigh on returns.

In addition, any security incident involving Rubrik’s SaaS platform would be especially damaging, given the company’s central value proposition of trust and cyber resilience. Customers rely on the platform to ensure the integrity, availability, and rapid recoverability of critical data. A relevant example is CrowdStrike in July 2024, when a faulty software update to its Falcon endpoint detection and response agent caused recurring system crashes and “blue screen of death” errors across millions of Windows systems globally. While not a breach or cyberattack, this incident highlighted the substantial risks cybersecurity providers face when their own platforms fail.

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6. Valuation

Comparable Multiples

Since Rubrik is not yet GAAP-profitable, I have compared its next twelve months (NTM) revenue versus NTM revenue multiple against a broad set of software peers. In the chart below (sourced from the newsletter), you can see that Rubrik trades below the peer group mean. The bottom-right corner of this chart is the “sweet spot”, as it represents higher growth at a lower multiple. Only two companies are growing faster than Rubrik, yet both command significantly higher multiples.

Notably, CrowdStrike (CRWD) and Zscaler (ZS), while not direct competitors, operate within the broader cybersecurity industry. Both are growing slower than Rubrik yet trade at far higher multiples. This highlights the current market focus on prevention in cybersecurity. As attacks become more frequent, resilience will emerge as a critical theme, positioning Rubrik as a potential beneficiary.

Reverse DCF

Although Rubrik is not yet GAAP-profitable, it has turned free cash flow (FCF) positive. Reverse-engineering its current share price of $83.97 (a $16 billion market cap) suggests the market is pricing in 37% annual growth over the next decade. At first glance, this seems aggressive, but a breakdown provides more context.

Rubrik’s trailing twelve months (TTM) FCF is $103 million, representing a 10% FCF margin. Given that Rubrik has only been FCF positive for three quarters, it is reasonable to expect this margin to double or even triple over the next 10 years. For comparison, CrowdStrike already delivers a 26% FCF margin while growing above 20%, and Palo Alto Networks generates a 34% margin.

Revenue growth is the second factor. Wall Street expects Rubrik to reach $1.89 billion in revenue by FY 2028, implying a 29% CAGR over the next three years. While Rubrik is not cheap, its valuation looks more reasonable when factoring in both its explosive growth and the operating leverage it will achieve as it scales and matures.

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7. Investment Outlook

Behind every great company is a great founder and leadership team, and Rubrik’s leadership meets this standard. CEO and co-founder Bipul Sinha brings more than 20 years of experience building billion-dollar tech companies. Before Rubrik, he worked as a venture capitalist backing firms like Nutanix and Hootsuite. His mix of engineering experience at Oracle, business acumen, and market vision has enabled Rubrik to anticipate industry trends and stay ahead of competitors.

Rubrik’s culture is another strength. One example is its practice of open board meetings, which fosters radical transparency and collective problem-solving. This alignment of employees with mission and strategy is rare among startups. CEO Bipul Sinha owns 6% of the company, and together with co-founders they hold 18%. This skin in the game ensures management incentives are aligned with shareholders. Strategic backing from Microsoft, which invested in 2021, has also provided Rubrik with technical synergy, distribution advantages, and market validation that have accelerated adoption.

Rubrik sits at the intersection of cybersecurity and data protection, addressing a $50 billion TAM. While cybersecurity today focuses heavily on prevention, rising ransomware threats (often powered by AI agents that never sleep) make breaches inevitable. Enterprises are increasingly shifting to cyber resilience, where Rubrik’s “undo button” for cyberattacks is mission-critical. Its role as a trusted third-party recovery provider also protects it from in-housing risk. Although Rubrik positions itself as a premium product, its value proposition significantly lowers TCO compared to incumbents, fuelling market share gains that should continue as it scales.

While the stock is not cheap and trades at a premium, Rubrik offers unique exposure to the resilience niche of cybersecurity, an area still under appreciated by markets. Its multi-product strategy expands TAM and demonstrates optionality in the model. Though Rubrik’s moat is still developing, signs of durable competitive advantages are emerging in the form of switching costs, network effects, and cost advantages. With strong founder-led leadership and strategic support from Microsoft, Rubrik combines vision and execution strength that position it to be a long-term winner.

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Wolf of Harcourt Street

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Email: wolfofharcourtstreet@gmail.com

Contents

1. Introduction

2. Moat Analysis

3. KPI & Financial Snapshot

4. Growth Opportunity

5. Risks

6. Valuation

7. Investment Outlook

1. Introduction

Uber is a technology platform that leverages a massive network, leading technology, operational excellence, and product expertise to facilitate movement from point A to point B. Operating as a digital aggregator, Uber connects riders seeking transportation with drivers willing to provide it. The company does not own any vehicles; instead, it charges a commission on each ride booked through its app. This asset-light model allows Uber to maintain a flexible and scalable operation without the overhead costs of owning a fleet of cars.

Key Features of Uber's Services:

• Ride-Hailing: Users request rides via the mobile app, which employs an algorithm to match them with nearby drivers.

• Dynamic Pricing: Uber uses a pricing strategy that adjusts fares based on real-time supply and demand conditions.

• Additional Services: Beyond ride-hailing, Uber has diversified into food delivery (Uber Eats), freight transport (Uber Freight), and electric bike and scooter rentals.

Since its inception, Uber has facilitated 50+ billion trips and boasts 161 million monthly active users alongside 6 million active drivers and couriers. Uber's innovative approach has disrupted traditional taxi services and catalysed the growth of the "on-demand economy", influencing sectors far beyond transportation.

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2. Moat Analysis

Recent declines in Uber's stock price reflect concerns about the durability of its competitive advantage, or moat. Below is an analysis of the key components of Uber's moat.

1. Switching Costs

Uber's switching costs are relatively weak, posing challenges but also opportunities. Riders and drivers can easily switch between competing platforms. Riders often install multiple ride-hailing apps and select based on price, while drivers frequently work across platforms like Uber, Lyft, and others, a phenomenon known as "rampant multi-tenanting."

To mitigate low switching costs, Uber has introduced loyalty programs like Uber Rewards and Uber One. Uber One, a membership program costing $9.99 per month, had 25 million members as of Q3 2024. These initiatives aim to encourage user loyalty by offering valuable perks as users accumulate points. Additionally, Uber’s strong brand recognition creates some psychological switching costs for users who associate ride-sharing with Uber.

2. Network Effects

Uber benefits primarily from indirect network effects:

• More riders attract more drivers, creating increased earning opportunities for drivers.

• Conversely, more drivers improve the rider experience with shorter wait times and broader service coverage.

However, Uber’s network effects face several limitations:

• Local Nature: The effects are localized rather than global; a rider in one city doesn’t benefit from drivers in another.

• Diminishing Returns: As driver supply increases, the marginal benefit of shorter wait times diminishes. For most users, the difference between waiting 1 minute versus 3–4 minutes is negligible.

To reinforce its network effects, Uber has expanded into adjacent services like food delivery and freight to create additional nodes in their network.

3. Cost Advantages

Uber’s asset-light business model is a significant cost advantage. By not owning or maintaining a fleet of vehicles, Uber minimizes capital expenditures and operational costs, enabling rapid scaling and a focus on technology and user experience.

Additionally, economies of scale allow Uber to negotiate favorable terms with drivers and suppliers. However, ongoing legal challenges regarding driver classification could disrupt this advantage if drivers are reclassified as employees rather than contractors.

4. Efficient Scale

Uber demonstrates efficient scale by leveraging its extensive network of drivers to provide services across more locations and times. This scale leads to higher driver utilization rates, reduced costs per ride, and the ability to spread fixed costs (e.g., technology development, marketing) over a larger user base.

Uber’s scale also supports effective cross-selling. By promoting additional offerings like food delivery and freight transportation to its large user base, Uber diversifies its revenue streams while increasing customer engagement.

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3. KPI & Financial Snapshot

Monthly Active Paying Customers (MAPCs)

MAPCs represent the number of unique consumers who completed a Mobility ride or placed a Delivery order on the Uber platform at least once in a given month. As of Q3 2024, Uber reported 161 million MAPCs, a 13% increase compared to the same period in 2023.

This metric is critical for Uber as it reflects customer engagement, loyalty, and market penetration. To enhance MAPC, Uber has implemented personalized rewards to boost usage frequency and introduced tiered loyalty programs to incentivize higher spending and strengthen customer retention. Notably, 16% of MAPCs are Uber One members.

Trips

The Trips KPI measures the number of completed Mobility rides and Delivery orders during a specific period. In Q3 2024, Trips grew 17% year-over-year (YoY) to nearly 2.9 billion.

The faster growth in Trips compared to MAPCs indicates that monthly trips per MAPC increased by 4% YoY, reaching 5.9,a new all-time high. This suggests rising user engagement and satisfaction, as customers are using Uber services more frequently.

In an era where data is the new oil, Trips data is a vital strategic asset for Uber. By analyzing trip data, Uber identifies customer behavior trends, informing product improvements and new feature development. This data also optimises driver allocation, routing algorithms, and surge pricing strategies.

Revenue

Uber generates revenue through diverse streams, leveraging its technology platform and global network:

• Mobility: Uber takes a commission of 15–30% per ride, contributing 57% of total revenue.

• Delivery: Commissions and delivery fees (15–30%) are charged to restaurants and customers.

• Freight: Uber earns a percentage of fees paid by shippers for each load.

• Subscription Memberships: Programs like Uber One provide recurring revenue.

Margins

Uber’s transformation from a cash-burning startup to a profitable enterprise is a standout success in the tech industry. After years of substantial losses, totaling nearly $32 billion between 2014 and 2022, Uber reported its first annual operating profit in 2023, with a net income of $1.9 billion. Margins have continued to improve in 2024.

What drove this turnaround?

1. Cost Control and Operational Efficiency: Economies of scale from revenue growth, combined with disciplined expense management, have significantly reduced expense ratios. For example, sales expenses fell from 38% of revenue in Q1 2021 to 10% in Q3 2024.

2. Business Diversification: The pandemic accelerated Uber's diversification. While Mobility services declined, Uber Eats thrived, helping the company weather the crisis. Cross-promotion between Mobility and Delivery enables Uber to acquire customers at a lower cost and generate higher lifetime value compared to competitors.

3. Subscription Model: The Uber One subscription program has proven to enhance user engagement and spending across services.

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4. Growth Opportunity

Uber's future growth opportunities are significant, driven by several key factors and market trends:

1. Expanding Market Size
The global ride-hailing market is projected to reach $141.5 billion by 2028, growing at a compound annual growth rate (CAGR) of 15.2% from 2024 to 2028. This growth is fuelled by factors such as integration with multimodal transportation, environmental sustainability initiatives, and expansion into rural and suburban areas.

2. Diversification of Services
Uber is well-positioned to capitalize on this growth through diversification. The company's New Verticals segment, which includes advertising and last-mile delivery, provides opportunities to tap into new revenue streams. Notably, Uber's advertising business has shown robust growth, with revenue increasing nearly 80% YoY in Q3 2024.

3. Subscription Model
The Uber One membership program is driving customer loyalty and engagement. Membership has grown by over 70% YoY in Q3 2024, surpassing 25 million members. Uber One subscribers now account for 35% of total bookings, highlighting strong potential for recurring revenue.

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5. Risks

Despite these opportunities, Uber faces significant risks, particularly from the disruption posed by autonomous vehicle (AV) manufacturers:

1. Reduced Barriers to Entry
The advent of AVs could lower barriers to entry in the ride-hailing industry. Competitors might deploy fleets of autonomous vehicles without needing to recruit and manage human drivers, increasing competition and potentially reducing profit margins across the industry.

2. Loss of Network Advantage
Uber's competitive advantage partly relies on its extensive network of drivers. AV manufacturers could bypass platforms like Uber by offering their own ride-hailing services. Companies such as Waymo and Tesla, which lead in AV technology, have the potential to capture market share. Recent YipitData reveals that Waymo holds a 22% market share of taxi journeys in San Francisco, surpassing human-driver taxi company Lyft.

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6. Valuation

Price-to-Earnings Ratio

Uber is currently trading at 30 times its LTM earnings. However, I believe this ratio carries limited weight for Uber due to its historical nature. As we know, markets are forward-looking, and Uber has only been profitable since 2023. This multiple does not account for the operating leverage Uber is expected to realize in the coming years. Over the past 12 months, Uber’s operating margin has been 6%, but consensus estimates suggest this will more than double to 14% by 2026.

Reverse DCF

By reverse-engineering Uber's current share price of $61.79 (equivalent to a $130 billion market cap), the market appears to be pricing in a growth rate of just 9.4% annually over the next 10 years. This assumption seems conservative given Uber’s market growth potential and the operating leverage it is beginning to achieve.

Consensus estimates project that Uber will reach $115 billion in revenue by 2033, reflecting a CAGR of 12% over the next decade. While this is a long-term estimate, it far exceeds the growth rate currently implied by the market. If Uber’s revenue grows at a 12% CAGR over the next 10 years, free cash flow (FCF) will likely grow at an even faster rate due to the benefits of operating leverage.

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7. Investment Outlook

The Uber investment thesis hinges on whether AVs will completely disrupt its business model. The primary risk from AVs lies in Uber's Mobility revenue stream, which currently accounts for 57% of total revenue, down significantly from 81% in 2019. I expect Uber to continue diversifying its revenue streams through the new verticals it is targeting.

In a worst-case scenario where AVs completely disrupt Mobility, Uber could lose half of its existing business. However, I believe it will take at least ten years, likely longer, for a fleet of AVs to replace human-driven taxis entirely. Under this scenario, Uber would continue generating FCF during this period, though its terminal value could be cut in half.

Next, let's assess the likelihood of AVs fully disrupting Uber. For this to occur, one or two dominant players, such as Waymo or Tesla, would need to monopolize the market and bypass Uber entirely. While this is a possibility, I believe an alternative scenario is more probable: AV technology becomes commoditized, leading to a market with numerous competitors.

Currently, Waymo and Tesla are leading the race, but once full autonomy is achieved, the technology may lose its uniqueness and become widely accessible. In such a commoditized market, brand differentiation would diminish, and customers would prioritize the lowest price and most reliable service. Smaller providers would struggle to compete independently and would likely need to partner with Uber to leverage its extensive network and infrastructure for distribution. Uber is already well-positioned in this potential future, having formed strategic partnerships with multiple AV companies, including Waymo, Cruise, and WeRide, to serve as a demand aggregator for autonomous rides.

In conclusion, while there are genuine risks to Uber's business model, the potential impact seems overstated. Much of the risk appears to be priced in, creating a favourable risk-reward scenario for investors.

If you'd like to support the work of an independent analyst, you can buy me a coffee. The proceeds will contribute to covering the annual running costs of the newsletter.

Buy me a coffee

Join the community of informed investors – subscribe now to receive the latest content straight to your inbox each week and never miss out on valuable investment insights.

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The Chat is a space designed to facilitate, real-time discussions, share knowledge and debate ideas with fellow investors. Join the conversation.

If you found today's edition helpful, please consider sharing it with your friends and colleagues on social media or via email. Your support helps to continue to provide this newsletter for FREE!

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Happy investing

Wolf of Harcourt Street

Contact me

Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

Contents

1. Introduction

2. Moat Analysis

3. KPI & Financial Snapshot

4. Growth Opportunity

5. Risks

6. Valuation

7. Investment Outlook

1. Introduction

InPost is a Polish e-commerce delivery company listed on the Euronext Amsterdam. It operates as an out-of-home (OOH) e-commerce platform, providing parcel locker services across Europe.

InPost’s operations span the entire e-commerce value chain, creating synergies in first- and middle-mile logistics that enhance the experience for both merchants and consumers. Their services cater to both business-to-customer (B2C) and customer-to-customer (C2C) deliveries.

The practicality and cost-efficiency of deliveries to Automated Parcel Machines (APMs) and Pick-Up Drop-Off Points (PUDOs) have made these options popular with customers. APMs and PUDOs are strategically located in high-traffic areas such as local businesses, supermarkets, convenience stores, and transport hubs like train and metro stations, ensuring easy accessibility.

Irish readers may recall a similar service called Parcel Motel, which was later discontinued after its acquisition by UPS in 2017. Interestingly, Parcel Motel's founder, John Tuohy, was inspired by InPost lockers in Poland. In fact, InPost CEO Rafał Brzoska supplied the lockers to Parcel Motel and helped organise financing through a Polish bank, as Irish banks were initially unwilling to provide it.

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2. Moat Analysis

InPost has established itself as a leading player in the parcel delivery industry, particularly in Poland, with several key competitive advantages:

1. Efficient Scale

InPost is the largest locker network in Europe, having achieved efficient scale with its extensive network of APMs. The company operates 23,470 APMs, 85% of which are within a 7-minute walk for Poland's urban population. This scale enables InPost to deliver up to 1,500 parcels per courier per day, which is 10 times more efficient than traditional door-to-door delivery.

2. Network Effects

InPost benefits from strong network effects that enhance its market position and drive growth. The company has integrated with more than 52,000 online merchants in Poland. As more merchants join, the service becomes more valuable to consumers, reinforcing its dominance. InPost’s mobile app has 12.6 million active users in Poland, creating a loyal user base. Around 20% of the most loyal users generate 68% of the APM volume. Additionally, InPost Pay simplifies the shopping experience with a one-click process, boosting purchase conversions by 30-70%, depending on the online store.

3. Cost Advantages

InPost's business model delivers significant cost advantages. Last-mile delivery typically accounts for 53% of total shipping costs, but using APMs reduces these costs by 80% compared to traditional methods. These savings are passed on to consumers, making online shopping more affordable. InPost’s largely fixed cost base also allows for operating leverage as volumes grow, enabling it to offer lower prices while maintaining higher profit margins.

Customer-Centric Culture

A cornerstone of InPost’s success is its customer-centric approach. The company has an impressive Net Promoter Score (NPS) of 80, reflecting high customer loyalty and satisfaction. Key aspects of its service that delight users include:

• 99% of parcels are delivered within one day of purchase.

• Customers have full control over pickup times, allowing flexibility.

• 81% of customers consider InPost Parcel Lockers the most environmentally friendly delivery method.

• Label-free returns simplify the process using QR codes on smartphones.

In one notable case, more than 400 residents in a small village petitioned to prevent the removal of an InPost Locker, which the council deemed an "eyesore." The locker was highly valued for its convenience, especially by busy parents and nighttime users, serving 50-60 people daily.

This customer-centric model has created a self-reinforcing cycle of growth. InPost’s overall success stems from its integrated ecosystem, with physical lockers being just one key component.

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3. KPI & Financial Snapshot

Key Performance Indicator (KPI)

InPost's Parcel Volume is a KPI that highlights the company’s growth and market penetration. In Q2 2024, InPost’s total parcel volume grew by 23% year-over-year to over 264 million parcels.

InPost’s parcel volumes are consistently growing at a much faster pace than the overall e-commerce market in its key regions. This indicates that the company is not only benefiting from market growth but is also increasing its market share.

Financial Snapshot

InPost’s revenue growth closely mirrors its parcel volume trend: the more parcels it delivers, the more revenue it generates. As volumes rise, operating leverage emerges in two distinct ways:

1. The fixed cost of deploying APMs, approximately €30,000 per machine, is spread over a larger number of deliveries, reducing the per-unit cost.

2. Delivery workers become more efficient by delivering more parcels per route, which reduces the labor cost per parcel.

Despite heavy investment in expansion, particularly in markets outside Poland, InPost’s free cash flow (FCF) margin has been steadily increasing due to the operating leverage achieved as it scales.

Building out an APM network is capital-intensive, requiring significant upfront capital expenditure and time. InPost enjoys a clear first-mover advantage over its competitors. For competitors to catch up, they would need to operate at a cash flow deficit for some time without guaranteed success. Meanwhile, InPost is already FCF positive and self-sufficient, having reached a critical mass of parcel volumes. It would also take years for competitors to match InPost's scale, as deploying 20,000 APMs in a single year is unrealistic. For context, the most APMs InPost deployed in a year in Poland was 6,000.

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4. Growth Opportunity

According to the Out of Home Delivery in Europe 2024 report, the European e-commerce market is showing signs of recovery after a downturn in 2022, with 4.9% growth in 2023. This recovery is largely driven by the rise of OOH delivery solutions and PUDO points. Sustainability is a major concern, with green last-mile delivery solutions gaining momentum. In 2023, APMs grew by 29%, and PUDO points by 6%, with key markets including Poland, the UK, France, and Germany.

InPost has a clear reinvestment runway focused on expanding its APM network across Europe and building a pan-European locker system. The company is actively expanding beyond its core Polish market into other European countries. The e-commerce market in the rest of Europe is 40 times larger than in Poland. InPost has established a strong presence in France following its acquisition of Mondial Relay for €513 million in 2021. In the UK, InPost already leads the APM market with 8,000 machines. Recently, Shopify announced that InPost UK parcel locker delivery will be available to all its merchants.

Another key mission for InPost is to create a pan-European locker network. The ability to drop off a package at a locker in Lisbon and have it delivered to another locker in Berlin for a fraction of the cost holds significant value for customers. This service doesn’t currently exist, but based on a quick Google search, it costs approximately €18 to do this via traditional door-to-door delivery, with a minimum delivery time of three days. This type of service would be impossible for local players to replicate. As a result, InPost, with its multi-country coverage, is uniquely positioned to achieve this. This reinvestment runway has driven an improving return on capital over the past 18 months, following the impact of the Mondial Relay acquisition.

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5. Risks

The main risk of competition facing InPost comes from two sources:

1. Traditional logistics players, including both established companies and new entrants.

2. E-commerce marketplaces like Amazon and Allegro, which have their own parcel volumes and could potentially develop their own APM networks given their financial resources.

However, I don't see e-commerce marketplaces as a significant threat to InPost due to its counter-positioning. InPost is merchant and marketplace agnostic, meaning it can spread the cost of its APM network across its entire user base. In contrast, Amazon and Allegro can only distribute costs over their specific user bases, giving InPost a lasting cost advantage. This also ties back to the failure of Parcel Motel, which began when it was acquired by UPS and became a fully closed network, used exclusively by UPS. Additionally, Amazon’s Prime service has conditioned customers to expect door-to-door delivery.

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7. Valuation

Price-to-Earnings Ratio

In terms of valuation, InPost is currently trading at 24 times forward earnings, which I believe is reasonable. The company is well-positioned to continue growing revenue by over 20% annually for the next several years due to international expansion opportunities outside Poland and increasing volumes within Poland, where GDP growth is four times faster than the rest of Europe. As people become wealthier, they tend to buy more, which should drive further growth. Additionally, InPost is poised to benefit from increased operating leverage as it scales, meaning earnings should grow faster than revenue.

Reverse DCF

By reverse engineering InPost's current share price of €17.00 (€8.5 billion market cap), the market seems to be pricing in a growth rate of just 9.2% annually over the next 10 years. This assumption appears conservative given InPost's rapid market share growth and the operating leverage it stands to gain. The current share price seems to reflect only the value of InPost's Polish operations, with little to no consideration for its international business.

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8. Investment Outlook

InPost is a fascinating company, well-positioned to capitalize on the rise of e-commerce in Europe with a business model focused on efficiency, cost advantages, and customer satisfaction. With a clear path for reinvestment and expansion into new markets, InPost offers strong long-term return potential. For more insight into InPost, I recommend checking out the Quality Investing podcast by featuring CEO Rafał Brzoska.

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Happy investing

Wolf of Harcourt Street

Contact me

Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

What has been the secret to Nubank becoming the world's largest digital banking platform outside of Asia and is it worth investing in today?

Contents

1. Executive Summary

2. Overview

3. Customer Base

4. Financial Analysis

5. Competitive Landscape

6. Leadership and Incentive Structure

7. Risks

8. Opportunities

9. Valuation

10. Investment Outlook

1. Executive Summary

• Nubank was launched to revolutionize financial services in Latin America by addressing inefficiencies, high costs, and exclusion associated with traditional banks. Operating as a neobank without physical branches, Nubank leverages a mobile-first, cloud-based model to deliver affordable, accessible, and customer-centric financial solutions. By utilising advanced data science for personalised credit decisions, Nubank provides a comprehensive suite of financial services, expanding access to banking for the underbanked and unbanked populations across the region.

• Nubank has rapidly grown into one of the world's largest digital banking platforms, serving over 100 million customers across Brazil, Mexico, and Colombia as of May 2024. In Brazil, it covers 55% of the adult population. Key to its success is a member-get-member referral program and a gamified approach to banking that drives high customer engagement and loyalty. Recognized as Brazil's Strongest Brand for two consecutive years, Nubank boasts an NPS of 90 and 83% monthly active customer rate. Its revenue model focuses on seamless user experience, increasing transaction volumes, and diverse product adoption.

• Nubank's competitive moat is fortified by its early market entry, efficient scale, modern technological infrastructure, and robust network effects. As the first digital-native bank in Latin America, Nubank has captured significant market share, allowing it to leverage its large customer base to achieve cost efficiencies. Its fully digital platform ensures low operational costs and high customer acquisition efficiency through organic growth and a strong referral program. Nubank's data-driven approach enhances customer experience, loyalty, and financial product development, resulting in superior underwriting, optimized credit limits, and lower delinquency rates, ultimately solidifying its market leadership and profitability.

• Nubank faces significant credit and emerging market risks. Its heavy reliance on lending, particularly in a high-default environment like Brazil, poses substantial credit risk. The bank's shift to interest-based revenue increases vulnerability to loan defaults, with recent delinquency rates rising. Additionally, operating in volatile emerging markets like Brazil, Mexico, and Colombia exposes Nubank to economic instability, high borrowing costs, currency fluctuations, and regulatory changes, all of which can impact profitability and operational stability.

• Nubank has a substantial growth opportunity by expanding its customer base and increasing average revenue per active customer. With 77.1 million unbanked adults in Brazil, Mexico, and Colombia, and low credit card penetration rates, Nubank can target a vast, untapped market. The adoption of Pix in Brazil and its early integration into Nubank's services further accelerates growth. Additionally, by leveraging cross-selling strategies, enhancing service offerings, and utilising customer data, Nubank can significantly increase its average revenue per active customer and market share in Latin America's financial services market.

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2. Introduction

Overview

Nubank was launched to revolutionize financial services for consumers and small businesses in Latin America. By challenging the status quo of incumbent banks, Nubank aimed to address the inefficiencies and high costs associated with traditional banking methods. Nubank made the decision to operate exclusively online, without traditional physical branch networks, which is commonly referred to as a neobank. These legacy banks often utilized uniform underwriting methodologies and lacked a strong focus on customer satisfaction, resulting in exorbitant fees and interest rates that ignored the needs of many consumers and excluded a significant portion of the population from the banking system.

In an era where technology companies are transforming various industries by placing the customer at the centre of their strategies, Nubank leverages a mobile-first and cloud-based model to deliver superior financial services. The company’s strategy revolves around a belief that technology-driven firms can capture market share from traditional providers, expand the size of addressable markets, and operate with enhanced economic efficiencies.

Brazil, characterized by some of the highest banking fees globally, presented an ideal environment for Nubank to introduce its customer-centric financial solutions. The broader Latin American market, encompassing around 650 million people according to World Bank data, represented a significant opportunity. Many individuals in this region are either underbanked, deeply dissatisfied with their traditional banking relationships, or entirely unbanked, highlighting the need for a new, innovative approach to financial services.

What Problem Does Nubank Solve?

Nubank addresses several key problems in the traditional banking sector, particularly in Latin America, including:

Trust Decline: Trust in banks and the broader financial system significantly deteriorated worldwide following the Financial Crisis in 2008. Confidence in financial institutions has remained low, with Gallup Poll data indicating a drop in trust from over 50% pre-Crisis to 33% in 2021 in the U.S., and similar trends observed globally. In Latin America, trust in banks is notably low, averaging 43%, which reflects a broader distrust in financial institutions in emerging markets.

High Fees and Interest Rates: Traditional banks in Latin America, especially in Brazil, often charge exorbitant fees and high interest rates for their services. Regulatory costs imposed on these banks are often passed on to consumers, maintaining high fee structures despite increased capital requirements. Research by De Genaro shows that higher capital requirements do not affect banks' profitability or fee income, as these costs are transferred to customers, indicating a systemic issue of fee exploitation. Nubank offers a more affordable alternative, reducing the financial burden on consumers.

Exclusion from the Banking System: A significant portion of the population in Latin America is either underbanked or completely unbanked. Traditional banks' rigid criteria and high costs often exclude these individuals. Nubank provides accessible financial services to a broader audience, including those previously excluded from the banking system. Traditional banks often provide a narrow range of financial products that do not meet the diverse needs of consumers and small businesses. Nubank offers a comprehensive suite of financial services tailored to various needs.

Poor Customer Experience: Legacy banks in the region tend to lack a strong focus on customer satisfaction, resulting in subpar service and customer support. Nubank prioritizes customer experience, offering user-friendly, convenient, and responsive financial services. Banking with traditional institutions often involves complex processes, bureaucratic hurdles, and inconvenient access to services. Nubank's platform simplifies financial management, making it easier for customers to handle their finances.

Homogeneous Underwriting Methodologies: Traditional banks typically use standardized underwriting methods that do not consider individual customer circumstances, leading to unfair credit decisions. Nubank employs advanced data science and proprietary models to offer more personalized and fair credit solutions.

Product Journey

In 2014, Nubank introduced its first product in Brazil: the Nu Credit Card, a purple Mastercard-branded credit card. This product marked Brazil’s first annual fee-free credit card and was paired with a digital, mobile-first customer experience. This innovative approach not only expanded Nubank's customer base but also provided critical insights for refining their data models.

To manage risk, Nubank approved only 20% of applicants and often assigned low initial spending limits, which were increased based on timely payments. The company continuously innovated its data-driven approach to assess credit risk, even considering the payment history of the referring customer. By focusing initially on credit cards, Nubank aimed to build customer trust, develop proprietary data, and establish a strong market presence.

Starting with credit cards allowed Nubank to establish a foundation for easily introducing new products. Credit card users frequently check their accounts, providing Nubank with a consistent engagement channel. This frequent interaction makes it straightforward for Nubank to introduce new offerings through the app, ensuring easy access and high visibility, thereby facilitating customer adoption and growth.

In 2017, Nubank launched NuAccount, a digital banking solution offering free deposits, transfers, payments, and low-fee cash withdrawals at partner ATMs, along with a competitive-yield savings feature. In 2018, Nubank added a free prepaid card for NuAccount customers, which helped it become the primary bank for many users.

In 2019, Nubank introduced personal loans and a business checking account for micro-businesses in Brazil, catering to nearly 22 million entrepreneurs. Nubank expanded to Mexico and Colombia between 2019 and 2020, launching its flagship credit card.

Between 2020 and 2023, Nubank significantly expanded and diversified its offerings:

• 2020: Nubank launched NuLife, a life insurance product, and acquired Easynvest, rebranding it as NuInvest. By 2023, NuInvest had 15 million active customers, becoming the largest direct-to-consumer retail investments platform in Brazil.

• 2021: The company introduced Ultraviolet, a premium metal credit card, and collaborated with Remessa Online for online remittance services. Nubank also launched "Buy Now Pay Later" solutions and NuPay for online purchases within the Nubank app.

• 2022: Nubank acquired Olivia, a data company specializing in AI and machine learning for retail banking, and launched Money Boxes, an investment platform.

• 2023: The company expanded its lending products in Brazil to include secured lines like public payroll loans, loans for retirees and pensioners, and FGTS-backed loans.

The Money Platform

Nubank has developed a comprehensive Money Platform that supports users through the 'Five Financial Seasons':

1. Spending: Nubank offers various spending solutions, including credit and prepaid cards, QR code-based payments, Pix instant payment arrangements, WhatsApp Pay, traditional wire transfers, and a diverse array of options through its marketplace.

2. Saving: The company provides personal and business accounts to help customers save effectively.

3. Investing: Nubank’s direct-to-consumer digital investment platform allows customers to manage their investments conveniently.

4. Borrowing: Nubank offers transparent and easy-to-manage credit cards, along with secured and unsecured loans with limits increasing over time as users build their credit histories.

5. Protecting: The company also offers insurance solutions to protect its customers.

This platform is designed to seamlessly integrate these aspects to enhance the financial well-being of customers. The company's business model is built on four core principles:

• Customer-Centric Culture: A relentless focus on understanding and meeting customer needs.

• Human-Centric Design: Prioritizing products, services, and interactions that create extraordinary customer experiences.

• Proprietary Technologies: Developing advanced technologies in-house, leveraging top global talent.

• Data Science: Utilizing powerful proprietary models to support every aspect of the business.

These principles create a self-reinforcing business model that enables Nubank to effectively serve its ecosystem of customers and partners, driving significant impact for stakeholders and establishing sustainable competitive advantages in the marketplace.

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2. Customer Base

Nubank has become one of the world’s largest digital banking platforms and a leading technology company, boasting an impressive customer base of over 100 million across Brazil, Mexico, and Colombia as of May 8, 2024. In Brazil alone, Nubank serves over 92 million customers, representing approximately 55% of the population aged 18 and above. This remarkable growth has outpaced the combined growth of the five largest incumbent banks in Brazil over the past 12 months. Nubank's member-get-member referral program has been instrumental in unlocking this potential and driving its customer acquisition.

Nubank's commitment to delighting its customers has earned it a powerful reputation and a valuable brand, both locally and globally. In 2023, Nubank was recognized as the Strongest Brand in Brazil for the second consecutive year by Design Bridge & Partners, IstoÉ Dinheiro magazine, and TM20 Branding consultancy. Nubank’s customer base is highly engaged and loyal, a testament to the company’s reputation for trustworthiness and reliability. Key factors contributing to this loyalty include:

1. Organic Growth: A significant portion of Nubank’s customers were acquired organically through word-of-mouth and direct referrals, without incurring direct marketing expenses.

2. High Net Promoter Score (NPS): Nubank scores an NPS of 90, far exceeding those of incumbent banks and other major local financial technology companies.

3. Primary Banking Relationship: As of March 31, 2024, Nubank was the primary banking relationship for over 59% of its active customers, meaning these customers had at least 50% of their post-tax monthly income leaving their NuAccount each month.

Nubank's popularity is bolstered by the gamification of its banking and credit platforms. The platform encourages users to build their credit limit by completing game-like "missions" that involve using various features such as its credit card and paying bills through their Nubank account. This gamified approach makes banking activities more exciting, interesting, and enjoyable, increasing customer acceptance, engagement, satisfaction, and ultimately driving the adoption of mobile banking services.

Nubank measures customer engagement and adoption by tracking the number of monthly active customers and their implied activity rate. A monthly active customer is defined as any customer who has generated revenue in the last 30 days of the measurement date. As of March 31, 2024, Nubank had 82.6 million monthly active customers. The activity rate, which is the ratio of monthly active customers to the total number of customers, was 83% at the end of March 2024, up from 82% in 2023.

Revenue Model

Nubank’s revenue model is designed to be customer-centric, leveraging its digital platform to offer a range of financial services at low or no fees.

Nubank generates revenue primarily from two main sources: fees and interest income. These revenue streams enable Nubank to maintain a robust and scalable business model that leverages its digital platform and extensive customer base.

Fees: This revenue stream is closely correlated to product usage and comprised 20% of total revenue in 2023.

• Card Transactions: Nubank earns fees and commissions from credit and prepaid card transactions, including interchange fees paid by merchants.

• Payments and Loyalty Programs: Revenue is generated from payment services and customer loyalty programs.

• Prepaid Mobile Top-Ups: Fees are charged for prepaid mobile phone top-ups, integrated into Nubank’s app for customer convenience.

• Marketplace and Financial Products: Nubank earns commissions and fees by operating a marketplace for investments, insurance, and remittance products through partnerships with financial service providers.

Interest Income: This revenue stream is from the interest charged on revolving and refinanced credit card balances, purchased credit card receivables, customer loans, and the interest earned on cash deposits. It comprised 80% of total revenue in 2023.

• Credit Card Balances: Nubank generates significant interest income from customers who carry revolving or refinanced credit card balances beyond the due date.

• Credit Card Receivables and Loans: By purchasing credit card receivables and offering loans, Nubank earns interest income, crucial for profitability in a high-demand credit market.

• Deposits and Government Bonds: Interest from customer deposits and investments in government bonds.

By focusing on seamless user experiences and efficient service delivery, Nubank attracts and retains a large customer base, driving transaction volumes and thereby increasing its fee-based revenues. The interest income complements this by providing a steady stream of revenue from credit-related products, which are in high demand in Latin America.

Key Performance Indicators

Nubank's monetization strategy hinges on a multi-faceted approach that leverages transaction volume growth, organic customer acquisition, and diversified product offerings to maximize revenue. This strategy is built around key metrics such as Purchase Volume (PV) and Monthly Average Revenue Per Active Customer (Monthly ARPAC), illustrating the effectiveness of increasing customer engagement, credit limits, and product adoption.

Purchase Volume: A central element of Nubank's monetization strategy is boosting the transaction volumes through its credit and prepaid cards. This is measured using the metric PV, which reflects the total value of transactions authorized through these cards. In Q1 2024, PV reached $31.1 billion, marking a 33% increase from Q1 2023. This substantial growth underscores Nubank's success in driving higher transaction volumes among its customers.

Monthly Average Revenue Per Active Customer (Monthly ARPAC): Monthly ARPAC is a critical metric that tracks the average monthly revenue per active customer. In Q1 2024, Monthly ARPAC was $11.40, up from $8.80 in Q1 2023. This increase is driven by several factors:

• Higher Credit Limits: As customers demonstrate responsible credit usage, their credit limits are increased, leading to higher spending and subsequently higher revenue for Nubank.

• Increased Customer Spending: As customers become more familiar with Nubank’s products and services, their overall spending through Nubank’s platform increases.

• Adoption of Multiple Products: Over time, customers tend to adopt more of Nubank’s financial products, further boosting their overall engagement and the revenue generated per customer. Historical data shows that customer cohorts generally increase their Monthly ARPAC over time, reaching over $20 between the fourth and fifth years.

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4. Financial Analysis

Revenue

Nubank's revenue has been growing like gangbusters for the past several years. In just four years, Nubank’s revenue has increased almost 12 times, growing at a CAGR of 89%.

As mentioned earlier, the majority of Nubank’s revenues now consist of interest income. However, this was not always the case, as up until Q4 2020, the majority of revenue was derived from fees. What has caused this shift in the revenue mix?

There are two crucial drivers:

1. Rapid growth in loan portfolio and credit products: Nubank has strongly focused on initiatives like payroll lending in Brazil. Since Q4 2020, the interest-earning portfolio has increased from $0.5 billion to $9.5 billion at the end of Q1 2024. As their lending business grows, interest income from loans becomes a larger portion of their revenue.

2. Increasing customer deposits generating interest income: Nubank reported having $24.3 billion in customer deposits in Q1 2024, up from $5.6 billion in Q4 2020. As their deposit base expands, the interest earned on those deposits becomes a more significant revenue stream.

Gross Margin

Nubank enjoys a very healthy gross margin due to its highly scalable digital platform. The cost of goods sold, or in Nubank's case, the cost of financial and transactional services provided, includes interest expenses, transactional expenses, and credit loss allowance expenses.

The gross margin profile for fees and interest income is quite different. Fee gross profit is derived after incurring transactional expenses and has resulted in a gross margin of 86% in Q1 2024 and above 80% since Q2 2021. This margin profile has increased over time due to the low-cost operating platform, which has resulted in a growing customer base to spread the fixed costs over.

Interest income gross profit is derived after incurring interest expenses and credit loss allowance expenses, equating to a gross margin of 35% in Q1 2024. Nubank front-loads credit loss allowance expenses based on the expected losses for the life of the credit, in accordance with IFRS 9 methodology. During 2023, the credit cards and personal loans portfolios saw an increase in expected losses due to expansions in the risk profile of newer cohorts in these two products. This trend continued through the first quarter of 2024.

Operating Margin

In 2023, Nubank started to reap the benefits of its platform's operating leverage as it posted an operating profit for the first time, despite still being in high-growth mode. This positive trend in operating margin continued in 2024 as Nubank continues to grow its customer base, up-sell and cross-sell products, launch new features, and ramp up operations in Mexico and Colombia, which are still running at a loss.

The major components of Nubank’s operating costs include customer service expenses, marketing expenses, and general & administrative expenses. The chart below reflects each of these costs as a percentage of revenue.

Nubank takes a very different approach to customer service and marketing expenses compared to traditional banks and competitors, which results in considerable operating leverage as the business scales:

• Customer service expense ratio: Nubank’s customer service expense ratio has fallen from 19% in Q1 2020 to 6% in Q1 2024, due to the fact that their cost to serve customers is only $0.90, which is estimated to be 85% lower than traditional banks due to being fully digital. Traditional banks tend to have very high customer service costs from maintaining extensive branch networks. While the cost to serve an active customer has decreased over the years, the revenue per active customer has skyrocketed, resulting in continued margin expansion.

• Marketing expense ratio: Nubank spent only around 2% of revenue on marketing over the past year, materially below the 7% average for most banks. Instead of paid marketing, Nubank relies heavily on word-of-mouth and customer referrals for acquisition, with 90% of new customers coming from unpaid referral channels. Their excellent customer service, generating an industry-leading NPS, drives this low-cost acquisition model.

While traditional banks spend heavily on both marketing and branch operations, Nubank flips this model. They drastically underinvest in marketing by providing an outstanding customer experience that generates organic referrals. This allows them to reallocate those marketing dollars into further enhancing their customer support operations and service levels, creating a virtuous cycle of low churn (0.2% per month) and more referrals.

Risk-Adjusted Net Interest Margin

Risk-Adjusted Net Interest Margin (NIM) is a key profitability metric for banks that measures the net interest income generated from lending activities after accounting for credit losses. The metric reflects the bank's ability to generate returns from its lending business while factoring in credit risk and loan losses. A higher Risk-Adjusted NIM indicates better profitability and risk management.

In Q1 2024, Nubank's Risk-Adjusted NIM was 9.5%, up 3.2 percentage points from a year ago, though down slightly from Q4 2023 due to higher provisions for loan growth. The expansion in Risk-Adjusted NIM outpaced the increase in the cost of risk, indicating Nubank was able to grow its interest-earning assets faster than non-performing loans.

As Nubank expands lending to riskier borrowers, the Risk-Adjusted NIM allows it to measure profitability while accounting for higher expected loan losses from that credit expansion strategy. The Risk-Adjusted NIM for incumbent banks in Brazil ranges between 4% to 6%. Nubank’s industry-leading Risk-Adjusted NIM further highlights its lower cost structure and more efficient risk-pricing models.

Financial Position

Nubank is one of the best-capitalized players in the region. Its Capital Adequacy Ratios (CARs) have very comfortable margins above the regulatory minimums in all the countries it operates in, even when not including the $2.4 billion excess liquidity held in Nu Holdings.

For anyone not familiar with banking, the CAR is a crucial measure of Nubank's financial health and its ability to meet obligations. It is computed by dividing the bank's capital by its risk-weighted assets. A high CAR indicates a substantial financial cushion, enabling Nubank to absorb losses and avoid insolvency. It is important to focus on the CAR as a measure of its financial strength, but some regular financial position metrics worth highlighting are:

• Asset to Equity ratio of 6, which is favorable compared to the industry norm of 12 or more.

• 40% loan-to-deposit ratio, which is significantly lower than peers.

• $6 billion in cash and cash equivalents.

• $398 million of Goodwill comprising of less than 1% of total assets related to acquisitions including Cognitect, Easynvest and Olivia AI.

• Return on Equity of 21% for the trailing twelve months.

It is reasonable to conclude that Nubank is in a strong financial position with a robust balance sheet, substantial cash reserves, and significant financial flexibility.

Cash Flow

I will not spend much time on the Nubank cash flow statement because banks operate differently from typical businesses. For banks, cash is both the product and a critical component of their operations. As you can see below, changes in operating assets and liabilities distort cash flow from operations as we know it.

Banks like Nubank are focused on growing their balance sheets by increasing the amount of credit and loans they hold. This growth appears as a negative cash flow and does not accurately reflect the company's financial health or operational success. Therefore, evaluating banks based on net income is more appropriate than using free cash flow.

With that being said, let’s move onto share-based compensation (SBC), which is a key item in the cash flow statement. Nubank, like many technology companies, utilizes SBC as part of its employee incentive structure. I will discuss this in detail in section 6, but the financial impact is that shareholders have been diluted by an average of 1.6% per year. SBC is a real cost of doing business, and the dilutive impact on existing shareholders should not be ignored.

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5. Competitive Landscape

Nubank operates in a highly competitive landscape, facing challenges from both traditional banks and other fintech companies. Here's an overview of Nubank's competitive environment.

Traditional Banks

Major Brazilian banks like Itaú, Bradesco, Banco do Brasil, Caixa, and Santander have a long-standing presence and a vast customer base. They provide comprehensive financial services and leverage established trust and brand recognition. These incumbents are increasingly investing in digital transformation to compete with fintechs.

In 2016, the Big Five banks lobbied to reduce the merchant payment deadline to two days, arguing it would benefit merchants, but in reality, it was to crush Nubank. Historically, Brazil's credit system allowed issuers like Nubank 30 days to pay merchants, whereas merchants in the U.S. receive funds in two days. This 30-day period worked in Nubank’s favor as consumers typically repaid their balances in 26 days, resulting in a positive cash flow cycle with four days of float.

Nubank highlighted that this change would be catastrophic for them as they did not have the balance sheet strength to manage such a rapid payment turnaround. The Central Bank of Brazil recognized that reducing the deadline would stifle competition and retained the 30-day payment period, supporting Nubank’s ability to continue operations.

The power of the Big Five banks in Brazil is evident from this anecdote and shows that it could have been over for Nubank even before it started if it weren't for the support from the Central Bank of Brazil.

Neobanks and Fintechs

Nubank faces stiff competition from other digital-first banks and fintech startups offering similar services:

• Inter: Founded in 1994, Inter started as a traditional bank and transformed into a fully digital neobank in 2014. Some of the services offered include digital accounts, credit cards, loans, investments, and insurance products.

• PicPay: Offers a digital wallet app that allows users to send and receive money, pay bills, store loyalty cards, and access other financial services.

• Mercado Pago: The fintech arm of the Mercado Libre e-commerce platform, which provides online payment solutions, including a digital wallet, merchant services, and consumer credit products.

• PagSeguro: Offers an end-to-end digital payment platform that enables merchants to accept various payment methods, including credit cards, boletos, and its own digital wallet PagBank.

Moat Analysis

A company’s moat refers to its ability to maintain the competitive advantages that are expected to help it fend off competition and maintain profitability into the future. I have analyzed Nubank's moat under the following sources:

1. Efficient Scale

Nubank’s efficient scale competitive advantage is multifaceted, encompassing its early market entry and modern technological infrastructure.

First-Mover Advantage

Nubank's status as the first digital-native banking platform in Latin America has enabled it to capture substantial market share quickly. Its pioneering presence in digital financial services in the region has solidified its leadership, particularly in Brazil, where it has the highest number of customers among digital banks. Nubank's success is not limited to Brazil. In Mexico, within just four years of its 2020 launch, it has become one of the top three credit card issuers, surpassing many traditional financial institutions in terms of the net number of cards issued in 2023.

As a first mover, Nubank has set industry standards for low fees and frictionless services, raising the bar for customer expectations. New neobanks must primarily compete against Nubank, which has already optimized its operations and cost structures. Nubank’s ability to spread fixed costs across its massive customer base of 100 million provides it with substantial scale advantages. This efficient scale makes it challenging for newer entrants to achieve similar cost efficiencies, as they cannot match Nubank’s low cost per customer.

The regulatory environment in financial services often favors established players. Navigating regulatory complexities can be a significant hurdle for smaller, less established companies. Nubank, as a market leader, benefits from its established position and regulatory compliance, making it harder for new entrants to gain traction.

Technological Infrastructure

Being built from the ground up as a digital bank, Nubank benefits from a cohesive and modern technological infrastructure. This is in stark contrast to the fragmented and outdated systems of traditional banks, allowing Nubank to operate more efficiently and effectively.

Leveraging millions of customer data points through AI and machine learning, Nubank continuously enhances its onboarding processes, customer experience, product development, and strategic decision-making. This data-driven approach enables rapid and precise responses to customer needs and market changes, significantly improving the user experience.

Nearly 40% of Nubank’s workforce is dedicated to customer support, combining automated self-service tools with a dedicated team known as Xpeers. This dual approach ensures high-quality, efficient service that is difficult for competitors to replicate, especially new entrants who lack similar scale and infrastructure. Effective customer support reinforces loyalty and satisfaction, key components of Nubank's competitive edge.

2. Network Effect

Nubank's ability to leverage a network effect competitive advantage is evident through its low-cost customer acquisition strategy and organic growth mechanisms.

Low Customer Acquisition Cost (CAC)

In Q1 2024, Nubank’s CAC was $7 per customer, with paid marketing contributing only 29% of this cost. This is consistent with the 2023 CAC, demonstrating Nubank’s ability to maintain low acquisition costs even as it scales. The CAC for retail banks in the U.S. ranges from $300 to $600. This stark difference highlights Nubank’s efficiency and cost-effectiveness in acquiring new customers.

Nubank’s primary driver for low CAC is its effective member-get-member referral program. This program leverages satisfied customers to refer new users, reducing the need for expensive marketing campaigns. Positive customer experiences lead to organic referrals, with satisfied customers acting as brand advocates. This word-of-mouth marketing incurs minimal costs and is highly effective in attracting high-quality, engaged customers.

Nubank ranks in the top 6 for app downloads in Brazil on both iOS and Android, making it the only finance app on the list. The other popular apps on the list include Instagram, TikTok, and WhatsApp, with Nubank ahead of the likes of MercadoLibre and Google. Nubank is operating at a different level compared to the incumbent banks.

Organic Growth Flywheel

As Nubank’s customer base grows, the platform’s value is enhanced, attracting more users. This expansion creates a positive feedback loop where more users lead to greater value and satisfaction, driving further growth. Nubank’s diverse suite of financial products increases customer engagement and satisfaction.

As customers use more products, their overall loyalty and likelihood to refer others increase. Over time, customer cohorts tend to increase their usage of Nubank’s products, contributing to higher PV and ARPAC. This growing engagement within existing cohorts strengthens the network effect, as satisfied customers bring in new users.

Nubank’s focus on exceptional customer experiences fosters trust and loyalty, enhancing the network effect. This customer-centric strategy is reflected in its high NPS, indicating a strong likelihood of customers recommending Nubank to others.

Nubank's strong brand reputation, reinforced by multiple awards and recognitions, further fuels its referral engine. Being recognized as the Strongest Brand in Brazil for the second consecutive year in 2023 and ranking among the top 10 Brands Loved by Brazilians builds trust and credibility, making referrals more effective.

3. Cost Advantage

Nubank’s cost advantage is rooted in its all-digital, cloud-based platform, which drastically reduces operational expenses compared to traditional banks. This model eliminates the need for physical branches and supports a lean organizational structure, leading to significantly lower costs. Nubank estimates that its cost to serve and general administrative expenses per active customer are about 85% lower than those of incumbent financial institutions in Brazil.

Employee-to-Customer Ratio

A key measure of Nubank’s efficiency is its employee-to-customer ratio, which, as of December 2023, stood at approximately 14,900 customers per employee. This is starkly higher than the 1,100 customers per employee ratio seen in traditional banks, demonstrating Nubank’s ability to manage a vast customer base with fewer resources. Incumbent banks in Brazil have vast and expensive branch distribution networks supported by large workforces and legacy systems. As of December 2023, the main incumbents in Brazil are reported to have 2,695 to 3,992 branches, whereas Nubank has zero.

Advantageous Unit Economics

Nubank also boasts advantageous unit economics. The company typically recovers its CAC through cumulative contribution margins within 12 months on average, showcasing its efficiency in customer acquisition and revenue generation. Beyond this period, Nubank continues to expand its revenue and contribution margins, indicating robust long-term profitability.

Customer Acquisition Efficiency

Nubank’s customer acquisition efficiency is evidenced by its Lifetime Value (LTV) to CAC ratio, estimated to be greater than 30x. As discussed earlier, Nubank’s current CAC is $7, meaning that the LTV is at least $210. This high ratio highlights that the revenue generated from each customer over their lifetime substantially exceeds the cost of acquiring them, reinforcing Nubank’s strong economic model and cost advantage.

4. Intangible Assets

Nubank's competitive advantage is significantly bolstered by its strategic use of intangible assets, particularly its proprietary data and the NuX credit engine. These assets enable Nubank to outperform traditional banks in several critical areas.

Enhanced Underwriting

Nubank's extensive data collection allows for refined underwriting processes, enabling accurate assessments of customer risk profiles and creditworthiness. The NuX credit engine uses advanced algorithms to balance expected marginal revenue against expected marginal loss, even factoring in undrawn portions of credit lines under adverse economic conditions. As we have seen earlier, Nubank has an industry-leading Risk Adjusted NIM.

Optimized Credit Limits

Credit limits are customized for each consumer through continuous data analysis. The "low and grow" strategy initially grants lower limits to higher-risk customers, which are selectively increased based on positive usage and repayment behavior. This approach minimizes initial risk exposure while rewarding responsible financial behavior.

Cost of Risk Management

By accurately predicting risk and dynamically adjusting credit limits, Nubank lowers its overall cost of risk. This efficiency allows the company to offer competitive lending rates and superior financial products to its customers. The dynamic risk management ensures a balanced approach between growth and risk exposure.

Superior Delinquency Rates

Nubank's data-driven approach has resulted in impressive delinquency management. As of March 2024, Nubank reported a non-performing loan rate of 5.0% for loans 15-90 days late and 6.1% for loans over 90 days late in Brazil. When adjusted for product and customer income mix, these rates are approximately 15% lower than the market average, according to data from the Central Bank of Brazil. This demonstrates Nubank's superior risk management capabilities.

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6. Leadership and Incentive Structure

Founding Story

David Vélez, born in Colombia, experienced a challenging childhood as his family fled to Costa Rica when he was nine to escape the violence from warring drug cartels. Despite these tumultuous early years, Vélez's drive to learn and succeed remained undeterred. He attended a German-language high school before earning an engineering degree at Stanford University. Vélez's career began with valuable stints at Morgan Stanley as an investment analyst and at General Atlantic as a senior associate, followed by a role at the venture capital firm Sequoia Capital. He later returned to Stanford to pursue an MBA, further enriching his expertise in finance and entrepreneurship.

Upon returning to South America, Vélez encountered a highly concentrated banking sector in Brazil, dominated by five banks that controlled 80% of the market. These banks profited massively from high-interest rates and exorbitant fees while delivering poor customer service, resulting in a significant unbanked population and dissatisfaction among consumers. Determined to address this disparity, Vélez envisioned creating a digital bank with minimal fees and accessible banking features. In doing so, the David (Vélez) vs. Goliath story took on a new meaning.

Through an acquaintance, Vélez recruited Cristina Junqueira, a Brazilian engineer with an MBA from Northwestern’s Kellogg School of Management, who had just left her job managing Itaú’s largest credit card division. To develop Nubank's technology, Vélez brought on Edward Wible, an American computer science graduate from Princeton and a former colleague from Sequoia. The trio established Nubank in a rented house in São Paulo, where Wible even lived upstairs.

In August 2014, Nubank secured $15 million in Series A funding led by Sequoia, with Nigel Morris investing through his fintech VC firm, QED. Vélez famously finalized the deal by taking the paperwork to the hospital for Junqueira's signature while she was in labor with her first child. The following month, Nubank launched its first product, the famous purple credit card, and the rest is history.

Management Team

David Vélez is the Chairman of the Board of Directors and the Chief Executive Officer. Vélez is described as structured, disciplined, and intellectual, contributing significantly to Nubank's long-term strategy. His farsightedness and sophisticated vision set him apart, particularly as a first-time founder.

Cristina Junqueira is the Chief Growth Officer. Besides being responsible for the operations and growth strategies in Mexico and Colombia, she also has a global role in leading functions like marketing and communications. Junqueira, known for her action-oriented and deadline-driven approach, acts as a galvanizing force within Nubank.

Edward Wible remains with the company, having served as Chief Technology Officer until 2021 before deciding to stand down to contribute more directly to the company’s systems and infrastructure. Wible was critical to Nubank's operations, driving its tech-centric approach. His leadership ensured that Nubank consistently renovated and improved its technology stack, avoiding the technical debt that plagues traditional banks.

Despite being 10 years old, the company still has all three co-founders involved in the day-to-day running of the business, which is an extremely positive sign.

Ownership

David Vélez is the largest individual shareholder in Nubank, with a 20% stake, while Cristina Junqueira holds 2.5%. After stepping back from executive leadership, Edward Wible does not appear to hold a significant stake in the company based on the disclosure in the 2023 annual report.

The company's largest institutional shareholder is Sequoia Capital, which owns a 6.8% stake. Other major institutional shareholders include Tencent, Baillie Gifford, and more famously, Warren Buffett’s Berkshire Hathaway, which invested $500 million in 2021 before the IPO.

Incentive Program

Nubank's executive compensation structure is designed to balance fixed and variable components, aligning the interests of executives with those of shareholders while maintaining competitive attractiveness to high-quality executives. Nubank explicitly calls out its equity compensation approach as essential to "creating long-term shareholder value" and fostering an "ownership-minded culture." The key components of the incentive structure include:

• Fixed Compensation: Executive officers receive a fixed base salary based on the scope of their duties. Fixed compensation provides a stable income, recognizing the value of executive positions and contributing to the retention of the management team.

• Profit Sharing: Executives in Brazil participate in a Profit Sharing Program tied to the achievement of pre-established business goals, as per union agreements. This short-term variable remuneration aligns executives' interests with immediate company performance and ensures that executives have a stake in achieving business goals.

• Share-Based Compensation: Long-term incentive plans, including options and Restricted Stock Units (RSUs), form a significant part of executive compensation. This aligns executive interests with those of shareholders, encouraging long-term commitment and performance. Share-based compensation is effective in attracting and retaining key executives, aligning their interests with long-term shareholder value.

What is most interesting about Nubank is that it has successfully implemented an ownership-minded culture that has manifested itself in some very distinct ways:

• High Employee Ownership: Approximately 95% of our employees owned Nubank shares or held share-based incentive awards as of December 31, 2023. This high level of employee ownership helps foster an ownership mindset and creates a cultural competitive advantage. This is extremely rare to see.

• Customer Giveback: Nubank discovered a bug in the system that caused an email reminder about payment due dates to be removed, resulting in customers incurring late fees. Upon discovering this, Nubank chose to restore the email reminder and refund the customers, even though this meant losing the additional revenue from late fees. This decision was guided by their values, particularly their commitment to customer obsession. Contrast this with how most companies might have exploited the bug for profit.

• Terminated CEO Equity Award: David Vélez was eligible for a Contingent Share Award (CSA) that would grant him up to 1% of total shares if the stock price reached certain milestones. However, in November 2022, Vélez terminated this 2021 CSA award as part of Nubank's efficiency program, forgoing potential compensation worth $356 million over seven years. Vélez's decision to terminate his CSA demonstrates alignment with shareholders and a focus on long-term value creation over personal compensation. It reinforces Nubank's principle of "thinking and acting like owners, not renters."

Referring back to the SBC discussed earlier in the report, my view is that Nubank's incentive program strongly aligns the interests of employees and management with those of the shareholders, justifying the moderate dilution as a worthwhile tradeoff for sustained high growth and a unique culture.

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7. Risks

1. Credit Risk

Credit risk is the most significant risk for Nubank due to its heavy reliance on lending for revenue and the credit profile of its customer base.

Revenue Dependence on Lending Activities

As we have seen earlier, Nubank's product mix has shifted from predominantly fee-based income to 80% interest income. Nubank's revenue model heavily relies on interest income from loans and credit cards, which constitute a substantial portion of its earnings. Any deterioration in credit quality directly impacts this revenue stream. For instance, if Nubank's loan portfolio shows a higher default rate, the interest income would decrease, and the bank would need to set aside more provisions for loan losses, affecting its profitability.

Nubank's COO Youssef Lahrech acknowledged that many banks and fintechs have struggled to execute a successful credit strategy in Latin America. He stated:

We know of a number of banks that tried moving in this direction, but then they had to take a step back because it was just too hard to execute or it just did not produce the results they were expecting.

High Default Rates

Brazil has historically experienced elevated default rates compared to other regions. In January 2024, the delinquency rates in the FinTech FIDC market hit an average of 9.5%. This is due to factors like economic volatility, high inflation, and income inequality. Maintaining the quality of Nubank's loan portfolio, which has grown to nearly $20 billion, is critical in this challenging environment.

Despite the macroeconomic headwinds, Nubank has managed to keep its non-performing loan (NPL) ratios below the industry average. However, in the recent quarter, the firm reported a 90-day delinquency rate of 6.3%, up from 5.5% in the previous year, reflecting the complexities of the Brazilian market.

Nubank's customer base includes many individuals who might be underserved by traditional banks. While this presents growth opportunities, it also means that a significant portion of Nubank's borrowers may have higher credit risk profiles. This segment is more vulnerable to economic stress, thus elevating the overall credit risk for Nubank.

2. Emerging Market Risk

Emerging market risk, the risk associated with economic, political, and social instability in developing countries, is another significant risk for Nubank.

Geographic Concentration

Nubank operates primarily in Brazil, Mexico, and Colombia, all of which are emerging markets. These regions are inherently more volatile than developed markets due to their economic, political, and social environments. For example, Brazil's GDP growth rate has been highly volatile over the past decade, with periods of recession and stagnation. Such economic instability directly impacts consumer spending, loan demand, and repayment capacity.

High Borrowing Costs

Nubank faces higher borrowing costs in emerging markets compared to developed markets. For example, Brazil has historically had higher interest rates compared to developed economies like the United States or European countries. Brazil's benchmark Selic rate of 11% has been significantly higher than the Federal Reserve's target rate in the US.

Currency Risk

Currency fluctuations in emerging markets can impact Nubank's financial performance. Depreciation of local currencies against the US dollar can increase the cost of foreign-denominated debt and affect the company's profitability. For example, the Brazilian Real has depreciated significantly against the US dollar over the past decade, which could increase the cost of Nubank’s dollar-denominated obligations and reduce its profitability when converted to local currency.

Regulatory Risks

In 2023, the Central Bank of Brazil placed a cap on interchange fees charged to 0.7% for prepaid cards. At the time of the announcement, Nubank said that if the changes had been in effect, its revenue would have been affected by 2.9%. This risk could potentially expand to other financial products and place Nubank's revenues at risk.

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8. Opportunities

1. Growth of Customer Base

Nubank has a tremendous opportunity to continue expanding its customer base by leveraging the significant pain points faced by consumers in the financial services market, capitalizing on powerful secular trends, and addressing substantial penetration opportunities in the region. The combination of a large unbanked population, low credit card adoption rates, and supportive regulatory environments positions Nubank well to grow its active customer base significantly in the coming years.

Large Unbanked Population

There are 77.1 million unbanked adults in Brazil, Mexico, and Colombia. This represents a vast, untapped market that Nubank can target with its accessible and user-friendly digital financial services. Nubank currently serves around 100 million customers, but the potential market is much larger given the region's population of 650 million. The unbanked population of Latin America as a whole is estimated to be 65%. This implies that Nubank has only penetrated about 15% of the total addressable market, leaving significant room for growth.

Nubank has opportunities for expansion into other geographies and markets, particularly those with substantial unbanked populations. CEO David Vélez has likened their growth strategy to "fishing with dynamite”. By leveraging its technological innovation and understanding local needs, Nubank can aim to replicate its success in Latin America in new regions such as the Hispanic market in the U.S., Africa, and Asia.

There is a lot of room to conquer. We are 100 million and yes, that is impressive. But we must not forget that this only represents 1.25% of the world’s population. We are confident that by doing what is best for our customers, we are winning them over for decades. We optimize long-term value creation, not short-term. It’s an infinite game.

- David Vélez

Pix

In 2020, the Brazilian central bank introduced a digital currency called Pix. Pix is an instant payment system enabling free, fast transactions via QR codes. The volume of Pix transactions has grown rapidly, with usage increasing by 74% in 2023, reaching nearly 42 billion transactions and quickly overtaking credit and debit card usage. According to the Central Bank’s data, 149 million Brazilian users, or 74% of the population, have already made a Pix transaction, and 145 million own an active Pix key as of December 2023. Pix transactions cost retailers an average of 0.22%, compared to over 1% for debit cards and up to 2.2% for credit cards, making it a cheaper alternative.

Nubank was an early adopter of Pix and used it to launch new products like Pix credit, which offers installment payments and additional revenue streams. Nubank ended 2023 with 13.6 million customers using Pix credit, with customers using it growing 166% from a year before. Nubank's market share reached 10% in originations of transfers, and they believe they are the market leader in terms of the number of registered and active Pix keys in Brazil.

Pain Points with Incumbent Banks

Incumbent banks in Brazil, Mexico, and Colombia dominate the market, holding between 70% and 87% of all loans and deposits. These banks charge high fees and generate outsized profits, which presents an opportunity for Nubank to attract customers by offering lower fees and more customer-friendly services. The high fees and perceived lack of customer-centric services from traditional banks create a significant pain point for consumers, making them more likely to switch to alternative providers like Nubank that offer innovative and cost-effective solutions.

Market Penetration

Credit card penetration is low in the region compared to developed markets. For example, credit card adoption rates are 52% in Brazil, 11% in Mexico, and 22.5% in Colombia, compared to 66% in the United States and 62% in the United Kingdom. This indicates significant potential for growth in Nubank's credit card offerings. Household debt as a percentage of GDP is lower in Brazil (34%), Mexico (16%), and Colombia (28%) compared to developed markets (55%-85%). This suggests there is room for growth in consumer lending, as households have the capacity to take on more debt.

Brazil as the Roadmap for Mexico

In 19 quarters since launching in Mexico, Nubank has surpassed Brazil's performance in achieving key KPIs, indicating a faster growth trajectory. Within one year of launching Cuenta Nu, Nubank's customer numbers and checking account holders in Mexico have exceeded those in Brazil at the same point in their respective timelines. Nubank dominates the new credit card issuance market in Mexico with a 29% market share.

Nubank Mexico has over 3 million credit card customers, outpacing some of the top three incumbent banks in the country. The credit card purchase volume has reached $1.6 billion, capturing a 6.1% market share, compared to a 4.3% share in Brazil during the same period. Nubank Mexico has amassed $2.3 billion in retail deposits, more than double the amount at the end of 2023. This represents a 1.2% share of total deposits in Mexico, compared to 0.5% in Brazil at the same stage.

Nubank has a 5.1% market share of customers in Mexico, meaning there is considerable opportunity to increase its market share. If Nubank can replicate its success in Brazil, it could have 45 million customers in Mexico by Q1 2027. This is probable given that only 49% of adults in Mexico have access to a bank account.

2. Growth of Average Revenue per Customer

Nubank has a substantial opportunity to increase its ARPAC by expanding its market presence, leveraging its diverse revenue streams, deepening customer relationships, and employing effective cross-selling strategies. By capturing a larger share of the growing financial services market in Latin America and enhancing its product offerings, Nubank can significantly boost its revenue per active customer over time.

ARPAC Comparison

For the three months ended March 2024, Nubank’s consolidated monthly ARPAC was approximately $11.40. However, for customers active across core products (credit card, NuAccount, personal loans), monthly ARPAC averaged $45. The ARPAC for incumbent banks in Brazil is estimated to be 4.5 times higher than Nubank’s. This gap highlights the potential for Nubank to increase its ARPAC by capturing a greater share of wallet and cross-selling additional products.

The near future for Nubank appears to be promising, driven by its focus on winning over high income individuals in Brazil and expanding its secured lending offerings. Despite having 70% of Brazilians who earn monthly income of more than R$5,000 on the platform, many do not yet use Nubank as their primary bank. This presents a substantial opportunity for the company to deepen engagement and increase wallet share by converting these users into primary account holders. Additionally, Nubank’s expansion into secured lending is poised to bolster its ARPAC, as secured loans typically feature lower non-performing loan (NPL) rates and higher spreads.

Serviceable Addressable Market (SAM)

The SAM for retail financial services in Brazil, Mexico, and Colombia was estimated at $200 billion in 2023. Nubank’s current market share is around 3%, indicating significant room for growth. Increasing its share within this large and growing market can drive substantial revenue gains. By deepening relationships with existing customers through enhanced service offerings and more personalized financial products, Nubank can capture a larger portion of customers' financial activities.

Increasing Share of Customers’ Financial Lives

Nubank's customer base is young, with 64% under 40 years old and an average age of 37. Latin America benefits from a young population with a growing middle class. As these customers accumulate wealth and experience new life milestones, their demand for diversified financial services will grow. This provides Nubank an opportunity to expand its product offerings to meet evolving customer needs.

Nubank can leverage its data to understand customer needs better and recommend suitable products, thereby increasing the number of products per customer. As of March 31, 2024, Nubank averaged four products per active customer, indicating successful cross-selling efforts. Enhancing customer segmentation and credit models can further increase approval rates and product uptake without additional customer acquisition costs.

Creating “Nu” Markets

Nubank has demonstrated a remarkable ability to identify and capitalize on untapped market opportunities in Latin America. Its success in creating an insurance product for previously uninsured customers serves as a prime example of how it can potentially create new markets and drive financial inclusion.

Prior to Nubank's entry, a significant portion of the Brazilian population lacked access to affordable and accessible insurance products. By leveraging its digital platform and customer-centric approach, Nubank introduced innovative insurance offerings tailored to the needs and budgets of this underserved segment. In June 2024, Nubank reached 2 million active insurance policies in Brazil, largely driven by Nubank Vida, a digital insurance product launched in 2020 in partnership with Chubb, which alone has over 1 million active policies.

The key point to emphasize is that Nubank’s opportunity is even larger than the serviceable addressable market, given that uninsured customers wouldn't even be showing up in the existing retail industry data.

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9. Valuation

Price to Earnings Ratio

Nubank trades at 25 times forward earnings. Despite having grown into its valuation over the past year, it still trades at a considerable premium to peers such as legacy bank Itaú, which trades at 6 times forward earnings, and neobank Inter, which trades at 14 times forward earnings.

It should not come as a surprise to anyone who has read this far that Nubank trades at a premium to its peers, given its growth prospects and rapid market gains over the past couple of years. But how much more efficient is it with its assets?

Return on Assets

Nubank's Return on Assets (ROA) was almost four times higher than that of legacy banks in 2023. Nubank's digital-first approach, lean cost structure, and strategic focus on high-yield lending products allow it to generate superior returns from its asset base compared to the asset-heavy and operationally complex incumbent banks in Brazil.

Financial Model

Valuing Nubank from the ground up is challenging due to the complexities inherent in its operations and financial structure. As referenced earlier, Nubank's reported cash flows are distorted because cash serves as both an input and output of the business. Using net income simplifies the modeling process while still capturing the essential profitability and operational efficiency of Nubank. Valuation is an art, not a science, after all.

Future earnings have been projected over five years using a discount rate of 12% and a terminal growth rate of 2%. Given the inherently risky markets that Nubank operates in, a higher discount rate has been assumed.

Between 2019 and 2023, Nubank’s total customers grew at a CAGR of 67%. This analysis assumes that total customers will reach 170 million by 2028, representing a CAGR of 13% during the forecast period. This would result in Nubank’s customers still only accounting for 26% of the total Latin American population.

Nubank’s average revenue per customer is forecast to almost double over the next five years, increasing from $86 in 2023 to $159 in 2028. As noted earlier, the average revenue per customer of incumbent banks in Brazil is estimated to be 4.5 times higher, so there is plenty of scope to capture a greater share of wallet and cross-sell additional products. A revenue CAGR of 27% is projected from 2023 to 2028 based on the total customer and average revenue per customer inputs.

The EBIT margin has been forecast to increase from 19% in 2023 to 32% in 2028 as Nubank benefits from the operating leverage inherent to its unique business model. Similarly, the Net Income margin has been forecast to scale from 13% in 2023 to 25% in 2028. For context, Itaú posted a net income margin of 27% in 2023.

A dilution rate of 1.5% per year has been assumed, in line with the historical average over the past couple of years.

Based on these assumptions, the fair value of Nubank is close to $17.19 per share, suggesting a potential upside of 36% based on the share price on June 26, 2024, of $12.86. The valuation analysis implies that Nubank is undervalued with a reasonable margin of safety. The analysis conservatively assumes Nubank will continue to gain market share but will still lag behind incumbent banks in total customers, average revenue per customer, and industry revenue market share metrics.

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10. Investment Outlook

Some important news broke yesterday, June 26, 2024, as Nubank announced the acquisition of Hyperplane, a data intelligence company specializing in AI-driven financial decision-making. This is a significant move towards AI-first banking, as Hyperplane’s AI technology will enhance Nubank’s ability to analyse vast datasets and personalise services on a granular level.

Nubank's investment thesis is centered around disrupting the financial services market in Latin America by leveraging technology and data to create a fundamentally different and superior customer experience. The thesis can be summarized into the following key points:

Low Cost to Acquire: Nubank has built a powerful brand and reputation, acquiring customers primarily through viral word-of-mouth and direct customer referrals. This approach avoids expensive marketing campaigns and incentives, focusing instead on creating strong customer experiences.

Low Cost to Serve: Operating in a fully digital environment without physical branches and simplifying processes have enabled Nubank to serve customers efficiently. This operational model achieves scale efficiencies that benefit both customers and investors.

Low Cost of Risk: Advanced technology and proprietary data science are used to assess and mitigate credit risk effectively. This capability allows Nubank to operate and scale efficiently while offering competitive pricing to customers.

Low Cost of Funding: Nubank's large and growing base of locally sourced deposits exceeds funding needs, enabling increased credit extension to customers. This creates a highly resilient, diversified, and low-cost funding model.

While Nubank may appear overvalued relative to traditional banking peers, this premium is justified as it represents one of the most significant disruptive forces globally. Nubank faces risks, particularly around credit and exposure to emerging markets, which have been present since its founding 10 years ago. However, bottom-up valuation analysis based on conservative assumptions and supported by secular growth trends indicates that Nubank presents an attractive opportunity.

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Happy investing

Wolf of Harcourt Street

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Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

What fueled Evolution’s astounding growth to transform itself from a niche provider into a major player in the online casino industry?

Contents

1. Executive Summary

2. Overview

3. Customer Base

4. Financial Analysis

5. Competitive Landscape

6. Leadership and Incentive Structure

7. Risks

8. Opportunities

9. Valuation

10. Investment Outlook

1. Executive Summary

• Evolution's success in the online casino industry is driven by its ability to solve key problems for gaming operators. They provide a comprehensive live casino solution that covers all operational aspects, recruit and train skilled game presenters, offer customization options for operators, maintain a diverse game portfolio, and integrate with land-based casinos. This approach streamlines operations, enhances player engagement, and supports the growth of online casinos.

• Evolution’s revenue model primarily relies on commission fees, where they earn approximately 10% of the operators' profits from using their casino games. Additionally, they offer customization options for operators, including dedicated tables for which they charge monthly fees. Set-up fees for new customers also contribute to their revenue. The combination of fixed and variable revenues allows Evolution to benefit from customer growth without being directly impacted by end user wins or losses.

• Evolution has leveraged the benefit of economies of scale effectively in its operations to achieve an EBITDA margin of 70%. Their games are highly scalable, accommodating an unlimited number of players simultaneously, which reduces overhead costs compared to traditional casinos. The fixed cost of live dealers can be spread across numerous players, resulting in more favorable unit economics. Unlike casino operators, Evolution doesn't incur customer acquisition costs, as their games remain consistent across various operators, enabling them to benefit from newly acquired players.

• Regulatory risk is a significant challenge for Evolution's business. Evolution utilizes an MGA license to operate in all EU countries but regulators may impose specific requirements, such as locating equipment within a jurisdiction. This could necessitate setting up studios in multiple countries or locations which is costly and would erode economies of scale benefits. Evolution's revenue heavily depends on its top five customers, contributing 30% in 2022, up from 22% the previous year. The rising concentration emphasizes their importance, but it also poses a concentration risk.

• Evolution's durable competitive advantages include strong intellectual property, scalability, network effects, and high switching costs, all of which contribute to its leading position in the live casino market and make it challenging for competitors to compete effectively. The global online gambling market is expected to reach $153.57 billion by 2030, with a projected CAGR of 11.7% from 2023 with Evolution management setting the strategic objective of outpacing global market growth in order to increase the gap to its competitors.

2. Overview

Evolution specializes in the innovation, development, and production of content for online casinos, primarily catering to business-to-business (B2B) clients. Their content can only be accessed through an operator's platform, which includes crucial elements like player authentication, account management, and user interface.

Evolution's business strategy centers on providing tailored online casino services to gaming operators in regulated markets across digital platforms. Its mission is to enable operator success while delivering an exceptional gaming experience to end users. The company's vision is to become the foremost online casino provider in the world, signifying its ambition to lead the industry and shape its future.

What is an Online Casino?

Online casinos offer players a realistic casino experience from their homes through live casino games. These games are hosted by qualified dealers and feature real-time play via high-quality video streaming. Specialized live game studios equipped with advanced technology and professional dealers create an immersive and interactive gaming environment. Players can interact with dealers through live chat, and a variety of classic casino games are available, including blackjack, roulette, baccarat, and poker. The games undergo regular third-party audits for transparency and integrity. This combination of technology and human interaction delivers an exciting and genuine casino experience to online players. 

A casino makes money by leveraging the "house edge," which is a built-in advantage in all casino games. Return to Player (RTP) represents what a game pays players over time. For instance, if 10,000 players bet a total of €100,000, and players receive €96,000 in winnings, the game's RTP is 96%. RTP influences players to spend time and money on these games. Online games typically have RTP in the mid-to-high 90%, while land-based casinos range from 70% to 90% due to fixed costs. 

The Ecosystem

Evolution has evolved significantly since its inception in 2006, starting with a basic Live Casino Roulette game and now offering a diverse ecosystem of Live Casino games tailored to various player preferences. 

Central to this ecosystem is their smart lobby, introduced to players in 2022, inspired by platforms like YouTube and Netflix, driven by an artificial intelligence (AI) recommendation engine that becomes more intelligent with each user visit.

The primary goal of this smart lobby is to help players quickly discover games they will enjoy. It achieves this through AI recommendations, videos, filters, recently played options, and search functionality. This personalized approach enhances the player experience and increases player engagement. The lobby represents a significant long-term investment in enhancing the user experience and personalizing it for each player.

Evolution offers a comprehensive live casino platform, the One Stop Shop (OSS), which covers hardware, software, video, employees, and user data, providing operators with a complete live casino solution and users with a unique gaming experience. OSS integrates Evolution, NetEnt, Red Tiger, Big Time Gaming, Ezugi, and Nolimit City brand games which were strategic acquisitions, simplifying and accelerating the integration process for casino operators. This platform offers quick access to a wide range of games, reduces time to market, and supports unified management of new casinos and regulated market changes. OSS also provides access to a single Back Office and a unified set of promotional tools.

The platform is continually improved for robustness, scalability, and support for regulated markets and concurrent users. Evolution's technical system is stable, reliable, and capable of handling large volumes of data while remaining scalable. The company has developed its own video coding solution to ensure continuous HD video streaming or other formats suitable for end users. In 2022, the system's availability was an impressive 99.88%, excluding scheduled maintenance, demonstrating its reliability.

Product Offerings

Evolution's game portfolio covers a wide spectrum of player preferences, from classic table games in Live Casino to visually captivating and feature-rich slot games. 

Live Casino: Evolution is renowned for its Live Casino games, which recreate the real casino experience through high-quality video streaming. Live Casino includes classic table games like Blackjack, Roulette, Baccarat, and Poker, with various versions and tables catering to different player preferences. Evolution also offers unique live games, such as MONOPOLY Live and Dream Catcher, which combine elements of traditional gaming with interactive entertainment. Game variants like Lightning Roulette and Infinite Blackjack introduce innovative features, enhancing gameplay and excitement.

RNG Slots: Evolution provides a selection of slot games, including both classic and modern video slots. Their portfolio encompasses a diverse range of themes, from ancient civilizations to fantasy worlds, offering something for every player's taste. Games like Gonzo's Quest and Starburst provide unique and engaging slot experiences that are not easily replicated by other providers. Evolution's slots are designed to be visually appealing, with immersive graphics and animations, along with exciting bonus features.

Game Shows: Evolution has expanded its offerings to include exciting Game Shows that blend elements of traditional game shows with live casino entertainment. Games like Crazy Time, Mega Ball, and Deal or No Deal Live provide a dynamic and interactive gaming experience. These games often feature hosts who engage with players in real-time, adding a social and immersive dimension to the gameplay. Game Shows offer players a chance to participate in thrilling live events and potentially win substantial prizes.

What Problem Does Evolution Solve?

Evolution solves several key problems for gaming operators through its development and provision of fully integrated live casino and slots solutions.

Comprehensive Live Casino Solution: Many gaming operators may struggle to provide a comprehensive and high-quality live casino experience to their players. Evolution's solution covers all aspects required by a gaming operator, including game presenters, streaming, production, supervision, and customer services. The Mission Control Room is central to Evolution's operations, focusing on operational excellence, system availability, security, and regulatory compliance. This eliminates the need for operators to manage multiple aspects of the live casino operation themselves, saving them time and resources.

Recruitment and Training: Finding and training skilled game presenters (dealers) and other staff can be a significant challenge for gaming operators. Evolution takes on the responsibility of recruiting and training these personnel, ensuring that operators have access to well-trained professionals who can provide an engaging and authentic gaming experience.

Customization and Adaptability: Different gaming operators have unique branding and customer preferences. Evolution's platform offers a high degree of adaptability, allowing operators to customize their live casino environment, including standard and VIP tables, the overall look of the environment, and dedicated dealer teams. This customization helps operators tailor the gaming experience to their specific audience.

Broad Game Portfolio: Keeping a diverse and engaging game portfolio can be challenging for operators. Evolution offers a broad portfolio of core games, including classic table games and innovative casino games. This variety keeps players engaged and attracts a wider audience.

Land-Based Casino Integration: Evolution also offers on-premise studios at land-based casinos in several countries. This integration allows land-based casinos to expand their online presence and leverage their existing infrastructure while offering a seamless gaming experience to their customers.

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3. Customer Base

Evolution's customer base includes a wide range of global online operators, platform providers, and an expanding number of land-based casinos. The company's growth strategy is centered around its existing customer portfolio, as operators typically expand their live offerings. Additionally, Evolution can follow its existing customers into new markets, further fueling growth.

As of the end of 2022, Evolution's customer portfolio comprised over 700 customers, consisting of both online operators and land-based casinos. These online operators typically offer various gaming verticals, including RNG (Random Number Generator) games like slots, live casino games, sports betting, poker, and bingo. Some of Evolution’s notable customers include DraftKings, Paddy Power, FanDuel, MGM Resorts and Wynn Resorts. 

In 2022, Evolution entered agreements with several notable entities, such as Italy's Sisal for online slots and jackpots, Holland Casino Online for a full catalog of NetEnt and Red Tiger online slots, Soaring Eagle Gaming for online casino content in Michigan, and PlayStar for online Live Casino and RNG-based casino games in New Jersey. Additionally, Evolution renewed its agreement with FanDuel Group to provide live dealer table games across the entire regulated US online gaming market. The company also expanded existing agreements to cover additional services and tables.

Revenue Model

Evolution generates its revenue primarily through commission fees and dedicated table fees in its live and RNG casino offerings.

Commission Fees: The majority of Evolution's revenue comes from commission fees. These fees are ~10% of the operators' winnings generated from Evolution's casino offerings. This means that Evolution shares a portion of the profits earned by the casino operators who use their live and RNG casino games. Commission fees provide the company with exposure to the overall growth of the global online casino market.

Live Casino Customization: Evolution offers various levels of customization to casino operators. The most basic agreements typically grant access to and streaming from generic tables. However, more complex agreements can include dedicated tables, custom environments, VIP services, native-speaking dealers, and other personalized features. These customized solutions help operators differentiate themselves in the market and cater to specific player preferences.

Dedicated Table Fees: Operators who opt for dedicated tables pay monthly service charges to Evolution of ~€20,000 per table. Dedicated tables are exclusively reserved for the operator's use and can be fully customized to meet their requirements, including studio environment, graphics, branding, and language. The fee for dedicated tables varies from customer to customer and depends on factors such as the type of game, the number of tables, and the hours of operation.

Other Sources of Income: In addition to commission and dedicated table fees, Evolution also generates revenue from other sources, including set-up fees. Set-up fees of ~€50,000 are charged to new customers when they launch their casino offerings with Evolution. These fees are invoiced in conjunction with the onboarding process and contribute to the company's overall revenue.

Evolution's revenue model is noteworthy because it consists of fixed and variable consideration from the gaming operators. Evolution benefits from the operator's customer growth without facing any direct impact from end user wins or casino losses.

Customer Due Diligence

Evolution has established due diligence processes for signing new agreements and continuously evaluating existing customers. Evolution can discontinue its services to operators that fail to comply with relevant regulations or jeopardize Evolution's market position and gaming licenses.

Evolution provides its products exclusively to customers with valid licenses for online casinos granted by relevant regulatory jurisdictions. The company supplies licensed business-to-consumer (B2C) casino operators who, in turn, offer the games to players. Additionally, Evolution serves licensed B2B actors who supply games to B2C licensed operators, who then provide them to players. Regulatory authorities issue licenses and monitor compliance, and Evolution conducts Know Your Customer (KYC) checks on its contractual partners, both B2C and B2B.

Due diligence is performed before accepting a new customer and is conducted annually. It includes checks on governance structure, customer licenses, and, for B2B customers, reporting of new operators and their licenses. Evolution also performs a Business Risk Assessment on each customer, rating them against a risk matrix. The company maintains an ongoing dialogue with regulators and undergoes regular audits.

4. Financial Analysis

As touched on earlier, the majority of Evolution’s revenues consist of commission fees for both live and RNG casinos. Evolution’s Live and RNG segments have completely different performance profiles. Live Casino is Evolution’s core competency and grows almost completely organically. Live makes up 84% of revenue and is growing 34% YoY as per Q2 2023. On the other hand, RNG makes up 16% of revenue predominantly through acquisitions and declined 4% YoY in Q2 2023 based on pro-forma figures. Management's goal for the RNG segment is double-digit growth but the segment has been losing market share.

During the second quarter of 2023, Evolution recorded total revenues of €441.1 million, representing an increase of 28% year-over-year (YoY). This growth can be attributed to increased commission income from existing customers and from new customers.

Evolution has grown revenue at a five-year CAGR of a staggering 52%. Evolution's live casino offerings are clearly in high demand. The company’s strategy of continuously launching new games and variations of traditional games has contributed to the growing demand for online casino games. This approach helps the company cater to evolving player preferences and maintain a competitive edge in the market.

Evolution's revenue by region showed growth double-digit across all regions in Q2 2023.  LatAm experienced the fastest growth at 61% followed by Asia at 48%, North America at 20%, and Europe at 15%. 

In LatAm, the company is witnessing an increase in player numbers. To support this growth, it has initiated studio expansion by establishing its first studios in LatAm in Argentina and Colombia. Looking at North America, the company is actively expanding its Live game portfolio. This expansion strategy aims to increase the share of Live Casino in the online gaming market in North America. Finally, in Europe, there is a high demand for new dedicated tables, surpassing the company's current delivery capacity. Management has emphasized its intention to address this issue in the coming quarters, indicating its commitment to meeting the growing demand in the region.

We are a little bit undersupplying the market in several regions, as mentioned, Europe, and that's a lot connected with the headcount growth. So we hope that we can increase a little bit more on headcount during the second half of the year - Jacob Kaplan, CFO, Q2 2023 Earnings Call

Evolution's major cost components are personnel expenses, facility and studio costs, and product development. Personnel costs encompass operations, IT, and recruitment. Expanding the Live Casino platform for new or existing operators incurs varying expenses, including set-up fees for new studios. Product innovation and development are significant costs, both as direct operating expenses and through the depreciation of development investments.

Evolution reported operating expenses amounting to €159.6 million for Q2 2023, an increase of 23% YoY. These expenses were primarily driven by higher personnel costs, attributed to the launch of new tables and studios. As of 30 June 2023, Evolution had 17,447 employees, an increase of 14% YoY.

Over the years, Evolution has demonstrated significant improvement in its operating margin. This margin has increased from 27% in 2014 to an impressive 63% in trailing-twelve-months (TTM) 2023. Evolution has benefited immensely from economies of scale in several ways:

Scalability of Games: Unlike traditional casino games which can only accommodate a fixed number of players at a time, the majority of Evolution's games can support an unlimited number of players betting simultaneously. This scalability allows them to serve a much larger player base without incurring additional overhead costs that brick-and-mortar casinos face, such as providing free drinks and casino maintenance.

Fixed Cost of Live Dealers: In Evolution's model, the live dealer salary becomes a fixed cost that can be leveraged across hundreds of potential concurrent players. This efficiency is in contrast to traditional casinos where live dealers serve only a few players at a physical table. Evolution's ability to spread this cost across a larger player base results in more attractive unit economics.

In 2022, Evolution’s revenue per average full-time equivalent (FTE) of €135k is five times greater than the cost per FTE of €27k.

Zero Customer Acquisition Costs: Evolution's business model differs from casino operators in that it does not incur customer acquisition costs. While casino operators spend on marketing to attract players, Evolution's games remain consistent across various operators. As players switch between operators, they continue to play Evolution's games. This unique advantage allows Evolution to capitalize on the upside from newly acquired players without significant marketing expenses.

In Q2 2023, Evolution achieved its highest-ever EBITDA margin of 70.7%. The company has navigated challenges such as price increases while maintaining operational efficiency and is actively working to minimize the impact of price increases on its operations. It continually seeks ways to enhance efficiency as it strives to sustain its growth trajectory.

One of the financial objectives set during the IPO was to achieve an EBITDA margin of over 35%. Evolution has not only met this objective but has significantly surpassed it, reporting a margin that is double the initial target.

Financial Position

• Over €541 million in cash and cash equivalents

• Positive working capital of €753 million

• Debt to Asset ratio of 80% 

• Over €2.2 billion of Goodwill comprising 52% of total assets

• Zero debt

If it weren’t for the significant Goodwill balance, this would be an A+ balance sheet. The Goodwill is a result of a number of acquisition most notably:

• NetEnt for €1.8 billion in 2020

• Big Time Gaming for €450 million in 2021

• Nolimit City for €340 million in 2022

This level of goodwill makes me a little uneasy because the risk of impairment, which would not affect cash flow, could significantly impact the company’s earnings. The goodwill balance is greater than the combined operating profit for the past seven years. The significance of this will be revisited below.

Cash Flow Analysis

For the twelve months up to the end of Q2 2023, Evolution generated over €900 million in free cash flow (FCF), representing a FCF margin of 55%. This is one of the most highly cash-flow-generative companies on the public markets. 

Given the cash-rich nature of the business coupled with no debt, Evolution returns excess cash to shareholders through a dividend. The Company’s dividend policy is to distribute a minimum of 50% of its net profits over time. While the current dividend payout ratio is around 46%, if the risk of goodwill impairment comes to fruition and impacts profitability, this could impact the dividend based on the existing policy. 

Return on Capital

Between 2013 and 2020, Evolution consistently achieved a Return on Capital (ROC) ranging from 35% to 45%. During this period, the company was very efficient at generating returns from its invested capital for two main reasons:

1. High operating margin: Evolution benefits from significant economies of scale. Their large scale operations allow them to spread costs efficiently, increasing profitability. 

2. Reinvestment runway: The live casino market is still experiencing growth and Evolution’s ability to expand into new markets, increase its client base, and introduce new games have contributed to its ability to generate higher returns on the capital it employs.

In 2021, Evolution's acquisition of NetEnt through share issuance had a notable impact on its ROC. Initially, ROC dropped significantly from its historical levels to 12%, but it gradually increased to approximately 16% by 2023. This decline in ROC during acquisitions is due to the immediate reflection of costs, while the benefits accrue over time. As a result, even deals that ultimately create substantial value for the acquirer may initially seem unattractive when viewed from this perspective.

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5. Competitive Landscape

The live casino industry is a dynamic sector within the broader online gambling industry, offering players an immersive and interactive gaming experience with real dealers and authentic casino settings. The key competitors include:

Playtech: Playtech is a publicly traded player in the interactive gambling industry with a history of providing high-quality gaming products. Initially focusing on RNG-based products like video slots, table games, bingo, and video poker, the company's success has been driven by innovation. Playtech was a pioneer in introducing the live dealer format in 2003, offering an immersive casino experience online. Today, they offer a diverse range of live dealer tables with games like blackjack, roulette, poker, baccarat, and dice. Playtech's client list includes well-known brands such as Betfair, Ladbrokes, Mansion, bet365, and William Hill. Playtech received the EGR Poker Supplier of the Year award in 2022.

VIVO Gaming: VIVO Gaming, established in 2010, is a privately-owned creator of live-dealer gaming solutions with studios in various locations, including Bulgaria, Costa Rica, London, Miami, Manilla, and Buenos Aires. They have formed strong partnerships with leading casino operators and offer technology that replicates the atmosphere of land-based casinos on players' computers and mobile devices. Their platform allows players to engage in real-time interactive gaming with options like roulette, blackjack, baccarat, craps, poker, Dragon Tiger, Sic Bo, Live Bingo, and sports betting. VIVO Gaming received the prestigious EGR Live Casino of the Year award in 2022, a title which Evolution had held for twelve consecutive years.

Pragmatic Play: Founded in 2015, Pragmatic Play is a privately-owned leading provider of premium gaming content for the gambling industry, specializing in delivering an excellent mobile gaming experience. They offer a wide range of innovative games, including video slots, table games, scratchcards, bingo, and live dealer tables. With offices in multiple locations, including Gibraltar, Malta, Isle of Man, Romania, and Germany, they serve various regulated markets. Pragmatic Play is known for creating HTML5 gaming content accessible on all devices, supporting over 150 currencies and 31 languages. Pragmatic Play received the EGR Casino Software Supplier award in 2022.

The graphic above includes Ezugi which is part of the Evolution Gaming group after it was acquired in 2018 for €16 million. Evolution has a dominant market position as evidenced by it being ranked top in five of the seven categories globally.

The comments from Evolution's CEO, Martin Carlesund, are fascinating in regards to competition: 

everything we do is about one thing: to expand the gap to competition and strengthen our market leadership

This mindset reflects the company's commitment to maintaining its position as a market leader. In fact, Evolution doesn't limit its competitive outlook to traditional peers in the gaming industry. They also consider major entertainment companies like Disney and Netflix as competition. This broader perspective has driven Evolution to be the first to release successful game show hits, showcasing their innovative approach to stay ahead. This has led to Evolution significantly outperforming listed competitor Playtech when it comes to revenue CAGR and EBITDA margin expansion over the past five years.

The advantage that Evolution holds over its rivals is underscored by the insights gathered by BWG Strategy through discussions with industry experts:

Evolution is widely considered the best in the business for live dealer products. They have the infrastructure and experience. Live dealer has many advantages and I think it will be quite big in the U.S. Market. Having robust infrastructure allows them to scale and manage the growth much better than their competitors - President at Casino Games Co.

Evolution Gaming - live table games are very popular in the few regulated states that are online today. They will benefit from market growth. Everyone likes Evolution’s games; they’ve figured out the community & connection aspect better than anyone else - Director of Loyalty at Betting Company.

Evolution, they essentially own the live dealer space already, and that format of online play sort of bridges the gap between table games online and table games on the casino floor. I know it has a ton of people on the land based side excited about the potential - Product Director, Digital Gaming at Connecticut Casino.

6. Leadership and Incentive Structure

Evolution was founded in 2006 by Jens von Bahr and Fredrik Osterberg in Stockholm, Sweden. The founding story revolves around the vision of Jens von Bahr and Fredrik Osterberg to revolutionize the online casino gaming experience. They recognized the potential for live dealer games to bridge the gap between the convenience of online gambling and the authentic atmosphere of a physical casino. This led them to establish Evolution Gaming and embark on a journey to develop cutting-edge live dealer casino technology.

Evolution Gaming's early years were marked by intense research and development efforts to create a platform that could seamlessly stream live casino games to players' devices. They focused on recruiting skilled dealers and developing state-of-the-art studio environments to replicate the ambiance of a traditional casino. One of the key milestones in Evolution's history was the launch of their first live casino studio in Riga, Latvia, in 2007. This studio became the foundation for their live dealer operations, offering a range of popular casino games like blackjack, roulette, and baccarat. The company's innovative approach, including features like real-time interaction with dealers and other players, quickly gained popularity among online casino operators and players.

Over the years, Evolution continued to expand its portfolio of live dealer games, introducing new variations and unique offerings to cater to a global audience. In 2021, the company rebranded as Evolution, dropping "Gaming" from its name to reflect its broader scope within the gaming and entertainment industry.

Jens von Bahr is Chairman of the Board having served as Chief Executive Officer (CEO) until October 2016 and Fredrik Osterberg sits on the Board having served as Chief Strategy Officer until April 2018. Martin Carlesund was appointed CEO in October 2016. Prior to joining Evolution, Carlesund served as CEO for Eniro Sverige, CEO for Highlight Media Group, Chairman at 24 Solutions, CEO at 3L System AB and CEO for Eniro Finland Oy. 

The company's largest shareholder is Capital Group, which owns a 15.1% stake. Next is Österbahr Ventures AB which is a joint venture between Jens von Bahr and Fredrik Österberg, with a 10.4% stake. Blackrock and WCM Investment Management both hold a 5.1% stake. 

Evolution’s management is incentivized through guidelines designed to attract, motivate, and retain senior executives, including the Group CEO, Group management, and members of the Board employed by the company. The key components of the incentive structure:

• Fixed Salary: Senior executives' fixed salaries are competitive and based on individual competencies, responsibilities, and performance. The fixed salary is subject to an annual review. 

• Variable Compensation: Senior executives may receive variable remuneration in addition to their fixed salaries. Annual variable remuneration is cash-based and tied to predetermined and measurable performance criteria aimed at promoting the company's long-term value creation. 

• Incentive Program: Shareholders' meetings have the authority to establish long-term share and share-price related incentive programs for senior executives. These programs are designed to align the interests of participating individuals with those of the company's shareholders and encourage personal shareholding.

In addition to the above, Evolution has implemented incentive programs that involve the issuance of warrants to key employees. These programs aim to align the interests of employees with those of the company's shareholders. The 2023/2026 incentive plan was initially put before the Board in February amd has yet to be approved per the below timeline:

• February 2023 Proposal: Evolution initially proposed an incentive plan involving 500 individuals and 5 million warrants. This plan had a maximum dilution rate of 2.32%, which caused concerns among shareholders. Additionally, there were unclear criteria for the allocation of these incentives.

• June 2023 Revised Plan: Evolution made adjustments to the incentive plan in response to the earlier criticisms. The plan was scaled down to involve 300 individuals and 2.5 million warrants, reducing the maximum dilution to 1.16%. Moreover, this revised plan introduced performance metrics tied to revenue growth, EBITDA margin, and ethics compliance to address transparency and accountability concerns.

• July 2023 Cancellation: Evolution announced the cancellation of the incentive program. This decision stemmed from changes in Evolution's share price during the program's implementation period, which no longer aligned with the original conditions of the proposal. As a result, the Board of Directors opted not to proceed with the program, pledging to collaborate with shareholders to develop a more suitable program for motivating the company's employees.

This ongoing situation is concerning, and as it rumbles on, it raises further doubts about the possibility of something more serious occurring behind the scenes.

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7. Risks

1. Regulation

Regulatory risk poses a significant challenge to Evolution's business. The company's revenue primarily comes from licensing and supplying gaming software to operators, making it highly dependent on the ever-changing and complex laws and regulations governing the gaming industry across various jurisdictions. 

A. Malta Gaming License

Evolution is licensed and regulated by the Malta Gaming Authority (MGA). Evolution is also licensed and regulated in many other EU jurisdictions as well as the United Kingdom, Canada, South Africa, and others. With an MGA  license, Evolution can operate in all EU countries. The introduction of new online gaming regulations in various European countries may necessitate specific licenses, curtailing the opportunity to leverage the single EU license and increase administration expenses.

B. Studios in Multiple Locations

Courts or regulators may impose specific requirements, such as locating equipment within a jurisdiction, which could disrupt Evolution's operations and potentially require the company to set up studios in multiple countries. Setting up studios in multiple countries is a costly endeavor. It involves expenses related to real estate, technology infrastructure, hiring and training staff, and ensuring compliance with local laws and regulations. These added costs can erode the economies of scale benefit that Evolution currently enjoys. Evolution's current business model relies on operating just seventeen studios worldwide to serve a global market. This concentration of resources and expertise allows for cost efficiencies and quality control. It is worth nothing that while this would reduce economies of scale it would increase barriers to entry for competitors.

A significant portion of Evolution's workforce, about 62%, is located in the low-cost economies of Georgia and Latvia. Expanding into the United States has led to increased studio presence but also higher employee costs due to higher average salaries. In 2022, Evolution substantially grew its U.S. workforce from 845 to 1,841 employees.

 C. Income Tax Rate

Evolution has benefited from low corporate income tax rates by channeling revenues through its Malta operation. However, as new revenue sources in North America emerge and global minimum tax initiatives come into play, these rates are anticipated to double. In 2022, Evolution's total tax rate was 7%, but the impending 15% global minimum tax could potentially double the company's overall tax rate, which would impact its net profits and cash flow.

2. Customer Concentration

While Evolution’s revenue is diversified geographically, it is significantly concentrated among its top five customers, who collectively contributed 30% of the company's total revenue in 2022. This represents a notable increase from the previous year when these top customers contributed 22%. The largest customer alone contributes approximately 14% or €204 million of the company's revenues, up from 11% in 2021.  This increasing concentration underscores the importance of these key customers to Evolution's financial health.

Relying heavily on a small number of major customers for a substantial portion of revenue poses a significant risk. If the business of any of these five customers deteriorates or declines, it could directly impact Evolution's revenue stream. Another significant risk is the possibility that one or more of these top customers might opt to switch to a competitor for their live casino solutions. Given the competitive nature of the gaming industry, losing a major client to a rival could lead to decreased revenue, lower profits, and potential financial challenges.

Another potential concern tied to the significant customer concentration is whether, given that a single customer is spending more than €204 million on Evolution's product, there is a risk that the casino might choose to bring the live casino solution in-house as a cost-saving measure.

Similar to computer manufacturers using the Windows operating system, casinos benefit from cost-effectiveness when they rely on existing third-party solutions:

• Leverage years of expertise: Building an in-house solution requires significant investment in development and maintenance, which can be costly. By using a fully integrated solution like Evolution, the operator can leverage seventeen years of compounded industry experience at a fraction of the time and cost. 

• Lower operational and capital expenses: Developing and maintaining a full technology stack, including game presenters, streaming, production, supervision, and customer service demands a large and specialized workforce. This results in substantial fixed operational costs. When casinos use third-party providers, they pay a percentage of their revenue in exchange for access to the solution. While this involves sharing revenue, it can be more cost-effective than bearing the full expense of developing and managing the end-to-end solution in-house. This also enables casinos to sidestep substantial ongoing capital expenses related to software development, infrastructure, and technology upgrades, particularly when creating new games.

• Risk management: Developing casino games or technology in-house carries a significant risk. If a game or technology project fails to perform as expected, the casino would incur substantial losses. By partnering with external providers, casinos can mitigate this risk and avoid costly failures. 

• Quality and innovation: In-house development may lead to a focus on cost control, potentially resulting in the creation of simpler, budget-conscious products. These products may lack the depth, features, and innovation found in offerings from specialized providers. Using third-party solutions ensures access to high-quality, feature-rich, and innovative games and technology.

This is supported by the input received from a traditional casino operator in response to BWG Strategy's inquiry about the competitive advantages of third-party suppliers compared to in-house game development by brick & mortar (B&M) operators:

They have the experience and the decade of R&D; they have all the mistakes and the learning curve. B&M casinos are not agile - compliance, budget issues, etc. Time is the biggest hurdle - there will be a lot of misses before they are successful - Former Vice President of Online Gaming Operations at Hard Rock International

8. Opportunities

1. Durable Competitive Advantages

Evolution has an opportunity to harness its enduring competitive advantages to further solidify its market position, expand its offerings, and continue setting industry standards. The following factors have been identified as to why Evolution can continue to lead the live casino market for the years ahead:

A. Intellectual Property

Evolution has a competitive advantage through its exclusive portfolio of proprietary games, such as Monopoly Live and enhanced classics like Lightning Roulette, which are difficult for rivals to duplicate. Casino operators must license Evolution's live casino solution to offer these games, creating a significant barrier to entry.

Evolution's large player base provides cost efficiency similar to the "Netflix advantage”. With most player traffic on their platform, Evolution's per-player investment in creating new intellectual property (IP) is lower than competitors, allowing more resources for innovation and game development. The success of games like Crazy Time, despite being expensive to create, showcases how Evolution can balance innovation with profitability.

Evolution’s traditional casino games, like Blackjack, offer a high RTP, attracting and retaining players while satisfying casino operators. Evolution's unique game show-style offerings typically have a lower RTP compared to traditional games. This lower RTP allows Evolution to recoup the costs associated with developing these complex and entertaining games. 

Evolution's commitment to developing new games is evident from its announcement to launch over 100 new games in 2023. In 2022, the company launched 88 new games. This continuous innovation keeps players engaged and interested in their offerings while expanding their IP portfolio. As they introduce more proprietary games, it becomes increasingly challenging for competitors to catch up or replicate their success.

B. Scalability

Unlike land-based casinos that are limited by physical space, Evolution operates in the digital realm, allowing them to break free from such constraints. This scalability advantage means that they can accommodate a virtually unlimited number of players at their casino tables without the need for additional physical infrastructure, such as expanding the casino floor or hiring more dealers. This results in higher returns on their investment (ROI) and margin expansion. In traditional casinos, adding more tables and dealers would directly increase costs, but Evolution can accommodate more players without significantly increasing expenses. Since 2014, Evolution has been able to more than double revenue per live table from €404k to €914k.

Evolution's vast network of 1,300+ tables, as of the end of 2022, demonstrates their dedication to maximizing capacity utilization. They provide hundreds of games in multiple languages around the clock and strategically leverage their global network for capacity management. This proved crucial during events like the COVID-19 pandemic, ensuring uninterrupted service to players. Their flexibility in managing capacity allows them to optimize ROI by reallocating resources as demand changes.

Evolution’s scalability acts as a competitive barrier. Potential competitors must replicate Evolution's global studio presence, develop unique games, and manage capacity effectively to be a meaningful competitor. Their large geographic footprint allows them to cater to diverse markets and players worldwide. This adaptability enhances the customer experience and broadens their global reach. This high barrier to entry makes it challenging for subscale competitors to gain a foothold in the market.

C. Network Effects

Evolution Gaming has established a strong Network Effects competitive advantage driven by the interplay of player engagement, social interaction, game variety, and market dominance.

The more players engage with a live casino game, the more immersive it becomes. Evolution enhances this social aspect, making players feel part of a vibrant community. They recognize social interaction's importance, allowing players to connect with friends and others in real-time, reinforcing the network effect and attracting players to their games.

Evolution's extensive game portfolio not only appeals to players but also attracts operators. Online casinos are always seeking to provide a variety of games to their customers. The more games Evolution offers, the more operators it can partner with, creating a direct network effect. This, in turn, leads to a better overall casino experience for players who have access to a diverse selection of games in one place.

Evolution enjoys a substantial traffic advantage over its competitors. This traffic dominance not only reflects the popularity of Evolution's games but also contributes to the Network Effects advantage by ensuring a larger player pool. Once players enter the Evolution ecosystem, they are more likely to stay within it. Evolution employs unique game exit and lobby redirection practices that encourage players to remain within their ecosystem. This makes games from other providers less accessible, reinforcing player loyalty and network effects.

D. Switching Costs

The substantial one-off setup fees of up to €50,000 for dedicated tables represent a significant upfront investment for casino operators. These fees, coupled with high margins, incentivize operators to stay with Evolution. Once a casino operator has invested in dedicated tables, it becomes reluctant to switch to another provider, as it would mean abandoning a sunk cost. This financial commitment acts as a strong deterrent to switching to a different live casino game provider.

In addition to the setup costs, casino operators must pay monthly fees of up to €20,000 per table. These ongoing costs further lock operators into their relationship with Evolution. With contracts typically running for three years, operators are financially committed to Evolution for an extended period, making it less appealing to switch to a competitor.

Evolution owns or leases the facilities where the dedicated tables are hosted. This adds to the switching costs because if an operator were to leave Evolution, it would not only lose access to the games but also the physical infrastructure. Evolution can potentially rebrand or repurpose these facilities, making it even harder for operators to switch providers.

Certain dealers become popular with players, and players develop comfort and loyalty to them. If a casino operator were to switch away from Evolution, it would not only lose access to the platform but also the dedicated and non-dedicated dealers. Losing these dealers could lead to player churn as they may seek out their favorite dealers on other platforms. This loyalty factor increases the switching costs for operators.

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2. Online Gambling Market Expansion

The global online gambling market is expected to reach $153.57 billion by 2030, with a projected compound annual growth rate (CAGR) of 11.7% from 2023 to 2030. This growth is attributed to factors such as smartphone and internet penetration, freemium models and cultural and legal approval. This presents a significant expansion opportunity for Evolution. 

Advancements in the digital space are fueling the expansion of online casinos, focused on building trust in the online gambling sector. Virtual reality (VR) technology is playing a key role in creating immersive gambling experiences, allowing users to interact realistically with the hardware, other players, and dealers, while also improving sound quality and game design.

Online casino developers are emphasizing solutions that support gamblers, ensure the authenticity of gambling activities, and prevent fraud. Many platforms offer free-play versions of games to attract new users, generating revenue through in-app and website advertisements.

In 2022, desktop devices accounted for around 48% of online gambling revenue. Desktops offer advantages such as a larger screen size, which allows players to enjoy game details and graphics fully. Additionally, desktops provide superior performance features like audio and picture quality, as well as customizable storage capacity, enhancing the overall gaming experience.

Advanced technologies in mobile phones have led to realistic gaming visuals, making smartphones a popular choice for accessing online gambling. The mobile device segment is expected to experience the highest CAGR from 2023 to 2030. This growth is driven by the emergence of immersive betting applications and the convenience of gambling via mobile devices. Evolution is well positioned for the increase in mobile device usage. Their mobile games are built in HTML5, ensuring seamless integration with operators' mobile websites and apps. In 2022, 68% of Evolution's revenue came from mobile gaming, highlighting the company's success in the mobile segment.

Europe held a dominant position in the online gambling market in 2022, commanding a market share of over 41%. This growth can be attributed to the legalization of gambling in several European countries, including Italy, Spain, France, and Germany. The region benefited from factors such as high-speed broadband internet availability, the rising popularity of online casinos, and increased smartphone usage. Despite this growth, the larger gambling markets in Europe have relatively lower online market shares which presents a further opportunity for Evolution given 65% of the total gambling market remains land-based.

While Europe dominated in 2022, the Asia Pacific region is poised for substantial growth. The increased use of internet services and the relaxation of restrictions related to online gambling and betting are anticipated to drive market development in the Asia Pacific in the coming years. The Asia Pacific region benefits from increased spending on leisure activities from robust economic growth.

Evolution recognizes the potential offered by the global expansion of the online casino market. It is rare to witness a company with a strategic objective of outpacing global market growth in order to increase the gap to its competitors.

9. Valuation

Discounted Cash Flow

Future cash flows have been projected over five years using a discount rate of 10% and a terminal EBITDA exit multiple of 17. For context, Evolution currently trades at an EV/EBITDA multiple of 17 which is on the low end given the quality of the underlying Evolution business notably its durable competitive advantages and stellar unit economics. A conservative approach will be maintained with the current market multiple. 

A revenue CAGR of 18% is projected from 2022 to 2027. In the global online gambling market, which is anticipated to grow at an 11% CAGR during the same timeframe, Evolution has consistently outpaced the market, with a growth rate of 36% compared to the market's 13% in 2022.

The EBITDA margin has been forecast to reach its highest point at 70% in 2023, after which it will level off at 69% for the next five years. This projection includes accounting for the additional studios needed in each U.S. state as part of the global expansion opportunity.

Management set a CapEx guide of €120 million for 2023 which would equate to a CapEx margin of 7%. This has been bumped up to 8% from 2024 to 2027 to align with global studio expansion. This results in the FCF margin reaching a peak of 56% before levelling off to 52%. Despite uncertainty regarding the management incentive plan, a maximum annual dilution of 1.16% has been assumed for this analysis.

Based on these assumptions, the fair value of Evolution is close to €131.53 per share suggesting a potential upside of 38% based on the share price on 11 October 2023 of €95.29. The EVO.ST SEK share price has been converted to EUR using the closing fx rate for that date.

Price to Earnings Ratio

Evolution trades at a forward P/E ratio of 17x which is at a premium to its other publicly listed competitor Playtech which trades for 8 times forward earnings.

Evolution commands this premium relative valuation for obvious reasons: growing four times as fast and almost three times as profitable. A company with a 70% EBITDA margin and a 26% growth rate appears undervalued at 17 times forward earnings.

10. Investment Outlook

The investment outlook for Evolution is promising due to its durable competitive advantages. Evolution's strengths lie in its intellectual property, scalability, network effects, and switching costs, which position it favorably within the growing online casino industry. Notably, the high demand for new dedicated tables in Europe, exceeding the company's current capacity, highlights the opportunity. These custom-branded tables incur significant upfront costs, creating higher switching costs for operators, implying higher value customers.

The outlook is not without its risks which include regulatory risks outside of Evolution’s control that could materially impact margins in the future. Additionally, concerns arise regarding the management incentive program tied to warrants issuance. 

Evolution's potential for future acquisitions is a strategic move that could make sense, provided fair prices are paid. The platform facilitates seamless integration of acquired brand games into the Evolution ecosystem, potentially increasing their value through synergies. Lessons from the acquisition of NetEnt, which may have been overpriced, can guide future acquisition strategies.

Evolution benefits from being a crucial infrastructure provider in an industry shifting from land-based to online casinos, which still account for 65% of the European market. This migration is driven by the significantly better RTP offered by online live casinos, thanks to their lower fixed costs compared to land-based alternatives. An investment in Evolution hedges bets on the dominant ‘pick and shovel’ play in the online casino industry at a very reasonable valuation.

Disclosure: At the time of writing, the author holds a long position in Evolution AB.

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Wolf of Harcourt Street

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Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

Why did Adyen experience such a dramatic rise and fall and is it worth investing in today?

Contents

1. Executive Summary

2. Overview

3. Customer Base

4. Financial Analysis

5. Competitive Landscape

6. Management and Incentive Structure 

7. Risks

8. Opportunities

9. Valuation

10. Investment Outlook

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1. Executive Summary

• Adyen’s success can be attributed to its ability to solve the complex and fragmented payment processing challenges faced by businesses. Adyen offers a comprehensive platform that simplifies the entire payment lifecycle, including transaction processing, risk management, authentication, and issuing. This solution addresses the problem of businesses having to integrate multiple payment gateways, collaborate with various banks, and manage transactions across different regions and payment methods.

• Over the last five years, Adyen has achieved a compounded annual growth rate of 44% in its processed volume, primarily driven by expanding existing customer relationships on the platform. Over 80% of this growth comes from nurturing these strong customer relationships, highlighting the importance of customer retention in Adyen's growth strategy. Adyen's adaptability and tailored payment solutions meet the unique needs of different sectors.

• Adyen faces significant competition from various businesses in the payments value chain. This competition comes from both traditional and non-traditional players and includes companies with larger merchant bases and greater financial resources. The risk of commoditization in the payment processing industry, driven by technological advancements, increased competition, and shifting consumer behavior, poses a challenge to Adyen. It may lead to reduced revenue per transaction and difficulties in maintaining profitability. 

• The digital payment market is experiencing significant growth, driven by factors such as increasing internet penetration, smartphone usage, technological advancements, and the rise of digital wallets. Adyen is well-positioned to capitalize on this growth opportunity by leveraging its innovative approach, supporting emerging payment technologies, and offering versatile payment processing solutions. Adyen has the opportunity to differentiate itself by offering a wide range of value-added services that cater to merchant needs, helping it stand out in a competitive payments landscape.

2. Overview

Adyen is a global financial technology company that provides payment solutions and services to businesses of all sizes and industries. Founded in 2006 in the Netherlands, Adyen has emerged as a leading player in the payment processing industry, offering a comprehensive platform that handles the entire payments lifecycle.

At its core, Adyen provides a wide range of payment processing solutions to businesses. This includes transaction processing, managing gateway services, facilitating risk assessment and management, and ensuring the timely settlement of funds. Adyen's platform is designed to simplify the complexities of payment processing, offering a one-stop shop for businesses looking to accept payments from customers worldwide.

Broadly speaking, Adyen's full-stack payment gateway can be segmented into four main areas: Payments, Risk Management, Authentication, and Issuing. 

• Payments: Adyen helps businesses accept, process, and settle payments online, in person, and with unified commerce. It supports over 100+ payment methods and offers customization options for B2C, B2B, and subscription models. 

• Risk Management: Adyen's RevenueProtect product helps businesses detect, prevent, and respond to fraud and disputes, with customizable risk rules and templates for various industries. 

• Authentication: Adyen's 3D Secure 2 technology enhances payment authentication behind the scenes to improve authorization rates. 

• Issuing: Adyen offers virtual or physical payment card programs with Application Programming Interfaces (APIs) for custom-branded cards, real-time authorization, and compliance with regulatory standards.

Adyen has strategically established direct connections with both local and global card networks and banking systems. This extensive network allows businesses to tap into a vast customer base and accept payments from different regions and currencies seamlessly. Adyen's global reach is a key driver of its popularity among multinational enterprises.

What Problem Does Adyen Solve?

Adyen solves the problem of complex and fragmented payment processing for businesses. Many businesses, especially those operating in the digital space, face challenges when it comes to accepting and managing payments from customers across different channels, regions, and payment methods. This can result in a cumbersome and inefficient payment infrastructure, which hinders their ability to provide a seamless and frictionless payment experience to their customers.

As an example, before teaming up with Adyen, Etsy grappled with complex payment issues. They had to integrate multiple payment gateways and collaborate with various acquiring banks to handle transactions from different countries, making payment management time-consuming. Additionally, they faced high transaction fees and struggled to offer diverse payment methods.

By partnering with Adyen, Etsy simplified their payment processes. Adyen's platform consolidated payment methods, gateways, and acquiring banks into one, eliminating the need for multiple integrations and providing a centralized view of payment data. Adyen also offered direct connections to card networks and banking systems worldwide, expanding Etsy’s payment reach.

Moreover, Adyen's platform included advanced fraud detection and risk management, ensuring secure transactions and relieving Etsy from payment-related worries. Overall, Adyen's solution streamlined payment processing, improved the customer payment experience, extended global reach, and reduced complexity and costs, allowing Etsy to focus on core business growth. 

3. Customer Base

Adyen serves a diverse customer base, catering to both traditional brick-and-mortar retailers and digitally native businesses. This diversity showcases its adaptability and ability to provide payment solutions that meet the unique needs of different sectors. Some of the industries within Adyen's customer base include e-commerce, travel, hospitality, technology, fashion, and more.

Multinational Corporations: Adyen has established itself as a preferred partner for many multinational corporations. Its global reach and capability to handle cross-border transactions make it an attractive choice for large enterprises with operations in multiple countries. These corporations rely on Adyen to facilitate seamless payments in various currencies and regions. 

Digital-Native Businesses: Adyen's platform is well-suited for digital-native businesses, including tech startups, e-commerce platforms, and app-based services. These businesses benefit from Adyen's agile and innovative approach, allowing them to quickly adapt to changing customer preferences and emerging payment methods.

Traditional Retailers: Adyen also caters to traditional brick-and-mortar retailers that are looking to transition into omnichannel sales strategies. Its Unified Commerce offering provides these retailers with tools to bridge the gap between online and offline sales, enabling them to compete effectively in the digital age.

Platform Businesses: Adyen partners with platform businesses, which use its technology to offer payment-related services to their own customers. These partnerships extend Adyen's reach and influence in the market. For example, ride-sharing platforms or online marketplaces may use Adyen's infrastructure to handle payments for their users.

SMBs through Embedded Finance: Adyen's expansion into embedded financial products (EFP) enables it to serve small and medium-sized businesses (SMBs) as well. Through partnerships and its EFP suite, Adyen empowers platform businesses to provide financial services to SMBs, such as cash advances, business bank accounts, and card issuing. This positions Adyen to tap into the growing SMB market segment.

The Key Performance Indicator

Adyen reported Processed Volume (PV) of €426 billion in H1 2023, growing 23% year-over-year (YoY) primarily attributed to the expansion of existing customer relationships on the platform. Over 80% of the growth came from these strong customer relationships, and there was minimal volume churn (less than 1%). This highlights the importance of retaining and nurturing existing customers as a key driver of Adyen's growth, which aligns with the company's historical growth patterns. Adyen has achieved a staggering PV five-year compounded annual growth rate (CAGR) of 44%.

The Digital segment, which is the largest, experienced slower growth due to competitive pricing in North America. In the first half of 2023, Digital volumes reached €267.1 billion, accounting for 63% of total processed volume and growing at a rate of 23% YoY.

The Unified Commerce segment continued to grow globally, reaching €109.2 billion in H1 2023, with significant YoY growth of 36%. Unified Commerce volumes made up 25% of the total processed volume.

The Platforms segment saw volumes of €49.7 billion in H1 2023, constituting 12% of total processed volume and growing at a more modest rate of 3% YoY.

While Adyen's top 10 merchants contributed to a larger percentage of total revenue in 2022 compared to 2021 (33% vs. 29%), no single customer accounted for more than 10% of the total revenue in either year. Similarly, in terms of net revenue, the top 10 merchants contributed a slightly smaller percentage in 2022 (18% vs. 20%), and there were no customers individually responsible for more than 10% of the total net revenue in both 2022 and 2021. This diversified customer base reduces the company's reliance on any single customer for a significant portion of its revenue.

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4. Financial Analysis

Adyen generates revenue from contracts with customers through four primary sources:

Settlement fees: These are fees paid by merchants for acquiring services, typically as a percentage of transaction value. Adyen charges these fees based on its costs plus a mark-up, and revenue is recognized when payment transactions are completed.

Processing fees: Merchants pay a fixed fee per transaction plus a fee determined by the payment method. Revenue is recognized when transactions are initiated via the Adyen payment platform.

Sales of goods: Adyen sells POS terminals and related accessories to merchants. Revenue for these sales is recognized when control of the terminal is transferred to the merchant, and this is considered distinct from payment services.

Other services: This category includes fees for foreign exchange services, third-party commissions, and issuing services. Revenue for these services is recognized at a specific point in time, while services transferred over time are related to the amortization of deferred revenue for services provided under merchant contracts, including terminal services fees as part of the unified commerce offering.

Adyen’s net revenue grew by 21% YoY to €739.1 million in H1 2023. Adyen has grown net revenue at a five-year CAGR of 35%. However, the growth was impacted by the changing macroeconomic environment and competitive pricing competition, particularly in the North American and online payments sector.

The take rate increased slightly to 17.3 basis points compared to 17.1 in the previous period but was influenced by the overall mix of merchants. Looking back historically, Adyen’s tiered pricing model has resulted in a lower take rate over the years, with take rate falling from a peak of 22.5 basis points in 2018. One way to easily notice this is by comparing the 44% CAGR in PV with the 35% CAGR in net revenue. The declining take rate is a result of the company extracting more value from its customers through its land-and-expand business model.

Net revenue contributions from different regions remained consistent YoY, with EMEA contributing the largest share at 57%, followed by North America at 25%, APAC at 11%, and LATAM at 7%. Notably, APAC experienced the fastest growth at 31% followed by North America at 23%, EMEA at 20%, and LATAM at 13%. 

Adyen experienced a significant increase in operating expenses in H1 2023, which amounted to €460.0 million, representing a 66% increase from H1 2022. This increase was primarily driven by investments in expanding their global team in preparation for future growth. As a result of this increase, the Operating Expense (OpEx) ratio has hit a record high of 62%. The average OpEx ratio over the past five years has been 47%.

The majority of the operating expense increase was driven by employee benefits which reached €285.9 million in H1 2023, an 80% increase YoY. This increase reflects both the annualization of hires made in 2022 and ongoing investments in scaling the Adyen team, emphasizing the importance of people in their long-term success.

Sales and marketing expenses in H1 2023 totaled €27.4 million, marking a 13% YoY increase. This increase was driven by various activities, including events and campaigns aimed at generating and accelerating commercial pipeline leads effectively.

The investment by Adyen in expanding its global team resulted in EBITDA decreasing 10% YoY in H1 2023. The EBITDA margin has consequently decreased from 59% in H1 2022 to 43% in H1 2023. Management plans to plans to slow hiring in 2024 when its team would have reached “its next maturity level’. Despite the short-term impact of rapidly building its team, Adyen still maintains a very high level of profitability. The average EBITDA margin over the past five years has been 57%.

Despite some areas of the business experiencing slower growth in H1 2023, management believes that its medium to long-term opportunities remain unchanged. They acknowledge that growth can be non-linear and reiterate their financial objectives:

Financial Position

• Over €1.9 billion in cash and cash equivalents net of payables to merchants

• Positive working capital of €2.4 billion

• Debt to Asset ratio of 64% 

• Zero goodwill

• Zero debt

This is an A+ balance sheet.

Cash Flow Analysis

First off, I would like to draw your attention to the fact that Adyen calculates free cash flow using EBITDA minus capital expenditure (CapEx) and lease payments instead of the conventional method because their working capital isn't typical working capital. Adyen holds cash that needs to be passed on to others, so it's not considered their cash in the true sense, and therefore, they adjust their free cash flow calculation to account for this unique financial situation.

Adyen posted free cash flow of €247.7 million in H1 2023, decreasing by 20% compared to the previous year, primarily due to increased CapEx. The CapEx investment reached €56.1 million, accounting for 7.6% of net revenue, up from 6.6% in H1 2022. The company front-loaded its infrastructure investments in the first half of the year to enhance the efficiency of its single platform at a larger scale. The free cash flow conversion ratio was 77%, down from 87% in H1 2022.

Return on Capital

Adyen has historically achieved high returns on capital. There are two main of reasons for this:

1. High operating margin: Adyen's payment processing business has historically enjoyed healthy operating margins. This means that a significant portion of the company's revenue translates into operating profits, contributing positively to its return on capital.

2. Reinvestment runway: Adyen's global presence and its ability to serve merchants worldwide have contributed to its ability to generate higher returns on the capital it employs.

5. Competitive Landscape

The payments ecosystem is a complex web of players, and Adyen competes with several key entities in this landscape. Adyen has positioned itself as a global payment solutions provider, offering a full-stack payment gateway, risk management, and front-end processing services. Here's how Adyen fits into the competitive landscape based on the roles of different players in the payment processing value chain:

Payment Processors: Adyen directly competes with payment processors such as Stripe, Square and Fiserv. These companies provide services to merchants to accept and process payments, including credit card transactions, online and in-person payments, and often offer additional services like fraud prevention and analytics. Most merchants use multiple payment processors to ensure business continuity in the event that one experiences technical issues, a practice likely to continue given the recent Square outage. This reinforces the belief that the payments industry is not a zero sum game.

Payment Gateways: Adyen operates as a payment gateway, allowing merchants to securely transmit payment data for processing. Payment gateways like Adyen are critical in ensuring the security and integrity of payment transactions. Competitors in this space include companies like Stripe and Braintree (a subsidiary of PayPal).

Credit Card Networks: Adyen interacts with credit card networks like Visa, Mastercard, and American Express to route and process transactions. These networks play a central role in facilitating transactions and are not direct competitors of Adyen but rather essential partners.

Issuers: Issuers, represented by banks like Chase or Bank of America, issue credit cards to consumers and assume the risk associated with those cards. Adyen doesn't directly compete with issuers but works with them to facilitate payments.

Acquirers: Acquirers, often referred to as merchant acquirers, enable merchants to accept credit card payments. Adyen can function as both a payment processor and an acquirer, and it competes with other acquiring banks like Wells Fargo and Elavon.

Independent Sales Organizations (ISOs): ISOs, like Wells Fargo and other banks, are intermediaries between merchants, payment processors, and acquiring banks. Adyen competes indirectly with ISOs as it provides end-to-end payment processing services to merchants.

Adyen vs Stripe Comparison

Stripe is Adyen’s closest direct competitor. Based on the 2022 Stripe annual letter, the following comparisons can be made:

• Adyen surpassed Stripe in processed in 2022, with $829 billion compared to Stripe's $817 billion. Adyens processed volume grew by 49% YoY compared to 28% for Stripe.

• On a net take rate basis, Stripe's 0.34% is double that of Adyen's 0.17%. Adyen's focus on enterprise clients with higher payment volumes results in lower negotiated rates, while Stripe started with SMBs and has higher blended take rates.

• Adyen reported a 55% EBITDA margin compared with negative EBITDA for Stripe. Stripe has a larger employee base, but Adyen processes more payment volume per employee, making it more efficient.
  

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6. Management and Incentive Structure 

Adyen was founded in 2006 by Pieter van der Does and Arnout Schuijff, both experienced entrepreneurs in the payments industry. The company's inception was driven by its shared vision to create a more streamlined and innovative payment platform that could address the evolving needs of businesses in the digital era.

Pieter van der Does, the CEO of Adyen, had previously co-founded Bibit, a successful online payment platform, in 1999. Bibit was later acquired by Royal Bank of Scotland in 2004. Meanwhile, Arnout Schuijff, Adyen's CTO, had extensive experience in the payments industry, having worked at various companies specializing in risk management and payment processing.

Recognizing the challenges and limitations of existing payment solutions, Pieter and Arnout saw an opportunity to build a more comprehensive and flexible platform that could handle the full payments lifecycle. Adyen follows the Adyen formula, which consists of principles to guide how the company operates and includes the importance of picking up the phone for effective problem-solving, fostering a culture of personal contribution, and maintaining flexible career paths. 

Adyen's management is incentivized through a remuneration policy that emphasizes a long-term orientation and aligns their interests with the company's performance and success. In 2022, the Management Board members did not receive variable remuneration, which means they were not awarded bonuses or performance-related pay during that year. Instead, their compensation was solely based on their base salary.

Management Board members receive very little share-based compensation (SBC). In 2022, only two out of the six managing directors received SBC, Mariëtte Swart and Alexander Matthey. This low level of SBC is very unusual, especially for technology companies and it is what sets Adyen apart from its U.S competitors. One contributing factor is the 20% bonus cap in the Netherlands, which prevents financial institutions from awarding bonuses to their employees that exceed 20% of their annual base salary.

The goal of the Adyen remuneration policy is to align management's incentives with Adyen's long-term objectives which include sustainable growth, development, profitability, and the overall financial success of the company. By tying compensation to these goals, the company aims to ensure that management's focus is on the long-term health and prosperity of Adyen rather than short-term gains. 

7. Risks

1. Intense Competition

Adyen faces significant competition in the financial technology and payment processing industry. As learned when analysing the competitive landscape, Adyen competes against a wide range of businesses in the value chain. These competitors may have dominant market positions or offer a broader range of products and services to customers that Adyen does not currently provide.

One key aspect of competition that Adyen faces is the size and scale of its competitors. Some competitors have larger merchant bases, higher transaction volumes, greater financial resources, and larger market shares compared to Adyen. These factors can provide significant competitive advantages, such as the ability to invest more in technology, expand their offerings, or negotiate favorable terms with merchants. 

Additionally, Adyen is not only competing against traditional payment processors but also facing competitive pressure from non-traditional players and other parties entering the digital payments industry. These new entrants may compete directly with Adyen in one or more functions involved in processing merchant transactions. They might introduce disruptive technologies, innovative business models, or unique value propositions that challenge Adyen's market position.

Intense competition can trigger price wars, where payment processors continually lower their fees to win or retain clients. This can erode the pricing power of established companies like Adyen and result in reduced revenue per transaction. It is worth noting that Adyen does not pursue deals at all costs. It maintains a focus on sustainable pricing and profitability. If pricing is not deemed sustainable, Adyen may choose not to pursue a deal.

2. Commodization of Payments

The risk of commoditization of payments, often referred to as the "Race to Zero," is a significant one for companies like Adyen. Commoditization refers to the process by which products or services become increasingly standardized, leading to intense competition and price pressures. 

Payment processing has evolved significantly over time, transitioning from primarily cash-based transactions to the use of credit cards and electronic payments. Payment networks like Visa and Mastercard were established to facilitate these transactions and charged fees for their services. Initially, fees were relatively high, limiting credit card acceptance to larger businesses.

There are three key factors that are leading to commoditization of payment processing:

1. Technological Advancements: Advances in technology have made payment processing more efficient and cost-effective. This has lowered the barriers to entry for new payment processors and increased competition.

2. Increased Competition: The payment processing industry has become increasingly crowded with various players, from traditional financial institutions to fintech startups. This intense competition has driven down fees as companies vie for market share.

3. Consumer Behavior Shift: The rise of e-commerce and digital payments has reshaped consumer behavior. More people prefer the convenience of online shopping and digital payments, which has further fueled competition in the industry.

This trend could impact Adyen negatively in a number of ways. As fees continue to decrease, Adyen may face challenges in maintaining its revenue streams. With fees and charges for payment processing services being driven down, Adyen may find it challenging to maintain profitability. In a commoditized market, clients may be more inclined to switch providers for better pricing or terms. Adyen may experience higher customer churn rates as clients seek cost savings or improved deals from competitors.

8. Opportunities

1. Digital Payment Market Expansion

The digital payment market was valued at $8.36 billion in 2022 and is projected to grow at a CAGR of 11.8% from 2023 to 2027. This growth is attributed to factors such as increasing internet penetration and smartphone usage worldwide. This presents a significant expansion opportunity for Adyen, given the favorable market dynamics and growth drivers.

The widespread availability of the internet, coupled with the prevalence of smartphones, has led to a surge in digital payment adoption. According to the Digital 2022 October Global Statshot Report by DataReportal, over 63% of the world's population has used the internet, providing easy access to online payment methods. Adyen can leverage this trend to expand its customer base globally.

The market's growth is driven by technological advancements, including the development of robust APIs that enable businesses to integrate payment solutions seamlessly. Adyen, known for its innovative approach, can benefit from these advancements to enhance its offerings. The introduction of Near-field Communication (NFC) and QR code payment technologies has boosted the adoption of e-wallets and contactless payments worldwide. Adyen can tap into this trend by supporting these technologies and providing secure, convenient payment solutions.

The use of digital wallets is poised for rapid growth. Digital wallets offer a range of functionalities beyond in-store payments, including online purchases, fund transfers, and the storage of various data types such as gift cards and loyalty cards. This versatility makes digital wallets attractive to consumers across generations, with millennials leading the adoption at 94%, followed closely by Gen Z at 87%, Gen X at 88%, and even 65% of baby boomers using them.

Estimates suggest that more than half of the global population will use mobile wallets by 2025. The use of P2P apps is projected to increase by 21% from 2022 to 2026, with an anticipated 70% of smartphone users using P2P apps by 2026. Adyen can capitalize on this growing trend by offering support for a wide range of digital wallets, enabling merchants to provide convenient and efficient payment options for their customers. 

2. Value-Added Services

The commoditization of payments is a real risk for Adyen but it also presents the opportunity for Adyen to differentiate itself through offering additional value-added services which can enhance the overall value proposition for merchants.

Adyen can expand support for Automated Clearing House (ACH) transactions, driven by their projected CAGR of 13.10% to reach $13.91 trillion by 2026. Adyen's platform can enhance ACH transaction efficiency, meeting the demand for faster and more convenient digital payments. Adyen can capitalize on the popularity of real-time payments, with a 69% YoY growth in the US and global adoption, offering businesses access to networks like RTP and FedNowSM for faster and more efficient payment options.

Adyen can partner with hardware providers and retailers to assist the transition to advanced payment technologies, including EMV chip tech and unattended retail systems like kiosks and vending machines. Adyen can promote the adoption of mobile point-of-sale (mPOS) solutions, allowing businesses to accept mobile device payments, benefiting from the anticipated 14.03% CAGR in mPOS transactions.

Adyen can integrate advanced payment security solutions into its platform, such as 3-D Secure 2.0 for enhanced authentication in card-not-present transactions. Additionally, Adyen can leverage biometric technology, including fingerprint scanners and facial recognition systems, to enhance payment processing security and improve the user experience.

Adyen can support emerging technologies like Secure Remote Commerce (SRC), which powers digital wallet solutions like Click to Pay. By enabling customers to store payment information securely and use it across various checkout environments and devices, Adyen can enhance the convenience and security of online transactions.

Maintaining excellent customer service and support can be a differentiator in a crowded marketplace. Ensuring that merchants have a seamless experience with Adyen's services can foster loyalty and trust. The company's technology and solutions are structured to enable swift adaptation to industry trends and customer needs. An example of this agility is demonstrated by Adyen being the first platform to introduce the Apple Tap-to-Pay product in 2022. This showcases Adyen's ability to stay at the forefront of innovation and leverage its technology to differentiate itself from competitors.

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9. Valuation

Discounted Cash Flow

I have projected the future cash flows over 5 years using a discount rate of 10% and a terminal EBITDA exit multiple of 17. I am opting to use this multiple based on the quality of the underlying Adyen business notably its growth prospects, margins and cash conversion. For context, Adyen currently trades a forward EV/EBITDA multiple of 19.

I forecast net revenue to grow in the low-twenties driven by the secular industry tailwinds as well as the expansion of the Adyen product offerings. I forecast the EBITDA margin to fall to 44% in 2023 before creeping back up to 55% by the end of year 5. Note that management's long-term guidance is for an EBITDA margin above 65% but I do not expect this to happen over the forecast period given the increased investment that the company is making for future growth. 

CapEx has been forecast at 5% annually in line with management guidance. Given the low levels of SBC, I have projected 3% dilution over the entire forecast period. 

Based on these assumptions I believe that the fair value of Adyen is close to €866 per share suggesting a potential upside of 24% based on the share price on 13 September 2023 of €700.

Price to Earnings Ratio

Adyen trades at a forward P/E ratio of 31x. Despite the multiple compression over the past year, Adyen still trades at a premium valuation relative to some of its publicly listed competitors. 

Adyen commands this premium relative valuation given its superior growth rate and margins. In my view, a valuation of 31 times earnings is reasonable for a company with a 44% EBITDA margin and a 20% annual growth rate.

10. Investment Outlook

Adyen has established itself as a reputable payment processing company with a global presence. Its business model has attracted a wide range of clients, including high-profile merchants. Adyen has historically enjoyed strong margins due to its focus on efficiency. Effective management is crucial for the success of any company, and Adyen has shown its capability in this regard. A well-managed company can adapt to industry changes and position itself for future growth.

Increased competition and the commoditization of payments could put pressure on Adyen's margins. As more players enter the market, it may become challenging to maintain the historically high margins. But, it's not simply about offering the lowest price, as any provider can do that and loose money. Adyen stands out by having the lowest cost structure due to its entirely in-house platform architecture. Its net take rate is only half that of Stripe, yet it manages to achieve an impressive 44% EBITDA margin despite investing heavily, while Stripe operated at a negative margin in 2022. Adyen could compete on price and undercut its competition if it chose to do so, but instead, it concentrates on providing the highest quality product.

One view as to why the Adyen stock price was halved after its H1 2023 results is that the market now doubts the company's terminal value and the sustainability of its competitive edge. Bears believe that margins are permanently affected and won't rebound over the long run, while bulls contend that the decline in margins and return on capital from increased investments for future growth is short-term. My view is the latter.

The valuation appraisal implies that Adyen is undervalued with a modest margin of safety. The analysis assumes conservative margin recovery but if Adyen can return to its long-term target the upside could be even more favourable to investors. 

Disclosure: At the time of writing, the author holds a long position in Adyen N.V.

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Wolf of Harcourt Street

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Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

What has propelled Cloudflare's market capitalization to triple since its IPO in 2019, and how has the company positioned itself to address the critical challenges of internet speed and security?

Contents

1. Executive Summary

2. Overview

3. Customer Base

4. Financial Analysis

5. Competitive Landscape

6. Management and Ownership

7. Risks

8. Opportunities

9. Valuation

10. Investment Outlook

1. Executive Summary

• Cloudflare's success can be attributed to their ability to offer a range of cloud-based services that help organisations tackle the challenges of managing complex infrastructure in today's ever-changing technology landscape. They've created a highly efficient, scalable, and serverless network that spans the globe, connecting with major ISPs, cloud services, and enterprises, which helps them save on co-location and bandwidth costs and makes them an attractive partner for ISPs worldwide.

• Cloudflare has a large and diversified customer base, consisting of both free and paying customers. The free tier service helps to test new products and gain feedback before promoting to paid tiers, and it attracts small businesses that can potentially grow into paying customers. Cloudflare's annual recurring revenue has seen significant growth in both the number of customers with high ARR and the total ARR value suggesting that the company's product strategy of expanding its offerings and upselling more services to customers is proving successful. Despite all of this, Cloudflare's revenue heavily relies on a small number of large customers, with 60% of their revenue coming from just 2,156 large customers. Growth in new paying customers has slowed to 13% in Q1 2023.

• Cloudflare's product shortcomings noted by Gartner, such as limitations in deployment options, inconsistent post-sale support, deficiencies in reporting and incident response capabilities, and a cluttered management interface, could potentially lead to a loss of customers who require these features for their specific use case. The company's gross retention rate falling below 90% further highlights this risk.

• Cloudflare's ownership and operation of over 285 data centres and its highly distributed development platform provide a significant opportunity for network leverage, enabling the company to offer faster, more reliable, and more secure services to its customers. Hyperscalers and new entrants may find it challenging to duplicate this approach due to the significant capital expenditure costs and the need to re-architect their systems.

• Cloudflare believes that it has a large addressable market that will reach $204 billion by 2026, with potential for growth in developer services, AI solutions, data localization, multi cloud ecosystems, and Zero Trust security products. The company aims to reach an annual revenue run rate of $5 billion within five years based on its existing portfolio of products and services. Cloudflare’s expanding set of products is an excellent opportunity for the company to consolidate security vendors, reduce costs, gain more control over traffic flow, and implement Zero Trust.

2. Overview

Cloudflare is a global cloud services provider with the mission to “help build a better internet”. As the technology industry has shifted from on-premises hardware and software to cloud services, organisations face challenges in managing their complex infrastructure. These challenges are exacerbated by the fundamental problems of the Internet, and on-premises hardware boxes are no longer effective solutions. As a result, a major architectural shift at the network layer is underway, and customers are consolidating behind a single global cloud services provider.

Cloudflare offers a broad range of services to businesses of all sizes and geographies, delivering security, performance, and reliability across on-premises, hybrid, cloud, and software-as-a-service applications. Their network is designed to be efficient, scalable, and serverless, allowing them to rapidly develop and deploy their products for customers. Cloudflare's software manages the deployment and execution of their product developers' and customers' code across their network, improving the performance of their highest paying customers and leveraging idle capacity across their network. Their network spans over 285 cities in over 100 countries worldwide, interconnecting with major Internet Service Providers (ISPs), cloud services, and enterprises, making them an attractive partner for ISPs globally and reducing their co-location and bandwidth costs.

Cloudflare offers a suite of deeply integrated products to provide security, performance, and reliability for an organisation's external-facing infrastructure such as websites, applications, and Application Programming Interface (API)’s. Customers can start with just one product and easily expand over time by adding most products with a single click. Cloudflare's integrated suite of products includes:

• Website and Application Services provides a range of products that help businesses protect and optimise their websites, applications, and APIs, while also offering analytics tools to monitor and analyse traffic data in real-time.

• Cloudflare One provides a comprehensive, cloud-based network-as-a-service solution that is secure, fast, reliable and future-proof for corporate networks. It leverages the public internet and offers network services, including connectivity, security, and performance, and Zero Trust services that protect, inspect and privilege data. It brings together how employees connect, on-ramps for branch offices, secure connectivity for applications, and controlled access to SaaS applications in a single pane of glass.

• Developer-based Solutions allows developers to create scalable applications using a serverless platform without worrying about infrastructure or operations. This results in more efficient and high-performance applications that can scale globally instantly, while freeing up developers' time.

• Consumer Offerings improve Internet performance and security for individuals, while also enhancing the effectiveness of its business offerings. The consumer products also serve as a marketing channel to raise brand awareness.

In layman's terms, Cloudflare provides a range of internet services to help protect websites and improve their performance. They offer services like website security, content delivery network (CDN), and domain name management. By using Cloudflare, websites can be faster, more secure, and more reliable, making it a better experience for visitors. Cloudflare's services are used by millions of websites around the world, from small blogs to large corporations.

Cloudflare has a hybrid pricing model that combines consumption-based and subscription-based pricing. The consumption-based pricing applies to certain services where customers are charged based on the volume of usage. The subscription-based pricing applies to services where customers pay a fixed monthly or annual fee for access to the service. Additionally, some services may have a combination of both pricing models. 

Cloudflare's hybrid pricing model offers flexibility and control to customers by providing options between subscription-based or consumption-based pricing. It also enables customers to easily scale their usage up or down without being locked into a fixed pricing plan. The model aligns Cloudflare's incentives with those of its customers and encourages increased usage by decreasing the cost per unit of service as volume increases.

3. Customer Base

Cloudflare has a global community of millions of free and paying customers who manage millions of Internet properties on their network. Paying customers are diversified across organisations of all sizes in major industry verticals. Their large customer count has been steadily increasing, and no single customer accounted for more than 10% of their revenue in the past three years. 

Some key metrics related to Cloudflare's customer base as of 31 March 2023:

• Total Customers: Cloudflare has over 168,000 paying customers but provides a free service tier to millions of users, which helps to test new products and gain feedback before promoting to paid tiers. While utilisation from the free tier is relatively low and capped, the benefit is significant as these users provide valuable signals to identify threats and malicious behaviour, which feeds into security effectiveness. The free tier also attracts small businesses that can potentially grow into paid customers.

• Annual Recurring Revenue (ARR): Cloudflare's ARR has seen significant growth in both the number of customers with high ARR and the total ARR value. The increase in the number of customers with ARR of $100,000 or more indicates a trend of strong growth in the high-value customer segment. It also means that the company's revenue growth is still heavily reliant on the addition of large customers, which may indicate a need to diversify the customer base in the future to ensure sustained growth.

• Cohorts: Cloudflare is experiencing significant growth in the number of large customers spending $500k or more and $1M or more. This growth in large customers is actually outpacing the company's revenue growth and the growth of its $100k customers. This suggests that the company's product strategy of expanding its offerings and upselling more services to customers is proving successful. It also highlights the importance of focusing on customer retention and upselling, rather than just customer acquisition, to drive sustained growth.

• Customer Retention Rate: Historically, Cloudflare has had a high customer retention rate, with a dollar-based net retention rate (DBNRR) of above 120%. For context, a DBNRR above 100% indicates that the company is generating more revenue from its existing customers than it lost from churn and contraction. 

  The DBNRR has slipped to 117% at Q1 2023, steadily declining from 127% twelve months prior. On the Q4 2022 earnings call, management explained that the declining DBNRR is not due to elevated churn but is attributable to slower expansion with pay-as-you-go customers and those spending less than $100k. Management reiterated their expectation that DBNRR will trend upwards over time towards their long-term target of 130% plus. During the Q1 2023 earnings call, management again explained that the declining DBNRR is not due to elevated churn but due to slower expansion from existing customers. 

Management’s explanation appears reasonable initially. However, I noticed that the comment “Gross retention above 90%” that was included in the Q4 2022 slide deck was removed from the Q1 2023 version above. The rest of the slide is identical. My assumption is that this comment has been removed because the gross retention has dropped below 90%.

4. Financial Analysis

Cloudflare’s growth and expansion of its customer base has resulted in a strong growth rate of around 50% annually for the past two years, with revenue reaching almost $1 billion in 2022.

However, this growth has slowed to 37% for the first quarter of 2023 with management citing:

a material lengthening of sales cycles, a significant decline in close rates, even as win rates held strong, and an extreme back-end weighting to the quarter

Cloudflare has some of the shortest sales cycles in the industry (<1 quarter) meaning that short sales cycle businesses usually see the impact upfront which resulted in the sales cycle increasing by 27%.

Cloudflare's gross margin has remained consistent for the past five years, ranging between 75% and 77%. This consistency indicates that Cloudflare has a good handle on its cost structure and has been able to maintain healthy margins even as it has grown. Cloudflare's cost of revenue primarily consists of expenses related to operating in co-location facilities, network and bandwidth costs, depreciation of equipment, and amortisation of internal-use software and acquired technologies. 

On a GAAP basis, Cloudflare is not yet profitable. The company recorded a Q1 2023 trailing twelve months (TTM) operating loss of $200 million resulting in an operating margin of -19%. 

Cloudflare achieved an important milestone in 2022 by achieving Non-GAAP profitability. As part of the Q4 2022 earnings, management laid out a clear path to achieving higher operating margins in the future, which will improve its financial performance and make it more competitive with its peers. 

Q1 2023 saw further improvements to the non-GAAP operating margin with management once again reaffirming the long-term model.

Cloudflare's improvement in operating margin has been driven by a reduction in the percentage of revenue allocated to sales and marketing (S&M), research and development (R&D), and general and administrative (G&A) expenses. The company has already reached its long-term target for R&D spend and is getting close to reaching the target for G&A. 

The increasing share of revenue generated by large customers is contributing to this improvement, as these customers are increasing their spend at a faster rate than overall revenue growth. This is driven by the adoption of more Cloudflare products, which can be upsold with less sales effort than landing a new customer. As a result, the expansion with large customers should support higher sales efficiency, allowing for less investment in sales and marketing while maintaining the same growth rate.

On the Q1 2023 earnings call Matthew Prince remarked: 

We've identified more than 100 people on our sales team who have consistently missed expectations. Simply put, a significant percentage of our sales force has been repeatedly underperforming based on measurable performance targets and critical KPIs. That's obviously a problem. But it's one in this environment with a particularly available and actionable solution. We are now in the process of quickly rotating out those members of our team who have been underperforming and bringing in new talent with salespeople who have a proven track record of success, grit, and a strong cultural fit

While this honesty might appear refreshing, it raises an important question. If the products truly have high demand, then why throw staff under the bus for not selling products that should be easy to sell?

The messaging around this was something that I was watching out for at the Cloudflare Investor Day 2023 which was held on 4 May 2023. The leadership team emphasized that:

We are not limited by TAM, opportunity or capacity, we are performance constrained

This message was consistently conveyed throughout the event, and the company has put forth a detailed 2023 Action Plan to improve performance, which is a positive development. We will soon discover whether the sales team or the Cloudflare products were responsible for the revenue slowdown.

Financial Position

• Total Liabilities as percent of Total Assets has disimproved from 66% in 2021 to 76% at Q1 2023 primarily as a result of the change in accounting treatment of Convertible Senior Notes (Prior to January 1, 2022, the Company accounted for its Convertible Senior Notes due 2025 and 2026 as separate liability and equity components; however, the adoption of ASU 2020-06 led to the Notes being accounted for as a single liability measured at its amortised cost).

• Significant level of debt (convertible senior notes) amounting to $1.4 billion making up 54% of total assets.

• Goodwill balance making up almost 6% of total assets arising from a series of acquisitions including Area 1 Security for a reported $162 million in 2022 (Source: Tech Crunch).

Cash Flow Analysis

Cloudflare's operating cash flow increased significantly in 2022 (+91% to $124 million), but a significant portion of this increase can be attributed to the sharp rise in stock-based compensation (SBC) expenses. The fact that SBC has increased by over 120% in 2022 to $203 million, which is over twice as fast as revenue growth, suggests that the company has been quite generous in awarding stock-based compensation to its employees.

This is concerning because of the amount of shareholder dilution that it is causing. At the end of 2022 there were 328.6 million shares outstanding compared to 321.7 million at the end of 2021. This represents shareholder dilution of 2.1% in 2022. Since the end of 2019, an extra 28 million shares outstanding are in circulation representing total dilution of over 9% in 3 years.

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Cloudflare recorded Q1 2023 TTM free cash flow of $44 million which improved from -$43m in 2021. Despite posting positive operating cash flow, Cloudflare has only recently started to produce positive free cash flow due to the investments in capital expenditure (CapEx) which have continued to ramp up at a CAGR of 40% over the past six years. 

Cloudflare's business model depends on robust global network infrastructure. Regular investment in network CapEx is critical to maintaining optimal performance and reliability of its services. It is reasonable to expect that network CapEx will gradually decrease over time, as the initial investments required to establish a global network infrastructure are completed. The focus will then shift to adding capacity to support increased usage. As part of the Q4 2022 earnings, management revealed that the company is allocating 11% to 13% for network CapEx in 2023, which is below the range set for 2022. Leadership have attributed this reduction to the flexibility, elasticity, and scalability achieved by the network.

Cloudflare is working to maintain and increase positive free cash flow margin going forward into 2023 and subsequent years. The introduction of new pricing and billing terms for pay-as-you-go customers, shifting from monthly to annual payments upfront is one initiative that should boost FCF. Customers who choose to remain on monthly payments will experience a 25% increase in cost. Although this segment represents less than 20% of Cloudflare's revenue, the lump sum payment upfront is expected to have a material impact on cash flow. Cloudflare is also negotiating for more front-loaded payment terms for the rest of its business under contract. By collecting cash at the beginning of a billing cycle, Cloudflare can increase its operating cash flow margins.

5. Competitive Landscape

Cloudflare is a Leader in the Magic Quadrant for Web Applications and API Protection (WAAP) compiled by Gartner. The report evaluates vendors based on their ability to provide security solutions for cloud-native web and API applications. The report highlights the importance of cloud-based security solutions and identifies the key features and functionalities that customers should consider when selecting a provider. 

Whilst Cloudflare is a leader in its field, it competes with several companies that offer similar solutions. Some of the main competitors include:

1. Akamai: Akamai is a global cloud and security provider and a Leader in the Magic Quadrant. Its primary offerings include a CDN and application security services. It has expanded its security portfolio with acquisitions and updates, including the merging of WAP with Kona Site Defender to create App & API Protector. Multiple add-ons and features are available, including Account Protector, updated ASE, and Terraform deployments.

2. Imperva: Imperva is a Leader in this Magic Quadrant and is a privately held application and data security vendor known for its advanced cloud WAAP features. Its Cloud WAF offering is part of the "Imperva Anywhere" portfolio, which includes other security services such as a WAAP gateway, database security, DNS security, and RASP. Notable improvements in the past year include better CDN and caching features, support for external HSMs, and enhanced bot protection with a new tarpit action. 

3. Radware: Radware is a Visionary in this Magic Quadrant, focused on applying machine learning techniques and rules to cloud WAAP security. They also offer innovative WAAP options for DevOps. Radware is primarily known for Distributed Denial-of-Service  (DDoS) protection and provides WAAP through various form factors, including appliances and as a cloud service. Recently, Radware added API threat protection features to its cloud WAAP, including automated detection of API changes and a feature to minimise false positives.

4. Fastly: FastlyCDN and DDoS provider, is a Challenger in this Magic Quadrant. Fastly's cloud-based WAAP, Next-Gen WAF, is deployed as a runtime agent and WAAP service. It relies on its proprietary SmartParse engine, which uses a mix of vendor, templated, and custom rules. Recently, Fastly has introduced edge rate limiting, Response Security Service, and support for GraphQL inspection and HTTP/3.

5. F5: F5 is a Niche Player in this Magic Quadrant. It provides a portfolio of application delivery and security products, including Distributed Cloud WAAP, Silverline Web Application Firewall, Silverline DDoS Protection, and Silverline Shape Defense. It also offers an appliance-based WAF (BIG-IP Advanced WAF) and a lightweight module for NGINX called App Protect. F5's February 2022 launch of Distributed Cloud WAAP is a significant step in its strategic shift to a cloud-native platform. F5 has also acquired Threat Stack to improve its cloud security and compliance capabilities.

* All figures in US$ billions

Research from The Forrester Wave positions Cloudflare as a Leader for Web Application Firewalls and a Strong Performer for Bot Management. The competitive landscape remains similar with Akamai and Imperva both featuring strongly.

Rule of 40

Cloudflare significantly outperforms its competitors according to the Rule of 40, despite being a relatively smaller player.

Despite Akamai's dominant position with $3.6 billion in revenue, which is almost four times larger than Cloudflare, it only grew its revenue by 4% compared to Cloudflare's impressive growth rate of 44% TTM. Akamai’s healthy FCF margin of 23% suggests that Cloudflare may achieve a FCF margin of over 20% within the next few years.

6. Management and Ownership 

Cloudflare was founded in 2009 by Matthew Prince, Michelle Zatlyn, and Lee Holloway. The founding story of Cloudflare began in 2004 when Matthew Prince and Michelle Zatlyn met while studying at Harvard Business School. After graduation, Prince worked at a law firm while Zatlyn worked at Google. In 2009, the two decided to start their own company and moved to California's Silicon Valley to work on their startup.

The idea for Cloudflare came to Prince while he was serving as a clerk for a judge in the U.S. Court of Appeals. He noticed that many websites, especially those of small and medium-sized businesses, were vulnerable to DDoS attacks and other cyber threats. Prince believed that he could help these companies by creating a system that would protect them from these attacks. Prince then reached out to Lee Holloway, a former colleague who had expertise in web performance and security. Together, they developed the initial concept for Cloudflare, a platform that would provide website security and performance optimization services.

As referenced in the intro, Cloudflare officially launched in 2010 and quickly gained popularity among website owners. The company's CDN and DDoS mitigation services helped websites load faster and stay online during peak traffic periods, while its security services protected them from cyber attacks. 

Cloudflare is led by its co-founders, Matthew Prince (CEO), Michelle Zatlyn (COO), and Lee Holloway (CTO). Regrettably, in 2015 Lee Holloway had to depart from the company due to frontotemporal dementia. Matthew Price is the largest individual shareholder in Cloudflare, with a 10.2% stake (Source: Fintel). This represents significant skin in the game and should mean that Prince's interests are closely aligned with those of other shareholders. The company's largest institutional shareholder is Morgan Stanley, which owns a 10.7% stake. Other major institutional shareholders include Vanguard and Baillie Gifford. 

Matthew Price achieves an 88% approval rating on Glassdoor with the company overall scoring 4.0 out of 5 by its own employees. Of note, some of the negative reviews relate to a change in culture and employee burnout.

Cloudflare's management is incentivized through long-term incentives and performance-based compensation, with no annual cash bonus program and no base salary increases in 2022. At the end of 2021, Co-founders Matthew Prince and Michelle Zatlyn were granted a 10-year performance-based option to purchase 3,960,000 shares of Cloudflare's Class A common stock, subject to certain stock price milestones being achieved and them remaining in primary leadership positions.

However, the Co-Founder Performance Awards were later forfeited by the co-founders after the Board of Directors withdrew the proposal to approve the awards from the agenda of the 2022 Annual Meeting, following feedback from stockholders, internal discussions, and advice from legal and other advisors. In April 2023, Cloudflare approved a special, one-time retention grant of 307,482 restricted stock units (RSUs) for each co-founder, which will vest quarterly over four years and are subject to double-trigger acceleration of vesting provisions. The new equity awards were structured as time-based equity awards sized for an annual grant, rather than the larger size and longer-term structure of the Co-Founder Performance Awards, to incentivize the co-founders to continue as key leaders in the short-to-mid-term and to drive business growth.

Thomas Seifert (CFO) and Douglas Kramer (General Counsel and Secretary) were granted long-term incentive compensation opportunities in February 2021 and 2022 in the form of restricted stock unit (RSU) awards and performance-based stock options that vest over four years based on the same stock price targets as the Performance Awards. However, due to market conditions and decline in the company's stock price, the original Performance Options were deemed to no longer incentivize the executives. Consequently, the Board of Directors approved amendments to the Performance Options in April 2023, which reduced the exercise price per share and modified the structure to contain nine separate tranches with updated Stock Price Targets. Tranche 1 Stock Price Target was more than halved from $156 to $72.

7. Risks

1. Customer Concentration

Cloudflare's risk of customer concentration is significant, given that more than 60% of its revenue is coming from large customers. The company generated $290 million in revenue in Q1 2023, and $174 million of that revenue came from 2,156 large customers. The average monthly revenue per large customer is $27,000, which suggests that the company's business model is heavily reliant on a relatively small number of customers.

On the other hand, the remaining $116 million in revenue came from a much larger customer base of 166,003 customers, with an average monthly revenue of just $233 per customer. This indicates that the company has a wide range of customers, from very small to very large, but that the revenue contribution from smaller customers is significantly lower.

The company's performance is dependent on upgrading paying customers to higher-tier subscriptions and expanding the number of products sold. The growth in new paying customers has slowed right down over the past two years meaning that Cloudflare is even more dependent on its existing large customers for revenue growth.

The company's gross retention rate falling below 90% further highlights the risk that large contracted customers could terminate their agreements, which could negatively impact the company's operations. Additionally, the company's customer retention rate is difficult to predict and may be impacted by a variety of factors such as customer satisfaction, economic conditions, and competition.

The company's subscription-based business model relies on customers renewing their subscriptions after the initial contract term. The mix of pay-as-you-go and contracted customers is important, as pay-as-you-go customers are an important source of revenue, but they are also more likely to terminate their subscriptions. Contracted customers have longer-term agreements, but they can still terminate their subscriptions under certain circumstances.

2. Product Risk

While Cloudflare is a leader in many of its areas, it is not without its product shortcomings which include limitations in deployment options, inconsistent post-sale support, and deficiencies in reporting and incident response capabilities as detailed by Gartner.

The fact that Cloudflare's offering lacks the option to run as an agent, a Kubernetes sidecar, or a containerized WAAP could deter organisations deploying API architecture and looking for a way to monitor east-west traffic. This limitation in deployment options could potentially lead to a loss of customers who require these features for their specific use case.

The inconsistent post-sale support provided by Cloudflare could lead to dissatisfaction among larger enterprise customers who expect more consistent and better support. This could result in a loss of customers who require reliable and consistent support to ensure the smooth operation of their business.

The deficiencies in reporting and incident response capabilities could lead to dissatisfaction among customers who require in-depth reporting and incident response capabilities to effectively manage their security. This could potentially lead to a loss of customers who require these features for their specific use case.

The cluttered and confusing management interface could also lead to dissatisfaction among customers who require a user-friendly and intuitive interface to easily perform custom security configuration. While Cloudflare has recently updated its WAAP UI based on customer feedback, it remains to be seen whether this will be sufficient to address customer concerns.

In comparison, Akamai offers a broad range of web application and web application security features, which appeals to large organisations looking to make a comprehensive set of features available in front of all their web applications. Akamai also offers leading threat intelligence capabilities with its client reputation feature and often releases new controls before the rest of the market. This gives Akamai a competitive advantage and could attract customers who value advanced features and capabilities. Akamai's consistently strong customer support creates trust and drives adoption, which is a notable achievement for a large platform provider. 

Similarly, Imperva offers multiple ML approaches for bot mitigation and event aggregation, which shows promise for simplifying the management and incident response process. Imperva's Account Takeover Protection module includes several interesting features, such as detection of credential stuffing, and is designed to determine malicious intent from successful logins or impossible logins. Imperva's "Imperva Anywhere" strategy resonates with security teams willing to centrally manage WAAP enforcement points in different form factors and to consider adjacent application security approaches, such as RASP and database security. Imperva's advanced features and innovative strategies could also pose a risk to Cloudflare's market position and customer base.

8. Opportunities

1. Network Leverage

Cloudflare has a significant opportunity for network leverage due to its ownership and operation of over 285 data centres across the globe, as well as the establishment of 12,000 network interconnects with regional ISPs, cloud service providers, and large enterprises. These interconnects were established through the provision of free services to individual users and small businesses, resulting in many connections being by invitation. This network leverage provides Cloudflare with a competitive advantage, as it enables the company to offer faster, more reliable, and more secure services to its customers.

Moreover, all services run on every host in every data centre, making every service deployment fully global and distributed as a first principle. The serverless runtime allows for critical isolation, enabling all Cloudflare products to be supported on one common backplane without creating a mess of code conflicts. This architecture provides enormous benefits, such as the ability to push new capabilities to the whole network at once, instead of planning for an additional layer upon which to host the service. This greatly increases the rollout speed and allows hardware resources to be shared across all services, resulting in significant cost savings.

Cloudflare's highly distributed development platform also provides a significant opportunity for network leverage. By maintaining a development platform, Cloudflare incurs overhead, but it also enables composability, where new offerings can be bootstrapped with the building blocks from prior releases. This approach accelerates product development and allows Cloudflare to provide customizable and personalised products to customers.

The architectural tenets embraced by Cloudflare differ from the conventional approach taken by most software infrastructure providers. As such, it is challenging for hyperscalers or new entrants to duplicate this approach. For new entrants, it would require building a network of 285+ data centres similar to Cloudflare's scale, resulting in significant capital expenditure costs. For hyperscalers, it would require a significant re-architecting of their systems and likely conflict with existing revenue streams.

Cloudflare's ownership of their infrastructure allows them to offer cost and performance advantages over competitors. Their free tier of services provides new product efficacy benefits and allows them to safely battle test new capabilities. This usage tier also feeds security efficacy and provides a way to identify threats and malicious behaviour. Cloudflare's powerful and generous offerings for application protection have made them the entry point for 22% of the world's busiest websites. This relationship provides an opportunity for Cloudflare to cross-sell and upsell IT teams on additional services and provides an advantage to their Zero Trust offering.

2. Innovation and Expansion

Cloudflare’s rapid pace of innovation and expansion has resulted in its addressable market increasing from $32 billion in 2018 to $204 billion in 2026. Leadership believes the company can reach an annual revenue run rate of $5 billion within five years based on its existing products and services. Cloudflare's revenue run rate exceeds $1 billion implying that it has penetrated less than 1% of a $146 billion market in 2023 for its existing portfolio of products. The company sees further potential in various areas, including AI, databases, Internet of Things (IoT), 5G, and network services. 

What makes this target achievable is that it is not dependent on taking significant market share from cloud hyperscalers. Instead, the company is looking to compete in developer services, such as object storage, where it can offer lower latency and cheaper pricing leveraging its global network.

Cloudflare's R2 storage product is an excellent opportunity for the company to expand its AI solutions by providing a neutral location for storing and accessing data across multiple cloud providers. As more companies move towards multi cloud environments, R2's consumption-based model can drive revenue growth as AI datasets continue to expand. Cloudflare's largest R2 customers are AI companies that are experiencing extraordinary growth as they put more data into their models. 

A leading generative AI company signed a one-year $1 million deal. The company had been a user of our free tier since 2017. And this deal originally started out as a relatively small gateway DNS opportunity to replace Cisco umbrella. However, when their browser-based application debuted in late November, demand for the company's AI-generated content absolutely exploded with unprecedented rates of adoption

The company in question is OpenAi, the developers of ChatGPT.

Cloudflare's differentiated data localization suite can become more critical to customers as localization and data residency requirements become law in various geographies. Furthermore, Cloudflare's R2 and other workers' products can become the glue at the centre of a multi cloud ecosystem, which is a significant opportunity for the company.

Cloudflare's Zero Trust security products are gaining traction in the market, as evidenced by several large deals with Fortune 500 companies and a European financial services company. Additionally, Cloudflare is gaining traction in the U.S. government market, aided by their recent FedRamp moderate authorization in December. They landed a major $7.2M five-year deal to operate DNS for the .gov registry, which is significant for Cloudflare as it connects their network to every federal agency, offering an entry point for other service upsells.

A recent survey conducted by Morgan Stanley indicated Cloudflare is making significant progress in this market compared to its Secure Access Service Edge (SASE) competitors. The results showed that Cloudflare has gained a larger market share than its SASE peers.

This traction in the market was further acknowledged by Gartner in the 2023 Magic Quadrant for Security Service Edge (SSE) report, becoming the only new vendor to receive recognition. 

Cloudflare's expanding set of products is an excellent opportunity for the company to consolidate security vendors, reduce costs, gain more control over traffic flow, and implement Zero Trust. 

9. Valuation

Discounted Cash Flow

This absolute valuation method has a number of limitations related to appraising the value of Cloudflare due to the company’s architectural decisions, infrastructure ownership and business life cycle stage. 

Discounted Cash Flow (DCF) analysis assumes steady cash flows, but Cloudflare's infrastructure ownership model may result in higher upfront CapEx costs and lower free cash flow early on, limiting potential for early cash flow margin expansion, which is a critical factor in DCF analysis. Additionally, Cloudflare's infrastructure ownership model does not fit traditional valuation models that assume a fixed cost structure, and its CapEx investments may be more variable, making forecasting more challenging.

Forecasting revenue and margins for companies that rapidly innovate and introduce new products and services is difficult particularly when the focus is not on maximising profitability. Cloudflare is an example of this, as the company has diversified its product portfolio and expanded its market segments over the past five years, growing almost five times larger than its original target market.

With all of the caveats out of the way, let’s take a look at the valuation and assumptions.

Using a discount rate of 10% and a conservative terminal value of 12, I have estimated the cash flows for the next five years. Considering the inherent difficulty in accurately projecting future cash flows for this business, I believe that a cautious approach is necessary.

I have used management’s updated guidance as the baseline for 2023 as I believe this is achievable. Looking further ahead, management expects to reach $5 billion of revenue within five years achieving a CAGR of 38%. My estimate of $4.4 billion is 12% short of the $5 billion target due to the lowered guidance for 2023 as I struggle to see how this can be achieved with a high degree of certainty, unless revenue growth accelerates significantly. 

Given the increased focus on cash flow and profitability from the leadership team, I project that Cloudflare can achieve management’s long term guidance for operating margin above 20% within five years which could translate to an OCF margin of 30%. As a yardstick, Akamai posted an OCF margin of 35% in 2022. 

Network CapEx is expected to trend down overtime which could result in overall CapEx as a percentage of revenue as low as 13% within five years. Akamai which also makes significant investments in building out data centres and network connectivity spent 13% of revenue on CapEx in 2022. This would result in a FCF margin of 19% by the end of 2027. During the Investor Day 2023, leadership expressed confidence in achieving a long-term free cash flow margin exceeding 25%.

Earlier analysis identified significant shareholder dilution over the past number of years. In 2022, the dilution rate was 2.1% (2021 4.7%, 2020 2.4%) but management has committed to a 3% cap on SBC dilution going forward. I have assumed an average dilution rate of 2% over the next five years.

Based on these assumptions the fair value of Cloudflare is close to $28 per share suggesting a potential downside of 44% based on the share price 11 May 2023. Of course, this needs to be taken with a grain of salt due to the limitations discussed earlier. Nonetheless, it is important to note how the margin profile of the company could evolve over time.

Enterprise Value to EBITDA Ratio (EV/EBITDA)

Cloudflare trades at a forward EV/EBITA of 76. While the ratio has improved significantly, it can appear a bit misleading as Cloudflare is not optimised for profitability. 

Nonetheless, Cloudflare trades at a significant premium to all of its competitors. While one would expect Cloudflare to command a premium given its faster growth rate and potential growth opportunities, the fact that it is five times more expensive than the nearest competitor indicates how rich the valuation really is.

10. Investment Outlook

Cloudflare has managed to achieve an incredible growth trajectory since it entered the public markets in 2019. The company's unique platform enables it to provide a range of services that help its customers improve the security, performance, and reliability of their internet-based applications and websites.

One key factor to consider when assessing the competitive durability of Cloudflare is the "snap test” - if the company were to disappear, would anyone notice? In this case, the answer is yes due to the critical role that Cloudflare plays in the overall internet. The company's network outage in 2021 highlighted just how important its services are to keeping the internet running smoothly and securely.

However, investing in Cloudflare is not just about the present state of the business but also the return that can be achieved from this point. Even allowing for the limitations in the DCF valuation pertinent to Cloudflare, it is richly valued on a relative basis, which means that investors need to ask themselves how much they are willing to pay for future growth. This is especially important given the inherent execution risk that comes with investing in a company like Cloudflare, where future returns are likely to be driven by products and services that have not yet been developed.

Although enterprises continue to rightsize their IT operations, Cloudflare's products are backed by strong long-term growth prospects. The company has a history of attracting major enterprise clients by rapidly innovating and delivering crucial internet-based services. If Cloudflare can successfully execute its updated go-to-market strategy and achieve a string of positive earnings beat and raises the negative sentiment that surrounds the stock would dissipate and the stock could rally. Any miss on growth expectations will cause short-term pain to investors as seen by the price reaction following the Q1 2023 earnings report.

Disclosure: At the time of writing, the author holds a long position in Cloudflare, Inc.

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What makes Datadog such a highly sought-after investment in the cloud technology industry, that it could reject a multi-billion dollar acquisition offer and is it worth investing in today?

Contents

1. Executive Summary

2. Overview

3. Customer Base

4. Financial Analysis

5. Competitive Landscape

6. Management and Ownership

7. Risks

8. Opportunities

9. Valuation

10. Investment Outlook

1. Executive Summary

• Datadog's success can be attributed to its early entry into cloud-based monitoring, offering a unified view of infrastructure, applications, and logs. Additionally, the company's diverse customer base, impressive retention rate, and increasing platform adoption demonstrates its ability to serve multiple industries and continue its growth trajectory.

• Substantial investment in R&D, which has steadily increased over the years, reflects its commitment to enhancing its platform and providing its customers with new and improved features. This has resulted in a self-selling product that continues to drive revenue growth, while also allowing the company to rapidly innovate ahead of competitors and maintain a strong market position.

• The cloud monitoring industry is a rapidly evolving and fast-paced environment, which poses several risks for Datadog, including disruption from emerging technologies, potential consolidation in the industry, increased competition, and the risk of customers switching to other solutions. Moreover, Datadog faces the risk of IT rightsizing leading to revenue growth slowdown and squeezed margins, which could result in reduced demand and surplus personnel.

• Market leadership position as acknowledged by Gartner and The Forrester Wave, underscores the competitive advantage. Datadog is well-positioned to benefit from the ongoing growth in cloud computing spend and the expanding observability market, with a significant opportunity to capture a larger share of the market.

2. Overview

Datadog is a cloud-based monitoring and security platform that integrates infrastructure monitoring, application performance monitoring, and log management. It provides real-time observability of an organisation's entire technology stack, enabling digital transformation and cloud migration. The platform is used by organisations of all sizes and across various industries to drive collaboration among development, operations, security, and business teams, accelerate time to market for applications, reduce time to problem resolution, secure applications and infrastructure, understand user behaviour, and track key business metrics.

Datadog was founded in 2010 with the goal of breaking down silos between Dev and Ops teams and facilitating collaboration. Since then, the platform has continuously expanded to unify separate tools into an integrated monitoring and analytics platform. Datadog's platform combines metrics, traces, logs, and other data from over 500 integrations to provide a unified view of infrastructure, application performance, and real-time events impacting performance. The platform is designed to be cloud agnostic and easy to deploy, with hundreds of out-of-the-box integrations and extensive customisations. Datadog's business model is centred around offering easy-to-adopt products that have a short time to value, and the company grows with its customers as they expand their workloads in the public and private cloud.

I can appreciate that much of the audience reading this report might not be from a technology background. In layman's terms, Datadog is a platform that helps businesses monitor their computer systems, networks, and applications. It collects and analyses data from different sources such as servers, cloud services, and databases to provide insights on the performance, security, and availability of these systems. Essentially, Datadog helps businesses keep their technology running smoothly and alerts them to potential problems before they turn into major issues. 

In terms of the costs, you can sign up to use a number of the platform features for free. For example, the infrastructure product can be used for free albeit with limited capability compared to the Pro and Enterprise licences.

Datadog offers a consumption-based pricing model allowing customers to pay only for the amount of data they store, the number of hosts they monitor, or the number of requests they make to the Datadog API. This pricing model is advantageous for customers with dynamic workloads or those who do not need to monitor a large number of resources continuously.

3. Customer Base

Datadog’s consumers consist of organisations of all sizes, in all industries, both private and public.

Some key metrics related to Datadog's customer base as of the end of 2022:

• Total Customers: Datadog has been able to maintain a high rate of customer growth which is a positive indicator for the company's ability to attract new customers and expand its user base.

• Annual Recurring Revenue (ARR): Datadog's ARR has seen significant growth in both the number of customers with high ARR and the total ARR value. The increase in the number of customers with ARR of $100,000 or more indicates a trend of strong growth in the high-value customer segment.

• Customer Retention Rate: Datadog has a high customer retention rate, with a dollar-based net retention rate (DBNRR) of above 130% for each of the past three years. For context, a DBNRR above 100% indicates that the company is generating more revenue from its existing customers than it lost from churn and contraction. The Datadog DBNRR means the company's strategy for upselling and cross-selling to existing customers has been effective, resulting in increased revenue per customer.

• Platform adoption: Platform adoption is increasing, and customers are using more products on the platform. This indicates that the platform is becoming more valuable to customers, and they are finding more ways to use it to meet their needs. Customers are not only using more products but are also becoming more deeply engaged with the platform, which could have positive implications for customer retention and loyalty.

4. Financial Analysis

Datadog’s growth and expansion of its customer base has resulted in growing revenue at a phenomenal rate over the past number of years. 

Datadog has been able to maintain a high gross margin while experiencing rapid growth, which suggests the company has been successful in managing its costs. As a software company, Datadog's main cost of sales comes from third-party cloud infrastructure hosting and software costs. These costs can be difficult to manage as the company grows, which makes the improvement in gross margin noteworthy.

On a GAAP basis, Datadog is not yet profitable. During 2022, the company recorded an operating loss of $59 million compared to a loss of $19 million in 2021. Operating expenses in 2022 amounted to $1.387 billion representing an operating margin of -4%.

Datadog invests heavily in research and development (R&D) to maintain its position as a market leader. In fact, R&D expenses represent the most significant component of Datadog's operating expenses.

R&D as a percentage of revenue increased from 23% in 2017 to 45% in 2022. This demonstrates Datadog’s commitment to maintaining its competitive edge by continuing to invest in the development of new products and features, and shows the importance that Datadog places on innovation, and how it values staying ahead of the curve.

The increase in R&D expenses over the past six years mirrors the increase in new platform products.

Sales & Marketing (S&M) expenses amounted to 36% of operating expenses in 2022. This represents an increase of 65% YoY and broadly follows the increase in revenue of 63%. More importantly, the S&M expense as a percentage of revenue has been trending downwards over the past five years. 

The S&M expense as a percentage of revenue trending downwards in tandem with the R&D expense as a percentage of revenue trending upwards suggest that Datadog’s products sell themselves. Instead of spending dollars convincing customers to use its products, Datadog is ploughing its gross profit into R&D for additional product features to serve its existing (and prospective) customers.

Financial Position

• Total Liabilities as percent of Total Assets is 53% improving from 56% YoY 

• Accounts receivable increased 49% YoY to $400 million but slower than the revenue increase of 63%

• Modest level of debt (convertible senior notes) amounting to $738 million making up 25% of total assets

• Goodwill balance making up almost 12% of total assets arising from a series of acquisitions including Screen SAS for a reported $220 million in 2021 (Source: Marketscreener)

Cash Flow Analysis

Datadog’s operating cash flow increased significantly in 2022 (+46% to $418 million), but a significant portion of this increase can be attributed to the sharp rise in stock-based compensation (SBC) expenses. The fact that SBC has increased by over 120% in 2022 to $363 million, which is twice as fast as revenue growth, suggests that the company has been quite generous in awarding stock-based compensation to its employees.

This is concerning because of the amount of shareholder dilution that it is causing. At the end of 2022, there were 317.6 million shares outstanding compared to 312.0 million at the end of 2021. This represents shareholder dilution of 1.8% in 2022. Since the end of 2019, an extra 21.8 million shares outstanding are in circulation representing total dilution of over 7% in 3 years.

Datadog recorded free cash flow of $354 million in 2022 which grew over 41% YoY. This represents a FCF margin of 21% down from 24% in 2021 but above 14% in 2020. 

Return on Invested Capital (ROIC)

Datadog has posted a negative ROIC for the past four years. This is driven by the fact that Datadog has not recorded an operating profit. Quality investors would view anything above 10% as an indicator of capital allocation.

It is my view that investors can only evaluate management's capital allocation skills after Datadog finishes its current period of intense R&D.

Rule of 40

Datadog significantly outperforms its competitors according to the Rule of 40, which is a comparison metric for high-growth SaaS companies that are not yet profitable. The Rule of 40 states that a company's revenue growth rate plus FCF margin should be equal to or greater than 40%.

Datadog is growing faster and has a higher FCF margin, except for Dynatrace, whose FCF margin of 27% is slightly higher than Datadog's 21%. This demonstrated Datadog's strong financial performance and that it is managing to balance its growth and profitability effectively, even though it is not yet GAAP profitable.

5. Competitive Landscape

Datadog is a leader in the Artificial Intelligence for IT Operations (AIOps)  report compiled by The Forrester Wave (Source: Datadog Investor Relations). The research identifies, evaluates and scores the 11 top vendors offering products with AIOps capabilities. 

Whilst Datadog is a leader in its field, it competes with several companies that offer similar solutions. Some of the main competitors include:

1. Dynatrace is a cloud-based observability platform that provides AI-powered monitoring and analytics for applications, infrastructure, and logs. The company offers solutions for monitoring performance, optimising user experience, and accelerating digital transformation.

2. New Relic is a cloud-based observability platform that provides real-time monitoring and analytics for applications, infrastructure, and logs. The company offers solutions for monitoring performance, optimising user experience, and troubleshooting issues.

3. Splunk is an enterprise-grade data analytics platform that provides real-time insights into machine-generated data. The company offers solutions for IT operations, security, and business analytics.

4. Elastic is a search and analytics platform that provides real-time insights into structured and unstructured data. The company offers solutions for logging, monitoring, and security analytics.

5. AppDynamics is a cloud-based application performance monitoring and analytics platform that provides real-time insights into application performance, user experience, and business impact. The company offers solutions for monitoring cloud-native applications, microservices, and containerized environments.

1. Revenue TTM = Revenue Trailing Twelve Months

2. Revenue FY1 Est = Revenue Growth Estimate for next Financial Year

3. R&D ratio = R&D expenses as a percentage of revenue

4. SG&A ratio = Sales, General & Admin expenses as a percentage of revenue

Compared to its competitors, Datadog is prioritizing R&D investments over S&M, allocating 45% of its revenue to R&D, which is significantly higher than its nearest competitor's 30%. Instead of relying on marketing campaigns like its competitors, Datadog is focusing more on its technology and product offerings to attract and retain customers.

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6. Management and Ownership 

Datadog was founded in 2010 by Olivier Pomel and Alexis Lê-Quôc. The two co-founders were previously working together at Wireless Generation, a company that provided educational software and services to K-12 schools. While working at Wireless Generation, Pomel and Lê-Quôc became frustrated with the existing tools available for monitoring and troubleshooting the company's infrastructure and applications. They found that the available tools were too complex and didn't provide the level of insight they needed to quickly identify and resolve issues.

To solve this problem, Pomel and Lê-Quôc decided to develop their own monitoring and analytics platform. They envisioned a platform that would be easy to use, offer real-time visibility into the entire stack of infrastructure and applications, and provide powerful analytics and alerting capabilities. In 2010, the two co-founders left Wireless Generation and founded Datadog. They started by building a simple prototype of their monitoring platform and began testing it with a few early customers. The platform was quickly embraced by customers, who appreciated its ease of use, real-time visibility, and powerful analytics.

Olivier Pomel and Alexis Lê-Quôc currently serve as the CEO and CTO, respectively. Oliver Pomel is the largest individual shareholder in Datadog, with a 7.40% stake whilst Alexis Lê-Quôc holds 4.6% (Source: Fintel). The company's largest institutional shareholder is The Vanguard Group, which owns a 8.4% stake. Other major institutional shareholders include Morgan Stanley and Blackrock.

Oliver Pomel appears to be well received at Datadog with a 92% approval rating on Glassdoor with the company overall scoring 4.0 out of 5 by its own employees. 

The 2022 annual report is not available yet so I have used the 2021 version to appraise the incentive scheme for management which is determined by the compensation committee. The Executive Compensation program includes a fixed base salary and annual performance-based cash bonuses. The bonus is determined by the achievement of pre-established company-wide priorities, set by the compensation committee, and reflects the executives' results and achievements in a given year. The compensation committee determined the size of the named executive officers' target bonus opportunities based on a review of various factors.

For 2021, the performance goals were based on the attainment of new ARR, with certain decelerators applied for all named executive officers if non-GAAP operating income fell below a target amount. The performance target for ARR was 100% of Datadog's fiscal year 2021 operating plan. The executives will only earn a bonus if the new ARR attainment is at least 80% of the performance target. In February 2022, the corporate performance goals for fiscal 2021 were determined to be 163% of the target, resulting in a bonus payout equal to approximately 243% of the named executive officers' annual target bonus opportunities. The realised value of equity awards is also a significant part of the executive compensation package.

It appears that Datadog management is incentivised to build shareholder wealth, as their annual performance-based cash bonuses are tied to the achievement of pre-established company-wide priorities, including the attainment of new ARR and non-GAAP operating income targets. 

7. Risks

1. Rapidly Evolving Industry

The cloud monitoring industry is a rapidly evolving and fast-paced environment, which poses several risks for Datadog. The company operates in a highly dynamic market that is subject to constant change due to emerging technologies, changing customer needs, and evolving industry standards. This makes it challenging for Datadog to keep pace with the latest trends and maintain its competitive position in the market.

One of the key risks associated with the fast-paced nature of the cloud monitoring industry is the potential for disruption. New technologies, products, and services are constantly emerging, and it can be difficult for companies like Datadog to stay on top of these developments. This requires a deep understanding of the market, as well as a commitment to ongoing research and development to stay ahead of the competition.

Another risk is the potential for consolidation in the industry. The cloud monitoring market is highly fragmented, with many small players competing for market share. As the market matures, it is likely that larger players will emerge, which could lead to consolidation through mergers and acquisitions. This could pose a threat to smaller players like Datadog, which may struggle to compete with larger, more established players with greater resources.

In addition, the cloud monitoring industry is seeing increased competition from new entrants. For example, Google-backed competitor Chronosphere has emerged as a potential disruptor in the market (Source: The Information). Distribution is key, as demonstrated by Microsoft's successful integration of Teams within the Office suite to compete with Zoom. The Hyperscalers could follow suit by bundling monitoring tools with their cloud platforms to make them more attractive and easily accessible than Datadog's offerings. This poses a risk for Datadog, which may struggle to maintain its market share in the face of increased competition.

The durability of Software-as-a-Service (SaaS) businesses is also a concern. While the recurring revenue model that underpins SaaS businesses like Datadog is attractive, there is always the risk that customers may switch to competitors or switch to other solutions altogether. This could lead to revenue churn and reduced profitability for the company.

To mitigate these risks, Datadog will need to remain agile and adaptable in the face of a rapidly evolving industry. This will require ongoing investment in research and development, as well as a commitment to staying ahead of emerging trends and technologies. The company may also need to explore strategic partnerships and collaborations to strengthen its competitive position in the market.

The rapidly evolving nature of the cloud monitoring industry can pose a risk for Datadog investors who may not have the necessary subject matter expertise to stay up-to-date on industry trends and developments. Investors who are not familiar with the nuances of the cloud monitoring market may find it difficult to fully evaluate the company's competitive position, growth prospects, and overall business strategy.

As part of my research process, I was fortunate to be able to discuss Datadog with Francis from the Software Analyst Newsletter. I recommend following him and checking out his work around Cybersecurity and DevOps.

2. IT Rightsizing

While Datadog has experienced strong growth in recent years, the company's latest earnings report suggests that it may be facing a risk of IT rightsizing. IT Rightsizing is the process of optimising IT resources to match business needs. This can involve reducing or increasing the amount of IT resources allocated to specific functions or departments to ensure that they are aligned with the organisation's goals and objectives. 

One key factor contributing to this risk is the slowdown in Datadog's revenue growth. While the company's revenue is still growing, it is doing so at a slower rate than analysts had predicted. For context, Datadog is expected to grow revenue by 24% in 2023 down sharply from 63% achieved in 2022. Datadog attributes this to macro headwinds affecting its lower-end customers and more conservative cloud spending across the enterprise market. This suggests that Datadog's customers may be looking to optimise their cloud workloads and normalise spending, which could result in reduced demand for Datadog's services.

Another factor contributing to the risk of IT rightsizing is Datadog's expectation that its margins will be squeezed as its near-term growth cools off. While the company has been able to expand its operating margins in recent years, it expects that figure to drop as growth slows. This could make it more difficult for Datadog to maintain its current level of investment in R&D, which could in turn make it more difficult for the company to stay competitive in the long term.

To address these challenges, Datadog is planning to increase its headcount by a mid-20s percentage in 2023. While this may help the company to continue innovating and developing new services, it could result in an excess of personnel and resources relative to the company's actual needs, which could lead to inefficiencies and waste if growth does not pick up as expected.

Overall, the risk of IT rightsizing for Datadog appears to stem from a combination of factors, including slower revenue growth, squeezed margins, and a potential excess of personnel and resources. To mitigate this risk, Datadog will need to continue innovating and developing new services that meet the evolving needs of its customers, while also keeping a close eye on costs and avoiding excessive investment in areas where demand may be limited.

8. Opportunities

1. Land and Expand

The Land and Expand model is a business strategy where companies initially introduce their products to a smaller segment of the market, and then expand their offerings within that market over time. Datadog has been successful in implementing this model, and it has become a significant driver of their growth.

One of Datadog's competitive advantages is their rapid and efficient product development process. They can build and release new product offerings faster than their competitors, which allows them to continuously offer new and relevant modules to their existing customer base. This strategy has proven successful as Datadog's annual user conference, Dash, highlights the number of new product releases they have planned, which has increased by 80% compared to the previous year. This demonstrates their commitment to offering new solutions to their customers, which in turn, helps increase revenue from existing customers.

Datadog's Land and Expand model has proven successful as it allows them to grow with their customers. As their customers' businesses grow, they add new modules which results in incremental revenue growth for Datadog. Additionally, as Datadog continues to develop new product offerings, their customers have more options to choose from, which creates more opportunities for revenue growth.

Furthermore, Datadog's position as a market leader in the Magic Quadrant for Application Performance Monitoring and Observability by Gartner reinforces their potential to expand their customer base. This recognition highlights the quality of their product offerings and their ability to compete effectively in a rapidly evolving industry. Leveraging research from subject matter experts like Garnter is one way for investors to navigate the risk of a rapidly evolving industry. 

Datadog's Land and Expand model has been a significant driver of their growth. Their rapid and efficient product development process allows them to offer new and relevant solutions to their existing customer base, resulting in incremental revenue growth. As they continue to develop new product offerings, they have the potential to expand their customer base and become an even more dominant player in the cloud monitoring industry.

2. Cloud Computing Adoption

Datadog stands to benefit from the ongoing growth in cloud computing spend, which is expected to continue over the coming years. As more businesses adopt cloud-based infrastructure and services, the demand for cloud monitoring and observability tools like Datadog is likely to increase.

According to research by Gartner, global cloud computing spend is projected to reach $1 trillion by 2026 with the cloud spend as a percentage of total IT spend increasing from 10% to 17%. This growth is being driven by the increasing adoption of cloud-based technologies by businesses of all sizes.

In addition to the growth in cloud computing spend, Datadog also has a significant opportunity in the observability market. According to Gartner, the observability total addressable market (TAM) is expected to reach $62 billion by 2026. As a leader in the observability space, Datadog is well-positioned to capture a significant share of this growing market. The company's ability to rapidly develop and release new product modules gives it a competitive advantage, allowing it to meet the evolving needs of its customers and stay ahead of its competitors. Additionally, Datadog's reputation as a market leader in application performance monitoring and observability, as recognised by Gartner, further enhances its potential for growth in the market.

The growth in cloud computing spend and the expanding observability TAM represent significant opportunities for Datadog to continue its growth trajectory and capture a larger share of the market.

I recently published a primer article on cloud computing for those interested in reading more about this area.

9. Valuation

Discounted Cash Flow

I have projected the future cash flows over 5 years using a discount rate of 10% and a terminal value of 12. I am opting to use a terminal value on the lower end of the range due to the risk factors identified. I believe that it is difficult to project the future cash flows with a great level of certainty. 

I have used management guidance as the baseline for 2023 and modelled the FCF to be slightly above adjusted EBIT margins per the historic trend. From 2024 to 2026, I estimate that revenue growth will reaccelerate back to the low 30% and EBIT margins to creep north.

In 2022, Datadog posted revenue of $1.76 billion which represented 4% of the observability TAM per Gartner. By 2026, I project Datadog revenue of $4.87 billion or almost 8% of the Gartner TAM which seems reasonable for the category leader. In 2027, I estimate revenue growth to fall back to the mid twenties.

Earlier analysis identified significant shareholder dilution over the past number of years. In 2022, the dilution rate was 1.8% (2021 2.5%, 2020 3%) and I have assumed the dilution rate to incrementally fall to 1% by the fifth year of the projection. 

Based on these assumptions I believe that the fair value of Datadog is close to $77 per share suggesting a potential upside of 13% based on the share price on 13 April 2023.

Price-to-Earnings Ratio (P/E)

Datadog trades at a forward P/E ratio of 63. While the ratio has improved significantly, it can appear a bit misleading as Datadog is not optimised for profitability. The company is investing heavily in R&D to prioritise long-term over short-term profitability

Datadog trades at a premium to most of its competitors, except for one, which is expected given its status as a category leader, its faster growth rate and potential growth opportunities that it’s R&D investments could generate in the future.

10. Investment Outlook

So far, the execution from Datadog has been flawless. It has achieved category leader recognition from both Gartner and The Forrester Wave. While growing faster than its competitors, it has also accelerated product development which is showing no signs of slowing down. The number of customers that are using more products is increasing in each cohort and this is indicative of a competitive advantage driven by switching costs.

However, the durability of this competitive advantage is uncertain due to the rapidly evolving nature of the industry. While Datadog is currently at the top, identified risk factors indicate that this cannot be taken for granted. In my view, it is difficult to predict who will be the top dog (pun intended) in the observability market in ten years time with any degree of certainty. One thing I can say is that I think the market will be much, much bigger than it is today. 

The absolute valuation appraisal implies that the company is undervalued with a modest margin of safety. I have used conservative assumptions but if Datadog can reaccelerate growth at a faster rate than assumed and increase its market share the upside could be even more favourable to investors. Relative valuation analysis indicates that the stock is trading at a premium to its peers and that the market has priced in much of this growth. 

Disclosure: At the time of writing, the author holds a long position in Datadog, Inc.

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Wolf of Harcourt Street

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What makes MELI such a dominant force in Latin America's e-commerce industry, and can it continue to achieve such an incredible return on investment for investors?

Contents

1. Overview

2. Customer Base

3. Financial Analysis

4. Competitive Landscape

5. Management and Ownership

6. Risks

7. Opportunities

8. Valuation

9. Investment Outlook

MercadoLibre, Inc.

Ticker: MELI

Sector: Consumer Cyclical

Market Cap: $59.9 billion

1. Overview

MELI is the largest online commerce ecosystem in Latin America, serving 18 countries. It provides six integrated e-commerce and digital financial services including Mercado Libre Marketplace, Mercado Pago Fintech platform, Mercado Envios logistics service, Mercado Credito, Mercado Ads solution, and Mercado Shops online storefronts solution. 

Mercado Libre Marketplace is an online commerce platform accessible through website and mobile app. It allows sellers, merchants, and individuals to list and sell merchandise across various categories such as electronics, apparel, home goods, toys, books, and consumer packaged goods.

Mercado Envios is a logistics solution offered by MELI in several countries. It allows sellers on the platform to use third-party carriers and logistics services, as well as offering warehousing and fulfillment services. By using Mercado Envios, sellers can offer a streamlined shipping experience to buyers and may be eligible for shipping subsidies. The volume Mercado Envios manages through its network means that it can offer better prices to merchants on logistic services.

Mercado Pago is a digital payments solution developed by MELI initially to facilitate secure and easy transactions on its Marketplaces. It now has evolved to offer a financial technology ecosystem in the digital and physical worlds, including checkout and payment processes for merchants on their own websites and physical stores as well as credit offerings to scale their business. Mercado Pago is available in several Latin American countries and aims to provide end-to-end financial technology solutions to underserved individuals and businesses, including those operating in the informal economy.

Mercado Credito is a credit solution available in several Latin American countries. It leverages MELI's loyal and engaged user base, both offering credit lines to online merchants and mobile point of sale device users as well as to buyers on and off Mercado Libre’s marketplace. The credit solution is differentiated from traditional financial institutions by using proprietary credit risk models with unique data that differentiate their scoring. In addition to loans for MELI purchases, personal loans are also available. Mercado Pago credit card was launched in Brazil in 2021, allowing users to pay in installments and earn additional points from its loyalty program, Mercado Puntos. 

Mercado Ads is an advertising platform that allows brands and sellers to display ads on MELI's webpages, increasing the likelihood of conversion. Mercado Ads enables merchants and brands to access the millions of consumers that are on its Marketplaces at any given time with the intent to purchase, which increases the likelihood of conversion.

Mercado Shops is a digital storefront solution that allows users to set up and manage their own digital stores, with integration with MELI's ecosystem.

Underpinning the entire MELI ecosystem is a loyalty program that offers benefits based on a point-generation system including discounts on shipping and access to third-party video content. Users can also subscribe for a monthly fee without having to reach the required points organically.

2. Customer Base

Given MELI's large customer base, it is diverse, and spans most age groups, income levels, and countries. However, certain trends and patterns can be identified. Here are some insights into MELI's customer base:

Geographic Distribution

As mentioned earlier, MELI operates in 18 countries across Latin America including Argentina, Brazil, Mexico, Uruguay, Colombia, Chile, Peru, Ecuador.

Brazil is the largest market for MELI, accounting for around 54% of the company's total revenue in 2022, followed by Argentina and Mexico.

Income Levels

MELI's customer base includes a wide range of income levels, from low-income to high-income earners. However, the company's growth has been driven in large part by the expansion of the middle class in Latin America in tandem with a significant increase in mobile phone penetration as well as the expansion of its logistics network. This has fueled demand for online shopping and created new opportunities for e-commerce companies like MELI.

Shopping Habits

MELI's customers have unique shopping habits, reflecting the diverse cultures and preferences across Latin America. For example, in Brazil, where cash is still widely used, MercadoPago has been instrumental in driving online sales by offering both cash-based payment options  as well as electronic ones. It is important to highlight that as the Brazilian Central bank has launched its own payments platform, PIX, MELI should be a direct beneficiary of more and more people paying electronically and entering the financial system. In Argentina, where inflation is a significant issue, many consumers have turned to MELI as a way to protect their purchasing power by buying and selling goods and services online.

Now, let’s view the MELI customers through the key service offerings.

Mercado Libre Marketplace

In Q4 2022, MELI’s FX-neutral GMV growth accelerated to 35%, with Brazil and Mexico driving the acceleration on the back of higher items sold. Unique buyers reached its highest ever level of 46 million, up 13% year-on-year, driven by growth in Brazil and Mexico.

Mercado Envios

Almost 311 million items were shipped through Mercado Envíos in Q4 2022, taking the total for 2022 above 1 billion items for the first time. Fulfillment penetration reached a record high of 43%, with sequential gains in all of its major markets. Almost 76% of orders were delivered within 48 hours. Managed Network penetration reached almost 94%, with Mexico, Chile and Colombia posting the largest year-on-year gains.

Mercado Pago

Total Payment Volume (TPV) reached almost $36.0 billion dollars on a consolidated basis, with FX-neutral growth accelerating to 80% year-on-year. MELI processed almost 1.7 billion transactions in Q4 2022 representing 63% year-on-year growth. Unique Fintech Active Users reached almost 44 million in Q4 2022, a 27% year-on-year increase, driven by higher engagement in all digital account use cases in all key markets, particularly Argentina and Mexico.

3. Financial Analysis

MELI has two main revenue streams: Commerce and Fintech. 

Commerce revenue includes Marketplace fees, classifieds fees, ad sales fees, and product sales revenue. 

Fintech revenue includes revenue from commissions on payment volume away from MELI’s marketplaces, interest earned on loans, revenues from sales of mobile point of sales devices, and financing fees from factoring credit card receivables (MELI earns a spread by charging the merchant a higher fee for installment payments than the cost they incur to factor the receivable).

MELI has been growing revenue at an impressive rate over the past number of years. During its most recent financial results for Q4 2022 MELI recorded revenue of $3.0 billion, an increase of 41% YoY. In less than two years MELI has managed to double quarterly revenue from $1.4 billion in early 2021.

In Q4 2022, commerce revenue grew by 36% helped by stronger monetization. During the same quarter, fintech revenue grew 93% driven by strong TPV growth and a higher take rate.

During this period where MELI doubled its revenue, its also increased its gross profit margin from 43% to 49%.

The increase in gross profit margin resulted primarily from the decrease in shipping operating and carrier cost, cost of sales of goods and collection fees, as a percentage of net revenues.

MELI has seen further expansion in its operating margin in 2022, increasing from 1.1% in Q4 2021 to 11.6% in Q4 2022. In addition to the gross margin benefits, this increase was driven by cost efficiency of sales and marketing expenses and strong profit growth in Fintech. Operating scale is beginning to kick in.

One area to pay close attention to is the non-performing loans (NPLs) in its portfolio. The provision for doubtful accounts increased by 147% in 2022. Whilst one would expect this provision to increase given the higher originations of loans, an increase of the non-performing ratio of the total portfolio relating to the over-90-day bucket was also a significant driver. During 2022, management revealed that they had slowed originations to contain the risks associated with a weaker lending environment, particularly in Brazil, which enabled them to maintain stable levels of early NPLs.

Financial Position

• Over $3.3 billion in cash and cash equivalents

• Total Liabilities as percent of Total Assets is 87% 

• Goodwill balance making up almost 1% of total assets

• Modest level of debt amounting to $2.6 billion making up 19% of total assets

• Loans receivable of $1.7 billion representing 12% of total assets

Note: MELI follows the U.S. Generally Accepted Accounting Principles (USGAAP). Under these standards, provisions for expected credit losses (which are net against loans receivable) are front-loaded, which means that they are recorded in advance rather than when they are actually incurred. This is different from the approach followed by traditional banks. As a result of this front-loaded approach, in periods of high loan growth, provisions for expected credit losses will also increase. However, this increase does not necessarily mean that credit quality is deteriorating.

Cash Flow Analysis

During 2022, cash flow from operating activities amounted to $2.9 billion, an increase of over 200% YoY. For the same period MELI recorded free cash flow of $2.5 billion which grew over 500% YoY. This represents a FCF margin of 24% for 2022.

It is worth nothing that capital expenditure (Capex) investments decreased by 20% in 2022. Most of the logistics spend by MELI is treated as operating expenditure (Opex) rather than Capex so flows through the Income Statement. Product & Technology Development expense increased 86% to $1.1 billion in 2022. I expect the FCF margin to fall back to the teens in 2023 as the company is showing signs of incremental investments in logistics in Brazil (Source: Reuters) and financial and e-commerce market development in Mexico (Source: Nasdaq).

4. Competitive Landscape

Given the amount of markets that MELI operates in, the list of competitors is almost endless. Each individual country that MELI operates in has local competitors in addition to global foreign players. Below is a summary of some of the key competitors that I have identified:

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• Americanas (Americanas.com) is run by Brazil retail giant Lojas Americanas. Founded in 1929, it’s also one of the oldest retail chains in Brazil operating over 1,900 physical stores around the country. The company also operates two other ecommerce sites aside from Americanas.com: Submarino and Shoptime. In January 2023, an audit revealed accounting inconsistencies in debt of about $8.3 billion, which led to the company going into receivership. The case is being investigated by Brazilian authorities to determine whether the issue was a gross error or fraud (Source: Reuters).    

• Amazon is one of the biggest e-commerce companies in the world and has a significant presence in Latin America. Although Amazon only launched its online marketplace in Brazil in 2019, it has quickly gained market share, mainly due to its fast shipping and vast product selection.

• PicPay has over 65 million registrations and is the digital wallet with most users in Brazil. The company offers credit cards, investments, personal loans and business management tools. The company was granted a banking license in Brazil in 2022.

• Nubank is a Brazilian neobank that offers a range of financial products, including credit cards, savings accounts, and personal loans, to individual customers. Nubank has a strong digital focus and operates entirely through its mobile app, which allows customers to manage their finances on the go. The company has grown rapidly since its founding in 2013 and is now one of the largest fintechs in Latin America.

• Rappi is a Colombian delivery startup that has rapidly expanded across Latin America. While Rappi is primarily known for its food delivery service, it has also ventured into e-commerce. Rappi has a platform called RappiMall, which sells products ranging from electronics to groceries.

5. Management and Ownership 

MELI was founded by Marcos Galperin in 1999 and received funding from various investors including J.P. Morgan, Goldman Sachs, and John Muse. In 2001, eBay acquired a 19.5% stake in the company, and in 2007, MELI became the first Latin American technology company to be listed on NASDAQ. The company expanded by acquiring 15 companies and in 2020, Galperin stepped down as president and was replaced by Stelleo Tolda.

Marcos Galperin remains the largest individual shareholder in MercadoLibre, with a 7.56% stake (Source: Fintel). The company's largest institutional shareholder is Baillie Gifford, which owns a 12.18% stake. Other major institutional shareholders include Morgan Stanley and Capital Group (Source: Fintel).

Marcos Galperin continues to serve as the CEO of MELI, and is widely regarded as one of the most successful tech entrepreneurs in Latin America. Under his leadership, the company has grown rapidly and expanded into new markets and business lines. In addition to Galperin, the MELI management team includes a number of seasoned executives with extensive experience in e-commerce, payments, and logistics. Many of them still at the company over twenty years since it was founded. Marcos Galperin appears to be well received at MercadoLibre with an 94% approval rating on Glassdoor with the company overall scoring 4.4 out of 5 by its own employees. 

6. Risks

1. Regulatory and Geopolitical

One key risk that MELI faces is regulatory risk, which has the potential to disrupt its business operations and limit its expansion in certain markets.

For MELI, the risk of regulatory changes arises from its involvement in financial services, such as payments, loans, and insurance. In many countries, financial services are heavily regulated, and any changes in regulations could have significant implications for MELI's operations.

Latin American countries have a history of high inflation rates, which could lead to government intervention in the economy and negatively affect the results of operations. For example, in Argentina, where MELI is headquartered, the Central Bank introduced regulations in September 2020 that restricted access to foreign currency in an effort to curb hyper inflation (Source: Nasdaq). Extensive exchange controls restrict the ability to exchange Argentine Pesos for foreign currencies and remit foreign currency out of the country, leading to the development of trading mechanisms such as the Blue Chip Swap Rate. The spread between the Blue Chip Swap Rate and the official exchange rate has been significant in recent years, and there is uncertainty regarding potential increases or modifications to these regulations.

The depreciation of local currencies creates inflationary pressures and restricts access to international capital markets, while the appreciation of local currencies may lead to a deterioration of public accounts and reduce export growth. The company also faces exposure to adverse movements in currency exchange rates, as almost all of their revenues are in currencies other than the U.S. dollar and must be translated into U.S. dollars for reporting.

2. Global Competition

Another key risk facing MELI is the threat of increased competition in the region.

Currently, MELI dominates the e-commerce market in Latin America However, the company faces increasing competition from both local and international players. Amazon, for example, has been expanding its presence in the region in recent years and is now the second-largest e-commerce player in Brazil. The competitive landscape analysis detailed a whole plethora of competitors vying for market share.

This increased competition could lead to a price war, with companies offering deep discounts to attract customers. This, in turn, could lead to lower profit margins for MELI, which could impact its ability to invest in future growth. Additionally, as competition heats up, it could become harder for MELI to attract and retain customers, as they have more options to choose from.

The financial services market is also increasingly competitive, with several fintechs established in Latin America. Mercado Pago competes with existing digital and offline payment methods, including banks and other providers of traditional payment methods, as well as local and global players offering digital financial services.

Increased competition is facing MELI, and the company must continue to invest in innovation and expansion to stay ahead of its rivals. The company will need to stay nimble and adapt to changing market conditions to ensure its continued success.

7. Opportunities

1. Unbanked Market

One key growth opportunity for MELI is the expansion of its fintech services. The company has already established itself as a leader in the e-commerce market, but it has also been able to gain a foothold in the financial services industry through its MercadoPago payment platform. MercadoPago has become the preferred payment method for many online transactions in Latin America, with over 1.7 billion transactions processed in Q4 2022 alone.

This growth has been driven by the company's ability to successfully leverage its e-commerce platform to build out its fintech capabilities. MELI's management team has indicated that it plans to continue investing in its fintech business to further capitalize on this growth opportunity.

The potential for growth in digital payments in Latin America is significant. According to Statistica, total transaction value is expected to show an annual growth rate of 15% resulting in a projected total amount of $371 billion by 2027 (Source: Statistica).

Within digital payments, the mobile payments industry is expected to register a compounded annual growth rate (CAGR) of 24.5% between 2023 and 2028 (Source: Mordor Intelligence)

The region has a large unbanked population which is estimated to be 45% (Source: Begini), providing a significant opportunity for companies like MELI to provide financial services to underserved communities.

2. Logistics Leverage

MELI has already invested heavily in its logistics infrastructure, building out a network of fulfilment centers and partnering with third-party providers to offer fast and reliable delivery to customers across the region. Take a look at this video of a sorter fulfilment centre in Brazil:

Another key opportunity for MELI is to expand its logistics services beyond its own platform. The company already offers fulfilment services to third-party sellers on its marketplace, but there is potential to go further and offer these services to businesses selling through other channels as well. MELI's existing infrastructure and expertise in the region make it well-positioned to provide these services, potentially opening up a whole new revenue stream for the company.

MELI could also leverage its logistics capabilities to expand into new product categories. The company has already made moves in this direction with the launch of its Mercado Envíos Full service, which allows sellers to offer larger and heavier items for sale on the platform. By continuing to build out its logistics infrastructure and capabilities, MELI could potentially expand into new areas such as grocery delivery, furniture and appliance delivery, and more.

There is significant demand for these types of services in Latin America, where traditional retail infrastructure can be limited and inefficient. By offering fast, reliable delivery of a wider range of products, MercadoLibre could capture a larger share of the e-commerce market in the region.

According to a report from eMarketer, e-commerce sales in Latin America will outpace worldwide growth in 2023 (Source: Insider Intelligence). This growth is being driven by factors such as increasing internet and smartphone penetration, as well as the COVID-19 pandemic, which has accelerated the shift to online shopping.

Data from Statistica suggests that this trend will continue for the next 5 years at least (Source: Statistica).

By continuing to invest in its logistics and fulfillment capabilities, MELI is well-positioned to capitalize on this growth and capture an even larger share of the e-commerce market in Latin America.

8. Valuation

Discounted Cash Flow

I have projected the future cash flows over 5 years using a discount rate of 10% and a terminal value of 14. Ultimately, the valuation hinges on normalising the 2022 FCF. I make two key adjustments:

• reduction due to increased Capex/Opex

• reduction due to provision for doubtful debts - NPLs greater 90 days

I believe the 24% FCF margin in 2022 should be more than halved in 2023 and going forward due to the above adjustments.

It should be noted that MELI management does not release any forward guidance meaning revenue and EBIT margins are entirely based on the authors estimates. Latin American e-commerce growth is expected to outpace the rest of the world and I expect MELI to increase its overall market share given the issues at Americanas and Shopee (Source: Reuters).

Based on these assumptions I believe that the fair value of MELI is close to $1,660 per share suggesting potential upside of 39% based on the share price on 23 March 2023.

Return on Invested Capital (ROIC)

MELI achieved a ROIC of 10.2% in 2022, up from 6.3% in 2021. A return above 10% is a strong indicator of good capital allocation from management.

MELI has got a long reinvestment runway ahead of itself given the markets that it operates in. If it continues to achieve the current level of ROIC, it should be able to produce solid returns for shareholders.

Price-to-Earnings Ratio (P/E)

MELI trades at a forward P/E ratio of 72. While the ratio has improved significantly, it can appear a bit misleading as MELI was not profitable until recent years be design.

From 2015 onwards, MELI ramped up investments in logistics to build out its infrastructure. This negatively impacts the short-term profit margins.

The high ROIC and P/E ratios are ultimately interlinked. As MELI can earn higher ROIC it can sustain higher levels of growth because it can reinvest earnings at a higher rate of return.

9. Investment Outlook

If you are not exposed to a company's products and services, you cannot get a true sense of it. Since MELI operates in Latin America, this would apply to most investors. In 2022, I had the opportunity to experience the offerings up close and personal. Here are a couple of quick anecdotes.

Firstly, Mercado Pago was absolutely everywhere. It is common to see signs in the western world displaying "Pay by Credit Card/Debit Card". In Argentina, it was “Pagar con Mercado Pago” (Pay with Mercado Pago). Secondly, while at a cafe in Buenos Aires, I witnessed a delivery person delivering a parcel directly to a customer, rather than to a cafe employee. This summed up the impressive level of efficiency and precision inherent in MELI's operations.

MELI's dominant market position, expanding fintech capabilities, and investment in logistics infrastructure make it well-positioned to capture a larger share of the growing e-commerce market in Latin America. It has proven its ability to defend its market position as demonstrated when Shopee shut operations in four Latin American countries in 2022.

In terms of valuation, the DCF analysis suggests that the company is undervalued based on assumptions including strong growth prospects and potential for future cash flows. However, the company's high P/E ratio implies that the market has already priced in high growth expectations and any deviations from those assumptions can have a significant impact on the stock price.

Disclosure: At the time of writing, the author holds a long position in MercadoLibre, Inc.

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Wolf of Harcourt Street

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Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

In this report, I will cover the following:

1. Overview

2. Customers

3. Capitalisation

4. Revenue & Margins

5. Balance Sheet and Cash Flow

6. Stock Price History

7. Competitors

8. Management and Ownership

9.  Risks

10. Opportunities

11. Valuation Multiples

12. Investment Strategy

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PayPal Holdings, Inc.

Ticker: PYPL

Sector: Financial Services

Market Cap: $215.3 billion

1. Overview

PayPal Holdings, Inc. was incorporated in Delaware in January 2015 and is a leading technology platform and digital payments company that enables digital and mobile payments on behalf of merchants and consumers worldwide. PayPal’s mission is to ‘democratize financial services to improve the financial health of individuals and to increase economic opportunity for entrepreneurs and businesses of all sizes around the world’. Their goal is to enable merchants and consumers to manage and move their money anywhere in the world, anytime, on any platform, and using any device when sending payments or getting paid. PayPal also facilitates person-to-person (‘P2P’) payments through the PayPal, Venmo, and Xoom products and services and simplifies and personalized shopping experiences for consumers through the Honey Platform. 

PayPal earns revenues primarily by charging fees for completing payment transactions for customers and other payment-related services that are typically based on the volume of activity processed on their payments platform. PayPal generally does not charge consumers to fund or draw from their accounts; however, they generate revenue from consumers on fees charged for foreign currency conversion and instant transfers from their PayPal or Venmo account to their debit card or bank account, as well as from interest and fees from their credit products. PayPal also earns revenue by providing other value added services, which comprise revenue earned through partnerships, merchant and consumer credit products, referral fees, subscription fees, gateway services, and other services that are provided to  merchants and consumers.

2. Customers

At the end of Q3 2021, PayPay had 416 million active accounts up 15% year-over-year (YoY) consisting of 383 million consumer active accounts and 33 million merchant active accounts. PayPal defines an active account as ‘an account registered directly with PayPal or a platform access partner that has completed a transaction on our Payments Platform or through our Honey Platform, not including gateway-exclusive transactions, within the past 12 months’. 

During Q3 2021, Total Payment Volume (TPV) grew 26% to $310 billion. PayPal defines total payment volume as ‘the value of payments, net of payment reversals, successfully completed on our Payments Platform or enabled by PayPal via a partner payment solution, not including gateway-exclusive transactions’. This increase comes even as eBay's TPV declined by 45% in the quarter and is now approximately 3% of the overall TPV. Excluding eBay, our volumes grew by 31%. 

For some background context here, eBay purchased PayPal in 2002 and later spun it out in 2015. As part of this arrangement it was with the agreement that PayPal would keep managing payments for a five-year transition period. From 1 June 2021, eBay now pays its sellers directly rather than through PayPal. 

3. Capitalisation

On 15 February 2002, PayPal went public for the first time, its stock exploding by 55% the first day and raising over $70 million. In July 2002, eBay announced that it would be acquiring PayPal for $1.5 billion, and it was made official in October.

In 2015, eBay decided to spin-off PayPal into its own public company. Under the terms of the spin-off, each eBay investor as of 8 July 2015, received one share of PayPal stock per eBay share owned. PayPal opened its first day at $41.46. 

Today, the PayPal share price trades at $191.28 meaning that if you had invested at the second IPO date you would have almost 5x your investment in 6 years.

4. Revenue and Margins

PayPal has been growing revenue at a steady rate over the past number of years. During its most recent financial results for Q3 2021 PayPal recorded revenue of $6.2 billion, an increase of 13% YoY. PayPal’s revenue growth has all the hallmarks of a long term compounder. In less than four and a half years PayPay has managed to double revenue from $3.1 billion in early 2017.

Whilst doubling revenue during this period, PayPal has also been able to maintain it’s impressive operating margin of 17% at Q3 2021.

PayPal is an extremely profitable business. From revenue of $6.2 billion, PayPal produced over $1 billion in operating income in Q3 2021.

PayPal is expected to grow revenue and earnings by 18% and 12% respectively in 2022 (Source: Zachs). 

5. Balance Sheet and Cash Flow

Commentary

• Over $7.7 billion in cash and cash equivalents

• Total Liabilities as percent of Total Assets is 70% 

• Current Assets to Current Liabilities ratio of 1.30

• Goodwill balance making up almost 13% of total assets. This balance is a result of a number of acquisitions including Honey for $4 billion and iZettle for $2.2 billion

• Low level of debt amounting to $7.9 billion making up 11% of total assets

During Q3 2021, cash flow from operating activities amounted to $1.51 billion, an increase of 15% YoY. For the same period PayPal recorded free cash flow of $1.29 billion which grew 20% YoY. PayPal is a cash generating machine. 

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6. Stock Price History 

After the second IPO in 2015 PayPal compounded at a steady rate before exploding in 2020 during the Covid-19 pandemic. The stock hit an all time high in July 2021 before experiencing a 40% drawdown over the last couple of months. During this time negative sentiment included the rumoured interest in acquiring Pinterest (Source: Reuters).

7. Competitors

The global payments industry is highly competitive, continuously changing and increasingly subject to regulatory scrutiny and oversight. PayPal competes against a wide range of businesses. 

Merchant Competitors

• Adyen growing payments company with global operations headquartered in the  Netherlands

• Stripe provides a payment gateway to application developers and competes with developer tools offered by Square

• Shopify, Big Commerce, Wix are direct competitors when it comes to e-commerce building

Consumer Competitors

Square’s Cash App stands as a direct and the most serious competitor to Venmo particularly in the U.S. At the end of 2020, Venmo has 52 million users while Cash App has 36 million but is growing faster.

The competition between Venmo and Cash App is a really fascinating one. If you are interested in reading a bit more into it, I recommend the Venmo vs Cash App paper by Maximillian Friedrich from Ark Invest. 

Other consumer competitors 

• Google Pay and Apple Pay allows consumers to make fast and easy purchases in stores and online

• Skrill which is a Paysafe company, provides a digital wallet, Payment gateway, and prepaid card among others

• Revolut and N26 which are more commonly used here in Europe

8. Management and Ownership 

PayPal was originally established by Peter Thiel, Luke Nosek and Max Levchin, in December 1998 as Confinity. In March 2000, Confinity merged with x.com, an online financial services company founded in March 1999 by Elon Musk. The company was renamed PayPal in 2001. After eBay acquired PayPal in 2002, the original PayPal employees had difficulty adjusting to eBay's more traditional corporate culture and within four years all but 12 of the first 50 employees had left. In the years that followed, this group remained close and became so prolific that the term PayPal Mafia was coined. Companies that the original employees have since founded include Tesla, YouTube, LinkedIn, Afirm, Yelp and Palantir. 

Dan Schulman is the current CEO and President having joined in 2014. Prior to joining PayPal, Schulman served as Group President at American Express. Prior to joining American Express, Schulman was President of the Prepaid Group at Sprint Nextel Corporation following its acquisition of Virgin Mobile USA, where he led the company as its founding CEO for eight years. Earlier in his career, Schulman was President and CEO of Priceline Group, where he led the company through a period of rapid growth and expansion. He also spent 18 years at AT&T, where he held a series of positions, including President of the Consumer Markets Division.

Dan Schulman appears to be well received at PayPal with an 92% approval rating on Glassdoor with the company overall scoring 4.0 out of 5 by its own employees. 

Given the legacy that PayPal has built over the past 20+ years it is not surprising that the company is no longer founder led. Nonetheless, Dan Schulman appears to be doing a good job.

9. Risks

1. Global Competition

As discussed in Section 8, the global payments industry is highly competitive and highly innovative. Many areas in which PayPal operates evolve rapidly with innovative and disruptive technologies, shifting user preferences and needs, price sensitivity of merchants and consumers, and frequent introductions of new products and services. Competition will further intensify as new competitors emerge, businesses consolidate and established companies in other segments expand to become competitive with various aspects of PayPal’s business model.

The emerging blockchain represents one such disruptive technology. We have seen the race to zero when it comes to trading fees with more and more brokerages offering zero fees. Legacy brokers have had to adapt to this model and are now playing catch up. I think the probability is high that something like this happens with payments. In this scenario, the monetisation would have to come from other value added solutions. 

PayPal often partners with many businesses and the ability to continue establishing these partnerships is important to the business. Competition for relationships with these partners is intense, and there can be no guarantee that PayPl will be able to continue to establish, grow, or maintain these partner relationships.

2. Cyberattacks

Cybercrime is on the rise globally and by 2020 is expected to cost the world $10.5 trillion annually (Source: Cybersecurity Ventures). As one of the largest payment processors in the world, PayPal has become one of the most heavily targeted brands for phishing attacks. PayPal scams come in many different forms and typically include phishing emails, spoofed websites, suspicious links, and malicious posts on social media. They are designed to look like official correspondence from the company and the aim is to trick as many users as possible into disclosing sensitive information. Examples include:

• Phishing emails - a problem with your account

• Phishing website

• Social media PayPal scams

• You’re a prize winner

Under payment card network rules and contracts with payment processors, if there is a breach of payment card information that PayPal stores, or that is stored by their direct payment card processing vendors, PayPal could be liable to the payment card issuing banks for their cost of issuing new cards and related expenses. Cybersecurity breaches and security vulnerabilities could subject PayPal to significant costs and liabilities, lead to loss of customer confidence and damage of reputation and brands.

10. Opportunities

1. War on cash

Growing numbers of consumers explored different payment mechanisms as an alternative to cash, credit and debit cards in 2020-21 due to a fear of touching cash. That added to a surge in mobile commerce activity, which saw consumers buy more goods and services online using their smartphones as physical stores were closed. Mobile commerce will represent 72.9% of total retail e-commerce sales worldwide in 2021, compared to 70.4% in 2020 (Source: Statistica). 

Digital wallets are making the idea of carrying around a physical wallet almost novel. A digital wallet refers to a software, electronic device, or online service that allows individuals or businesses to make electronic transactions. Total spend through digital wallets will exceed $10 trillion in 2025, up from $5.5 trillion in 2020 (Source: Juniper Research). 

It’s widely expected that higher volumes of lower-cost smartphones in emerging economies that feature integrated mobile payment technologies like near field communications will make a significant contribution to that e-wallet expansion. The study from Juniper predicts that over 34% of handsets will use contactless payments by 2025, compared to 11% in 2020.

2. Super App

In 2020 PayPal laid out its vision for the future of its digital wallet platform and its PayPal and Venmo apps. This plan involved a shift in product direction that would make PayPal a U.S.-based version of something like China’s WeChat or Alipay or India’s Paytm. Like those apps, PayPal aims to offer a host of consumer services under one roof, beyond just mobile payments. The number of consumers using digital wallets is expected to double to 4.4 billion globally by 2025, and nearly half of consumers already cite simplicity as the top reason to use a digital wallet (Source: Juniper Research).

In September 2021, the first version of that app was officially introduced, offering customers a single place to manage their bill payments, get paid up to two days earlier with the new Direct Deposit feature provided through one of our bank partners, earn rewards and manage gift cards, send and receive money to friends, family and businesses, pay with QR codes for purchases and redeem rewards in-store, access and manage credit, Buy Now, Pay Later services, buy, hold and sell crypto, as well as support causes and charities they care about.

The new app includes a personalized dashboard of a customer's PayPal account, a wallet tab to manage payment instruments and Direct Deposit, a nance tab that includes access to high yield savings and crypto capabilities, and a payments hub that includes send and receive money features, international remittances, charitable and non- prot giving, bill pay, and a two-way messaging feature to send notes of acknowledgment after peer-to-peer. 

11. Valuation Multiples

Below are some of the key valuation metrics that I have identified for PayPal.

When PayPal hit an all-time high of $310 in July 2021, the P/S ratio hit 16. Today, PayPal trades at a P/S of just 8. 

But, how does this valuation compare to competitors? 

The first thing to note is that Square’s Price/Sales ratio is artificially low due to the accounting treatment of Bitcoin revenue. Based on the PE ratio PayPal is very attractively valued relative to its competitors. I would argue that PayPal is fairly valued if not a little undervalued. This is underlined by the fact that both the P/S and PE valuation multiples are at the lowest levels since the pandemic in March 2020. 

12. Investment Strategy

PayPal is a proven high-quality compounder. It also benefits from strong tailwinds with the switch to a digital economy presenting a long runway for growth. On the flip side, the risk of disruption is a significant risk. New and emerging technologies are going to change the way we transact and I do believe that it will turn into a race to zero fees. This does not mean that companies like PayPal will not be required, it simply means monetisation coming from other areas of the value chain.

PayPal has proven that it is capable of innovating. You don’t last over twenty-three years in a highly competitive industry without being able to innovate. As a recent example, PayPal decided to build their own BNPL solution whereas Square spent $29 billion on the acquisition of AfterPay.

When it comes to investing, the price you pay ultimately determines the return that you will achieve. At the current valuation PayPal is very attractively valued. My opinion is that the risk of disruption has been priced in. 

Disclosure: The author holds a long position in PayPal.

Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

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Wolf of Harcourt Street

Disclaimer: I am not a financial adviser and I am not here to give specific financial advice. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The information is based on personal opinion and experience, it should not be considered professional financial investment advice. There is no substitute for doing your own due diligence and building your own conviction when it comes to investing.

In this report, I will cover the following:

1. Overview

2. Customers

3. Capitalisation

4. Revenue & Margins

5. Valuation Multiples

6. Balance Sheet and Cash Flow

7. Stock Price History

8. Competitors

9. Management and Ownership

10.  Risks

11. Opportunities

12.  Investment Strategy

Airbnb, Inc

Ticker: $ABNB

Sector: Communication Services

Market Cap: $106.8 billion

1. Overview

Airbnb is a company that operates an online marketplace for lodging, primarily homestays for vacation rentals, and tourism activities. Since it was founded in 2007 it has grown to 4 million hosts who have welcomed over 800 million guest arrivals to approximately 100,000 cities in almost every country and region across the globe. Hosts on Airbnb are everyday people who share their worlds to provide guests with the feeling of connection and being at home. 

Airbnb’s hosts are the foundation of the community and business. Stays are made possible by hosts. It is their individuality that makes Airbnb unique. From schoolteachers to artists, hosts span more than 220 countries and regions and approximately 100,000 cities. Airbnb enables hosts to provide guests access to a vast world of unique homes and experiences that were previously inaccessible, or even undiscovered. The role of the host is about more than opening their door. A great host enables guests to find a deeper connection to the places they visit and the people who live there.

The community of hosts started by sharing their spare bedrooms on Airbnb in a few large cities. Soon, hosts listed entire homes, cabins, treehouses, boats, castles, and luxury villas — practically any space that you could think of — in big cities, small towns, and rural communities in nearly every corner of the world. Hosts generally fall into two categories: individual and professional. Individual hosts are those who activate their listings directly on Airbnb through the website or mobile apps. They come from all walks of life and list their spaces, including private rooms, primary homes, or vacation homes on Airbnb. Professional hosts are often those who run property management or hospitality businesses and generally use application programming interfaces to list their properties on the platform. These hosts expand the types of listings available to guests. Once there were millions of homes on Airbnb, the company recognized that hosts could share not only their homes but also their interests and talents. From exploring graffiti art in New York City to finding hidden jazz clubs in London, Airbnb Experiences offer authentic activities in over 1,000 cities around the world. 

2. Customers

In Q3 2021, Nights and Experiences Booked of 79.7 million represented a significant increase of 29% year-over-year (YoY) and slight a decrease of 7% compared to Q3 2019 levels. Excluding Asia Pacific, global Nights and Experiences Booked exceeded 2019 levels in the quarter. Continued strength in average daily rate (ADR) drove even stronger gross booking value (GBV) performance than Nights and Experiences Booked. In Q3 2021, GBV was $11.9 billion, representing a YoY increase of 48% and an increase of 23% compared to Q3 2019.

Guests

This summer, Airbnb reached a major milestone of 1 billion cumulative guest arrivals as more people got vaccinated and travel restrictions were relaxed. 

Hosts

Host earnings reached a record $12.8 billion in the quarter, and active listings continued to grow. This economic empowerment is what continues to attract new hosts to the platform.

Monetisation

The primary source of Airbnb’s revenue comes from service fees from bookings charged to both guests and hosts. Depending on the size of the reservation, guests are required to pay a nonrefundable service fee based on the type of listing—usually between 5% and 15%. A more expensive reservation results in lower service fees for guests because families or groups with larger reservations can save money for other travel expenses.

Hosts are also charged a 3% fee with every completed booking to cover the processing of guest payments. When a reservation is booked, guests pay the service fee—unless the host cancels or retracts the listing. If the reservation is altered, Airbnb adjusts service fees to accommodate users.

3. Capitalisation

Airbnb went public on the 9th December 2020 through an IPO raising an $3.5 billion valuing the company at $47 billion. Shares were priced at $68 but soared to open $146. Airbnb is very recent to the public markets and its story is only getting started.

4. Revenue and Margins

Airbnb has had a very tough start to life as a public company. A global pandemic was always going to have a big impact on a company that operates a travel and experiences platform. However, during its most recent financial results for Q3 2021 Airbnb recorded revenue of $2.24 billion. This was a new quarterly record and represented an increase of 67% YoY. This also surpassed the Q3 2019 pre-covid revenue by 36%.

Gross margin was 86.1% in Q3 2021 compared to 83.1% in Q3 2020. Apart from Q1 and Q2 2020 when the covid pandemic was at its worst, Airbnb has maintained a gross margin in excess of 70%. 

Despite being in high growth mode, Airbnb recorded a profit on the bottom line of $834 million during Q3 2021 compared to a profit of $219 million YoY. This represents a net income margin of 37%, up from 16% year-over-year. It is important to point out that Q3 is historically Aibnb’s strongest quarter given the seasonality involved in travel and tourism. 

5. Valuation Multiples

Airbnb very much lives up to the characteristics of a growth stock and trades at high valuation multiples. Below are some of the key valuation metrics that I have identified. I have included the PE ratio but despite Airbnb posting a profit in Q3, it does not have a track record of profitability as this is not the focus for the business at this time. 

When Airbnb shares hit an all-time high of $219 in February of this year, the P/S ratio hit 38. In July when Airbnb was trading at its lowest since going public the P/S ratio halved to 19. Post Q3 earnings Airbnb now trades at a P/S ratio of almost 30. 

But, how does this valuation compare to competitors? 

The short answer is that Airbnb is significantly more expensive than its closest competitors. This is not a cheap stock.

6. Balance Sheet and Cash Flow

Commentary

• Over $5.9 billion in cash and cash equivalents

• Total Liabilities as percent of Total Assets is 67% 

• Current Assets to Current Liabilities ratio of 1.86

• Goodwill balance making up almost 5% of total assets meaning the impact of the risk of impairment is low. This balance is a result of a number of acquisitions including Hoteltonight for $400m in 2019

• Quite a bit of debt on the balance sheet with almost $2 billion in long-term debt

7. Stock Price History 

After the IPO at the end of 2020 the share price spiked immediately hitting an all time high of $219 in February 2021. Since then, the shares traded downwards into the lock up period, trading as low as $130 in May 2021. The stock then built its post IPO base for a number of months before the recent power earnings gap after crushing Q3 estimates in November. This week the price pulled back to the 200 day moving average in line with the broader market correction in growth names.

8. Competitors

As Airbnb operates an online marketplace, it faces competition for both hosts and guests. 

Competition for Hosts

Airbnb competes to attract and retain hosts on its platform to list their homes and experiences, as hosts have a range of options for doing so. Airbnb competes for hosts based on many factors including the volume of bookings generated by guests, ease of use of the platform, the service fees charged, host protections and brand. The pandemic has also meant that a cancellation policy is now a key consideration. 

Competition for Guests

Airbnb competes to attract and retain guests to and on its platform, as guests have a range of options to find and book accommodations and experiences. Airbnb competes for guests based on many factors, including unique properties and availability of listings, the value and all-in cost of offerings relative to other options, brand, ease of use of the platform, the trust and safety of the platform, and community support. The pandemic has also resulted in a shift towards competition based on the availability of property close to where guests live and in non-urban markets, as well as the perceived safety and cleanliness of listings on the platform.

Competitors include:

• Online travel agencies (OTAs)

  • Booking Holdings (Booking.com, KAYAK, Priceline.com, and Agoda.com); Expedia Group (Expedia, Vrbo, HomeAway, Hotels.com, Orbitz, and Travelocity); Trip.com Group (Ctrip.com, Trip.com, Qunar, Tongcheng-eLong, and SkyScanner); Meituan Dianping; Fliggy (a subsidiary of Alibaba); Despegar; MakeMyTrip; and other regional OTAs

• Internet search engines

  • Google, including its travel search products; Baidu; and other regional search engines

• Listing and meta search websites

  • TripAdvisor, Trivago, Mafengwo, AllTheRooms.com, and Craigslist

• Hotel chains

  • Marriott, Hilton, Accor, Wyndham, InterContinental, OYO, and Huazhu, as well as boutique hotel chains and independent hotels;

• Chinese short-term rental competitors

  • Tujia, Meituan B&B, and Xiaozhu

• Online platforms offering experiences

  • Viator, GetYourGuide, Klook, Traveloka, and KKDay

Despite all of the competition, Airbnb has the highest Net Promoter Score (NPS) compared to its competitors. 

9. Management and Ownership 

Brian Chesky is the co-founder and Chief Executive Officer of Airbnb. In 2007, Chesky and Joe Gebbia became Airbnb’s first hosts. Since then, Chesky has overseen Airbnb’s growth to become a community of over four million hosts who have welcomed more than 800 million guests across 220+ countries and regions.

A graduate from the Rhode Island School of Design, Chesky has embedded his creative roots in Airbnb’s culture, product and community. This design-driven approach has enabled a system of trust that allows strangers to live together, and created a unique business model that facilitates connection and belonging.

Chesky is a signatory to the Giving Pledge and has committed to donating the net proceeds of his CEO equity compensation to community, philanthropic and charitable causes. Originally from Niskayuna, New York, Chesky is an Airbnb Experience host in San Francisco.

Brian Chesky appears to be very well received at Airbnb with an 92% approval rating on Glassdoor with the company overall scoring 4.2 out of 5 by its own employees. 

In Brian Chesky, Airbnb meets my criteria of being led by a visionary founder. 

10. Risks

1. Future pandemics

This risk is pretty obvious. In an attempt to limit the spread of the COVID-19 virus, governments imposed various restrictions on travel, limitations on social or public gatherings, and other social distancing measures, which have had and may continue to have a material adverse impact on business and operations and on travel behavior and demand.

In response to the economic challenges and uncertainty resulting from the COVID-19 pandemic and its impact on the business, in May 2020, Airbnb announced a reduction in their workforce of approximately 1,800 employees. This reduction in workforce would have resulted in the loss of institutional knowledge, relationships, and expertise for critical roles, which may not have been effectively transferred to continuing employees and may divert attention from operating the business, create personnel capacity constraints, and hamper the ability to grow, develop innovative products, and compete. Any of these impacts could materially adversely impact the business and reputation and impede the ability to operate or meet strategic objectives. The reduction in headcount and other restructuring activities resulted in a charge of over $151 million in 2020.

Research from the National Academy of Sciences in the United States suggests that probability of a pandemic with similar impact to COVID-19 is about 2% in any year, meaning that someone born in the year 2000 would have about a 38% chance of experiencing one by now. The report goes on to state that the probability is growing and highlights the need to adjust perceptions of pandemic risks and expectations for preparedness. 

2. Failure to retain existing hosts or add new hosts

Airbnb depends on hosts maintaining their listings on their platform and engaging in practices that encourage guests to book those listings, including increasing the number of nights and experiences that are available to book, providing timely responses to inquiries from guests, offering a variety of desirable and differentiated listings at competitive prices that meet the expectations of guests, and offering exceptional hospitality, services, and experiences to guests. Ultimately, these practices are outside of Airbnb’s control. If hosts do not establish or maintain a sufficient number of listings and availability for listings, the number of Nights and Experiences Booked declines for a particular period, or the price charged by hosts declines, Airbnb revenue would decline and business, results of operations, and financial condition would be materially adversely affected.

If Airbnb are unable to retain existing hosts or add new hosts, or if hosts elect to market their listings exclusively with a competitor or cross-list with a competitor, Airbnb may be unable to offer a sufficient supply and variety of properties or experiences to attract guests to use the platform. 

As mentioned earlier, Airbnb has over 4 million hosts. If one of these host’s results in a guest having a bad experience, this might irreversibly damage the Airbnb brand image and result in guests using alternatives outside the Airbnb platform.

11. Opportunities

1. Work from anywhere trend

The world is undergoing a revolution in how we live and work. Technologies like Zoom make it possible to work from home. Airbnb makes it possible to work from any home. This newfound flexibility is bringing about a revolution in how we travel. Millions of people can now take more frequent trips, take longer trips, travel to more locations, and even live anywhere on Airbnb.

For centuries, people have been confined to where they work. Then the pandemic hit and suddenly released tens of millions of people from the need to work in specific places at specific times. They can now work from anywhere, travel any time, and stay longer. 

This trend towards more flexibility will only accelerate. In recent months, some of the largest companies in the world, including Apple and Microsoft have announced increased flexibility for employees to work remotely, and it is expected that more companies will follow.

Airbnb started out as a platform for vacation rentals. The pandemic accelerated the remote work trend. Airbnb is now also a platform for living. During the Q3 earnings conference call, management noted:

‘Long-term stays of 28 days or more remained our fastest-growing category by trip length and accounted for 20% of gross nights booked in Q3 2021, up from 14% in Q3 2019’

2. Adaptability

One of Airbnb’s most important competitive advantages is its adaptability. Airbnb does not own any physical property meaning it can quickly pivot to any change in travel demand. In comparison, hotels are constrained by supply and cost constraints. Management noted the following on the Q3 earnings conference call:

‘Instead of guests traveling to the same historically popular urban destinations, we’ve seen consistent demand growth in both nearby and rural destinations. Over 40% of gross nights booked in Q3 2021 were within 300 miles of home, up from 32% in Q3 2019, while gross nights booked to rural destinations increased more than 40% in Q3 2021 from Q3 2019. Meanwhile, we’ve seen urban travel gradually returning, but fanning out beyond iconic cities. In Q3 2021, our top 10 cities represented 6% of gross revenue, down from 11% in Q3 2019. During the pandemic, more than 100,000 cities have had at least one Airbnb booking, including more than 6,000 cities and towns receiving their first booking ever’

Over 6,000 cities and towns receiving their first booking ever suggests that there are few if any hotels in some of these locations. If any of these locations takes off and becomes a hipster travel location, Airbnb can leverage the properties already in the area to cater to this demand by enticing new hosts at zero marginal cost. However, this is not as simple for a hotel as the average hotel can take up to three years to build with a significant upfront cost. 

12. Investment Strategy

Airbnb has got all the hallmarks of a category defining leader. The platform is scalable with an enormous addressable market. The company has a strong market position, a recognisable brand and a visionary leader in Brian Chesky who has managed the issues faced during the pandemic admirably. Airbnb is a stronger company now than it was before the pandemic due to the actions of its founder which included reorganising the company structure and becoming more lean and efficient. 

There is a pent up demand for travel and I can see this lasting past the next twelve months. Heading into 2022 I believe that a lot of people have plans to visit destinations that they couldn’t for almost two years. Layered on top, Airbnb benefits from the work from anywhere trend which is going nowhere.

While the stock is certainly not cheap relative to its peers, the advantages that Airbnb possesses over the competition means that it commands a premium valuation. On 10 December it was announced that Airbnb will be added to the Nasdaq 100 index effective as of the close on 17 December.

Disclosure: The author holds a long position in Airbnb.

Contact me

Twitter: @wolfofharcourt

Email: wolfofharcourtstreet@gmail.com

Hit the subscribe button below if you have not already done so in order to receive the latest content straight to your inbox each week.

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All previous posts are viewable on the website.

Visit Website

If you enjoy what you see, please give it a like, comment below and share.

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Happy investing

Wolf of Harcourt Street

Disclaimer: I am not a financial adviser and I am not here to give specific financial advice. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. The information is based on personal opinion and experience, it should not be considered professional financial investment advice. There is no substitute for doing your own due diligence and building your own conviction when it comes to investing.

In this report, I will cover the following:

1. Overview

2. Customers

3. Capitalisation

4. Revenue and Margins

5. Valuation Multiples

6. Balance Sheet and Cash Flow

7. Stock Price History

8. Competitors

9. Management and Ownership

10. Risks

11. Opportunities

12. Investment Strategy

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