Full Transcript: Chuck Akre with Patrick O’Shaughnessy

Quick note: I transcribed this rather quickly, shortened some parts and I may have missed things. I’ve also shared some takeaways and my favorite quotes from this conversation in a much shorter post. If you want to share, please link to the original transcript at this webpage and attribute transcription to James Hull. Thank you!

The following is a transcript of Chuck Akre – The Three-Legged Stool – [Invest Like the Best, EP.135] – Patrick O’Shaughnessy (iTunes link). You can find the podcast in any podcast app.

Patrick O’Shaughnessy (PO) – Why based in one-traffic light small town?

Chuck Akre (CA): Here because of quality of life issues. I’m a person who works well without a lot of commotion around. Low level of activity around here is helpful to us. Being able to sit there with our doors open and not be disturbed by outside events.
With Middleburg as it relates to Central Park South, if my office were there I’d have a thousand friends who were very bright and very interesting and I’d be distracted. I’d become curious and engage in their thought process. And it would distract me from what it is I do well.

PO – Nirvana Three-legged stool. Day to day process?

CA: My participation in the business evolves and continues to evolve and so on. I’m personally doing less pure fundamental research today than I did years ago. There are others here who do that. And we talk about ideas and stuff all day long.

And I spend a lot of time reading, that’s how ideas bubble up in my universe and others here use screens, but mostly we’re—it’s a serendipitous, inefficient, let’s just say, non-quatitative approach.

PO – You’ve mentioned before that imagination is as, or more, important than knowledge, can you talk about that concept?

CA: Run across thousands of people who are very bright and are not good investors. So pure knowledge is not, in and of itself, a ticket to being a good investor. 

Imagination and curiosity are what’s hugely important. We’ve discovered things over the years purely by being curious. And continuing to keep involved in the search process to find these exceptional businesses.

PO – Can you distinguish at all between curiosity and imagination? One sounds like a search and the other like a creative force.

CA: Well they both are creative. My older son was a tenured college professor for a while and he used to say he worked at a university that, as he said, didn’t have the luxury of being highly selective in its student body. And he said the thing that disappointed him the most was even his best students, his students who got As typically only wanted to know what they needed to know to get an A rather than have curiosity.

And I find that curiosity has been useful to me in the search for investing and in relating real life experiences, to allowing my to pursue real lines of thought, whether its trying to figure out if a stock car track might be interesting or something else.

I guess I’m not very articulate at explaining the difference between curiosity and imagination, but they go hand-in-hand in being creative and identifying good businesses.

PO – Talk about the origins of investing nirvana three-legged stool.

CA: Three legs are sturdier than four legs, they can adjust to uneven ground. I’ve come to adopt that as what I call the visual construct for what we choose to describe as the integral components of what makes a great investment.

That’s some thing I came to because I had no background whatsoever in the business world, I was an English major and had been a pre-med student before I was an English major and I had no courses in business whatsoever so I had clean canvas and a willingness and a desire and a curiosity to learn and so my voyage was: What makes a good investment? What makes a good investor? In trying to put all this together there was a quantitative aspect to it, but in describing what makes a good investment is, each of those three legs 

I’ll back up again and say. Our investment goal has always been from the outset, to try to produce an outcome that is above average. Stepping back even a bit farther..
I had examined early on, and continue to, rates of return in all different asset categories and made the observation that the rates of return in common stocks, over long periods of time, was higher than everything else on an unleveraged basis in a consistent long-term basis. 

The rates of return on common stocks in the United States in, let’s say, the last 100 years is in the neighborhood of 9 to 10 percent. And in fact we don’t care what it is precisely, we want to know what it is generally. 

We made a quantitative observation about why that’s so. That observation is that in our judgement it corresponds, correlates, to what the real return on what the owner’s capital is in those businesses. And we have done many times a quick little show and tell about why that’s so. And conclude that the return in an asset will approximate the ROE, in our case we usually use free cash flow return on owner’s capital, given a constant valuation and the absence of any distributions.

You get that from your quantitative background completely, and they you would wisely say, “well Chuck, everybody knows you don’t have constant valuation in the markets, so we say, we understand that too so we work hard to have a modest starting valuation to try to reduce that risk. 

So understanding that if our goal is to have above-average outcomes then we need to have businesses that have above average returns. That’s the first leg. We try to identify businesses that have had high returns on owner’s capital for a long time and we spend a lot of time trying to figure out why that’s so and what’s caused that. And what’s the runway ahead of them look like, is it broad and long? Do they still have the opportunity to earn high return, above average returns on capital? 

And we want those businesses to be run by people who have demonstrated that they clearly great at running the business, because they’ve achieved this, but also who by our observation treat us as partners even though they don’t know us. 

You’ve read it enough times I’m sure, but I say our experience is once a guy sticks his hand in your pocket, he’ll do it again. And so we just have no reason to go there. It’s just human behavior, we constantly find people who’s behavior is antithetical to our interests. 

Leg one is the quality of the business enterprise.
Leg two is the quality and the integrity of the people who run the business.
Leg three is what is their record and opportunity for reinvestment?

Once we have all those things in place then we just aren’t willing to pay very much for these businesses. 

It’s just a short-handed way for us to say, 1-2-3 this is what’s important to us. 
And our experience is, if we own exceptional businesses, one of the hardest things to do is not sell them. All businesses have hiccups in their business operations. All businesses have things that occur that are unplanned for, that are thought about but not necessarily expected. And, that’s life.

Nothing is perfect, nothing is Jack Welch’s 20% a year take it to the bank. Long after he’s left we’ve found out much of that was a house of cards. 

And so we just had our 30th anniversary of Akre Capital and did some presentations. One of our partners did one that was entitled “The Art of Not Selling”. And it’s truly very hard to do. And in fact it may be one of our great assets, our ability to not sell.

PO – I’m a quant and I recognize the art in each of the legs of the stool, I’d love to spend a few minutes on each. 

Long Bandag story. Gave an intern a box of cut-outs that he’d accumulated from magazines, newspapers and said, “see if there’s anything interesting in there.”

Lesson: Find a company with above average returns. Ask: What business is it in? If it’s above average for the business, then they are in a different business. Goal is to find out what business they are in. (Understand what you own.)

PO – How has your assessment of the underlying business value in the first leg of the stool evolved over the last 10-15 years? Are there major differences in what you are looking for in finding a great business?

CA: The first difference is that in the last 10 or 15 years is that the overall returns of all businesses have gone down. And they’ve gone down, in my mind and our judgement here, because the pervasive lower level of interest rates. While it doesn’t — you don’t necessarily A = B + C — it is a pervasive effect and it’s caused the returns of all businesses to be lower, in our judgement.

The second thing is the way some of these businesses have earned their returns are way that were new to us and we didn’t catch on to them. So our returns in the last few years, which continue to be well-above average, have been done entirely without the FANGs or any of those businesses. Without any of them. And it’s just because we weren’t smart enough and quick enough to figure them out.

PO – How do you think about that moving forward?

CA: Everyday is a learning day.

And we have to figure out which of those businesses are truly attractive and are not subject to rapid changes of technology or governmental intervention or retaliatory issues relating to different countries and different parts of the world. That sort of stuff.

PO – Maybe an interesting way to dive in deeper, would be to talk about recent businesses that you’ve bought, I know you hold for a very long time, so some of the recent ones might be 7 years old. Talk about something, industries, companies, whatever that you find most interesting in recent times. 

CA: We try not to talk very much about the companies in our portfolio and we certainly never talk about ones that are coming in or going out.

So the issues are all the same. So this is 2019. In march of 2010, we added our first position to MasterCard and it was during the time of Dodd-Frank and issues in Congress. And more specifically what had become known as the Durban Amendment. 
MasterCard and Visa were selling at 10 or 11 times. And when you dove into the numbers we discovered the operating margins and the returns on capital—there’s not word in the English language that’s superlative enough to talk about them. I would just say, you could cut the margins of MasterCard and Visa in half, twice and you’d still be above average for an American business.

So clearly something extraordinary is going on there. What does this mean? I ask this question rhetorically around the office. What does that tell you? 

Well it tells you (A) there’s a big target on their back. Everybody wants some of that. (B) it tells you that they’re probably jamming every expense they can think of into the income statement to try to reduce how good the margin is that they are showing. And then (C), we spent time trying to figure out what’s causing that. We think we know. And we’ve quit talking about it. Haha. So I’m not going to talk to you about it. 

If you read any research from Wall Street, and we read very little, there is no one who talks about that, who talks about the rates of return they are earning on their capital because Wall Street in general has a completely different business model than we have. Our business model is to compound our capital. Wall Street’s business model, generically, is to create transactions. 

Logically, well, what’s the best way to create a transaction? To create what we call false expectations. And what are false expectations? Earnings estimates. O’Shanhessey is going to earn 1.73 next quarter, and it comes in at 1.72 and the remark is “They missed!” By one. So we call it, “beat by a penny, miss by a penny.” That’s the syndrome. And that gives us opportunities periodically, because the markets behave in ways that we happen to think are irrational relating to something like that.

A name that’s been in the news for 4 years now and had some controversy around it is DollarTree, where we own a big stake. The dollar store business was really an oligopoly in the United States with three major players: FamilyDollar, DollarTree, and Dollar General.

PO – I’m curious if there are other heuristics that you use, besides high ROEs, high ROICs above the market that you use.

CA: See that sign up there, read it.

Signs in his office:

“Everything should be made as simple as possible but no simpler.”

Lots of very bright people can build really intriguing complicated ways to figure out why something is cheap or expensive. And we try to keep things as simple as possible.

“The bottom line of all investing is the rate of return.”

We use that as our key tool. for everything. We try to look at everything at a top down basis. So we were talking about the FANGs and modern technology and we say that as a generalization all of that is about changes in distribution. Of all kinds. Whether its information or cars.. Amazon starting with books and then selling cloud services. It’s all about distribution. Distribution about saving information.

So that’s looking at things in a simple fashion. Let’s try to look at things as simple as we can and understand the big context. What’s going on? We’re all at risk of getting caught in the weeds of what’s going on, and that’s misleading.

PO – Do you tend to separate things into product innovation and distribution innovation when evaluating a business?

CA: No, we’re not that smart. 

PO – Seems to be working okay, not being that smart. 

CA: That’s an important observation, it’s working okay. 

PO – Let’s talk about the second leg of the stool, the people in these businesses. What would you say are the most common characteristics of the managers of the businesses that you’ve ended up owning for a long period of time.

CA: Well, they don’t have a screen in their office showing you the price of the stock. And there are lots who do. And sometimes you find it in the lobby of the company and sometimes you find it on the CEOs desk. That doesn’t interest us. 

We’ve had incidences where principals in companies have called us up and said, “Why are you selling our stock?” Once we recover from that affronting question, if in fact we have been selling the stock, which may be the case, or maybe we’ve sold it all. We say, well actually that was clearly the right decision, because we don’t want to be partners with people who are concerned about those things running their business. Their focus is on the wrong thing, in our judgement.

So this is an interesting exercise. One of the questions that we like to ask of a CEO is: How do you measure whether or not you’ve been a success at running this business? And as you might expect, some of them say, well price of the stock goes up. Or we hit our earnings target. Or we delivered on all the things that the board asked of us. It’s a rare occasion where the CEO articulates an idea where he shows he understands the idea of compounding the economic value per share. And you stand back and say, well why is that so? And the answer is that they’re not trained to do that. They’re trained to run businesses. They’re not trained to think about compounding the intrinsic or the economic value per share. It’s really the single most important thing.

PO – That sounds like a capital allocation story. I know you are a huge fan of business biographies and some of my favorites have always been the Henry Singleton’s of the world, who are some of the master capital allocators and often very flexible. Talk about the role of capital allocation amongst the CEOs in the second leg of the stool.

CA: We own a company called O’Reilly Automotive, it’s also part of an oligopoly and the oligopoly includes O’Reilly, Autozone and O’Reilly acquired a company called CSK Autoparts, I’ll say close to 10 years ago. It was, it was 07/08. CSK had a huge presence on the west coast where O’Reilly had none. … It gave them a much greater national footprint. And they did a superb job in the logistics of integrating all those CSK stores into the O’Reilly network. Re-merchandizing the whole business.

O’Reilly was about 50% to the Do-It-For-Me people, the independent garage business as well as the Do-It-Yourselfers. And that was unusual because most of the Autozone and the other competitor had a much more larger exposure to the Do-It-Yourselfers.

When you are serving the Do-It-For-Me’s time is money and they had a car on their lift they needed the part right away because the lift was out of commission if they had a car on it waiting for a part. So the timeliness of the delivery of parts was critical. And that means that they had to have a denser distribution network. That was pretty interesting. And you’ve seen the others try to move into that direction.

After they did that, this company O’Reilly had very little debt. In fact in 2008 because of the recession, they were unable to borrow all the money for the acquisition, so they ended up having to issue stock. And we owned 10% of CSK at the time, so we got a reasonable share of O’Reilly stock, which we still own and it’s 12 or 13 times what we paid for O’Reilly. At any rate, in terms of capital allocation after they paid off all the short-term debt, because they were generating a lot of cash, they said, well we’re not going to be able to make any acquisition that won’t be a Hart-Scott-Rodino problem, and therefore they changed their capital allocation. So they began to lever up the company and buy in shares. Which they had never done. They’ve now bought in 40% of their shares. It was a really intelligent capital allocation decision by the management and the board at that time, which is highly unusual. We’ve all seen boards who are rushing out to buy in their shares when they are at peak valuations. That’s not what they were doing. 

The other side of that goes back to the late 80s, when I got involved in a company called International Speedway. And it’s a long story, you’ve probably read about how I got involved. At any rate, at the time, the company had 2.5 million shares outstanding, and the family who had founded that was called the France family. And Bill France Jr lead the company, he was a strong and dynamic leader. And they went through a period of time in the 70s/80s where they hired a CFO, where they never had one before. Bill France’s wife Anne had always handled the books.

And there’s an apocryphal story where once they’d hired the CFO and they had him in the office and they were walking him through the stuff
Anne or Bill said, “So should we tell him about the cash?” 
New CFO was like “Cash, what cash?”
“Well the cash that was in the safe.”
“What cash is in the safe?”
“Well the money that we got for the Daytona tickets that we sold in advance of the race, we put it in there because we don’t earn it until the race is run.”

And so, interesting then, if you looked at the annual report, if you read the balance sheet, there’s no debt. But when you read the notes they describe the equity as being 73% of capital. What’s the rest of it? Deferred revenue. Well what’s deferred revenue? It was cash in the safe. 

Now I mean you talk about people running a conservative balance sheet and a conservative business. That’s about as conservative as you can get. Discovering that about the behavior of the people. Those experiences stick with you, in terms of how people behave.

PO – What have been some of your favorite biographies?

CA: There was a man who had been an editor at Barron’s magazine and became a financial counselor, his name was Thomas Phelps and he wrote a book called 100-to-1 in the Stock Market in 1972. And that was book that, to this day, remains inspirational to me, fundamental to me in terms of thinking about the issue of compounding return. He didn’t ever explicitly talk about compound return, but clearly what his message was… he outlined, in round numbers, 350 public companies that between 1935 and 1971 you could have bought and made 100x your investment by 1972. And what you infer from that is the only difference is the rate of return. 

The rate at which it was compounding, that was the only difference. That meant if you wanted to have higher rates more quickly you needed to have businesses that were compounding their capital. And so, we talked earlier about MasterCard and Visa and their enormous returns and there’s no way that they can reinvest that cash to earn those kinds of returns in anything else. And so they buy in stock and pay cash dividends and it grows and that sort of stuff, but it’s a less efficient way for us to grow our capital than if they were able to reinvest it all and get those same rates of return. 

PO – So you have some great companies that you’ve talked about, companies like American Tower, where the reinvestment story in fascinating, and that’s the third leg of the stool. So let’s talk about that, you can use that or any other example.

CA: Absolutely. Well they made another acquisition last week, in Africa, and bought one of the players in the oligopoly of independent tower companies in the African continent.
While each new tower is itself an individual asset, the collection of 55,000 towers around the world now, they all look similar. And my notion about the tower companies is that they find themselves in a position that is much like Microsoft in the days of the growth of personal computer. If you wanted to have a personal computer, you ended up having to go through Microsoft because they owned the operating system. It was a tollbooth.

And if you want the growth in wireless communication and as we’ve gone from 1G to 2G to 3G to 4G to 5G, and by the way 5G is very much of a mirage, people are talking about it like it being out there on the table today, it’s not going to be here for years, really and truly. Each of those demands a denser network of towers to increase the reliability and lack of drops and so on. And the tower companies which are host to antennas become that same tollbooth. If you want growth in wireless communications they go through antennas, which are mostly on towers, sometimes they’re on buildings and that sort of stuff, but the tower companies are in that business as well. And so they act as tollbooth in the growth of wireless communication. It’s staggering.

PO – I’m curious though, in an idea like that, take something like retail datacenters, maybe a similar take on that. If this thing is going to keep growing, it’s sort of a toll. How often do you think about diversifying across that sort of bet, like the increase of digital communication?

CA: We’re not smart enough to dance with all the dances. We’ve been involved with datacenters in the past, we’re not in them now. I wouldn’t say that was necessarily the correct decision. But we explore and we learn and sometimes we, for example, we think a lot about the businesses that we’ve sold and whether that was the right decision. And sometimes it was not. Well, who does it perfectly?

You talk about being a quant and so on. If this business were susceptible to a purely quantitative approach they wouldn’t need me, and they’d just punch the button and it would solve for all your problems. That has not happened.

And the really brilliant mathematician James Simons of Renaissance Capital, I don’t know how many inputs they have but my guess is its probably in the 10s of thousands of inputs, which is a staggering way. And they’ve been able to do something that is truly exceptional. And perhaps Ray Dalio falls in that category with a little different approach. We don’t have any of that skill. We don’t think in those terms. We think about it in that very old fashioned concept of businesses. How do you tell if a business has been successful?

You’ve seen in my talks where I’ve said that and you ask the audience and they raise their hand and say, well the price goes up. Fair enough. Suppose it’s not a public company and you have no price discovery how do you tell? 

And I say, on the back of an envelope, you go to your accountant and say well this is what the owner’s capital is today and this is it a year ago and it’s higher than that by X percent and so on. That’s how you tell.

That’s why rate of return is what drives us. Did I understand that implicitly 30 years ago or 50 years ago. No.

Stuff that is right in front of your face, sometimes doesn’t reveal itself in terms of its importance for a long time. i carry a little coin in my pocket that says I’m a chartered member of the slow learners. And that’s in fact the case, I’m not a teenager.

PO – We’ve talked about this great businesses wrapped in a bad balance sheet.

CA: Oh, American Tower. That was a great example. 

We still own stock, in our separate accounts or in our partnership that cost us 80 cents or 79 cents. $209 a share today. It was a great business. I mean the incremental margin on a tower once it’s at, let’s just say 2 tenants, it might be 1.8 or it might be 2.1, but 2 tenants. The incremental margin on that business is north of 90%. And anything telephony in the 80s was levered 10 to 20 times. And American Tower was levered 16 times. Fully vertically integrated, they had steel companies, they had tower engineers, they had RF engineers, they had everything. And when everything telephony started to fall off a cliff, March of 2000, that’s when they started to fall off a cliff, American Tower had to scramble to deleverage itself. It had in 2002 it had come back to $5 a share and we had owned stock. We had owned stock when it had spun off of American Radio in Oct ’99 and it had come out at $15-16 a share, spun out to its shareholders. And it had got as high as $60 and then by March of 2002 it was $5. And then by September 2002 it was $2. And on their balance sheet they had about $6 billion dollars of debt but they had $200 million coming due in November 2003, this was fall of 2002. And they couldn’t use their bank lines to pay that off, because taking money from a bank line to pay off funded debt, that wasn’t possible. And they were scrambling to sell assets to continue to raise money. It was a relatively small amount of money but it was coming due, and we were in the middle of this 2 year downturn and 3 year downturn in the market that from top to bottom had fallen more than 50%. And we went and saw Steve Dodge, who was the Founder and CEO in September, the stock was $2 and he bought more stock on the way down at $11, that sort of stuff. And we understood from him, he told us as he told anyone who talked to him, that he could manage that problem through private equity world, it would be expensive, but he could manage it. And so the shareholders risk was not of the company collapsing, it was a risk of massive dilution. Because you could pay that off in cash or in shares, in their option. So it could be taken care of, but the risk to shareholders was massive dilution and the stock got as low as 60 cents on the October 3rd or whatever it was of 2002 and we bought stock at 79 cents, and we still own some in the partnership and my wife and I still own some. 

And there’s a great example of Thomas Phelps. You only need to be right in your investment decisions once or twice in a career. Once or twice in a career. And the challenge is how do you identify that. And so that’s why, in this whole issue of the three-legged stool, and the reason we have four up there is they are all very different. They come in different sizes and shapes. It’s an important notion. Visual construct. 

How do you figure out which ones are going to still be doing that 10 or 20 or 30 years down the road. Which ones today have high returns? So typically you want something that’s small so the market cap of American Tower was $200 million dollars or something like that, as opposed to $100 billion dollars today. And did I properly guess that 80 cent stock 79 cent stock was going to be worth $209 or 10 dollars in 11 years? No. But we’ve continued to buy it along the way, and as accordingly our clients and shareholders partners have prospered as a result of that. As we say, They’ve done well so we’ve done well.

PO – You mentioned earlier this idea of not selling as an asset of the firm. What are the things that would cause you to sell?

CA: Just as we describe the business model, the people model and the reinvestment model. When something goes wrong with one of those, it causes us to reexamine. We’re just like everybody else, we’re just human and we’re fallible and we don’t always get that right.

We had a case where we sold our holdings in Ross Stores 4-5 years ago. And they had gone through a change in the CEO and the new CEO was not made available to the investing community, there were some other issues going on at the time and we felt uncomfortable. We moved on, took a profit and so on. It turns out that was a mistake. It was a mistake where we didn’t have, that is it was a mistake in that the company has continued to do well and we weren’t part of it. They had an interesting and a good business model, retailers are hard as a generalization but we conclude now and the partner here who was doing the work on it will tell you pretty clearly that he’s concluded that it was a mistake to have sold it at the time, but we didn’t know that at the time and it was a reasonable thing that we did based on things that we knew. It happens. 

PO – I want to ask the same sort of three-legged stool question but about people that you work with, you mentioned you were an English and pre-med major, unencumbered by bias when you came into the business, what do you look for

CA: An English major, a pre-med major, a person involved in the investment management business.. they’re all the same. And people say, well what do you mean? Well they’re about collecting data points and forming judgements around them. It’s all the same.

So reading business biography you learn about people’s behavior. And sometimes you see it through the eyes of a biographer who has maybe a little rose tint to the glasses and sometimes you see it through just pure actions and sometimes you experience it. 

And so I told you that back in the 70s and 80s we had this experience with International Speedway, we had this experience over 10 years. We haven’t been in it for a long time, for a number of reasons. In the summers I had gone up and spent some time in Maine in the summers and I had gone up in the weekends and to a little dirt track to watch a stock car racing. And I noticed over the years that the dirt track got better and got paved and it got boxes and it got better equipment and the race cars were better. And I said that’s pretty interesting and I was drawn to the idea of entertainment businesses and unconstrained possibilities and so I came back to the office, and I was a stock broker at the time and I found the Standard & Poors corporate records and found all of the companies that were involved with horse racing and dog racing and car racing, all of that sort of stuff. To try to see if I could find some interesting businesses and there were three companies involved in automobile stock-car tracks, not Fomula-1 or anything like that. And those were Charlotte Motor Speedway, International Speedway, and Atlanta Raceway. And I invested in Atlanta and Charlotte, didn’t invest in International Speedway. 

In a long and complicated story, but Charlotte Motor Speedway there was man who owned 70% of it and he made a move to take it private after I had started buying stock in the market. And it was a North Carolina based company and I thought that it’s going private price was insufficient. And in North Carolina law, minority shareholders had a right of dissent. I had a lawyer in North Carolina who was a brother-in-law of a lawyer in Alexandria. He ended up getting me into a class action lawsuit and we went all the way through to discovery and found that this man, who was the Chairman of the company wanting to take it private, had failed to include all the corporate assets in there, had not had independent outside appraisals, all sorts of things. We caught him with his pants down. He was a thief and we had the goods on him. So he settled with us for probably three times his going-private price and it was a sealed settlement, it was not to be disclosed. And so that was an example of a guy putting his hand in your pocket. That company got reconstituted, it was a successful business, it is today. There’s another company he was involved with, successful public company. But I’ve never invested in any of them because I knew that man’s behavior. And my experience was, he’ll do it again, and in ways I won’t anticipate. And we’ve had that happen in a private investment where the people behaved in ways we never expected and we think are both incompetent and dishonest, and that happens periodically. 

PO – You mentioned earlier Bill France and him being an exceptional leader, maybe in contrast to this guy. What was it that made him an exceptional leader?

CA: Well first of all, early on he wasn’t taken with Wall Street and he did things that he thought made sense for his business, for example chatting with him one time, they had races like the Daytona 500 which would sell out. But he knew that his customers were, as he’d call them, blue collar workers. And so there were sensitivity to pricing of the tickets and so he would raise the price of the seats maybe every 4 or 5 years. And he would raise them quite modestly. But he had that pricing power, like in the old days Washington Post which kept the price of the paper at a buck or whatever it was, when everyone else was raising prices. They had a lot in their pricing power they could exercise but didn’t because they thought it made a difference. He would do things like that. And he would add seats in a very modest way, so he wouldn’t have very many unsold seats. And that changed the company towards the end of his life, when they got enamored with Wall Street and they started listening to the analysts and the bankers and they needed to raise the prices for everything and add way more seats. They’ve gone through all that, had the downside of that experience, in the last recession have taken seats out, that sort of stuff. 
He was way more customer oriented in that business than his successor who happened to be his daughter.

PO – Hoping to ask about how curiosity has lead you into other interests besides business, your interest in land conservation, talk to me about the background there, what interests you and how you’re involved.

CA: We’re just great believers in open space and the beauty of open space and its value to our populations. So the primary way we’ve been involved is putting conservation easements on our farms and land. And that is a function of the tax code. The tax code permits you to make donations of an easement on land which restricts its future use. The language in the Federal tax code says that these restrictions are in perpetuity.

And as I say to people, I don’t for a minute believe that will occur, times will change and people will figure out how to move around — so that just means that you just have to do the best you can while you are here. But that’s true in all things. And then in addition to that I sit on the board of the Maine chapter of the Nature Conservancy which does land conservation in a very large scale and all of the things which come from that which have to do with Maine and other states and around the world. Restoring fish to their native rivers by taking out dams or putting in massive amounts of forest into hydro carbon exchange market. Things of that nature. Which improve the quality of life for everybody around.

PO – In terms of advice for young people, we talked about imagination and curiosity, those are precursors you have to have those things. Any other advice you would give younger investors or would-be investors out there in terms of what might make them more successful if that’s what they want to do with their career?

CA: Follow your passion. And read like crazy. And be curious, about everything. I make the joke about the fact that back in the Clinton administration there was a guy who lived at the Jefferson Motel who ended up being caught by a relationship with a dominatrix. So I used to joke about the dominatrix is a business model. She could price however she wanted to price and all that sort of stuff. So it’s relating real life experiences. 

My example of pricing power is the following: It’s a holiday weekend a big holiday weekend. Your wife is having 100 people to a party in two hours. And the toilets are stopped. You will pay that plumber whatever he asks as long as he can get there before the party. That’s pricing power. 

So I’m always looking for ways to understand pricing power, because pricing power is key. So think about that as it relates to MasterCard and Visa. As I say, we have our notions and we don’t talk about it any more. And you’ll notice that the company never talks about it.

PO – What’s the kindest thing anyone has ever done for you?

CA: Wow, that’s personal, so I probably won’t share that. But the willingness of people to make themselves available, whether its me or somebody acting towards me or my family, is incalculable in terms of its value to you as a human being, so I spend a fair amount of my week every week trying to figure out what I can do to be useful to other people.

Every day is a learning day – Chuck Akre

Chuck Akre

Chuck Akre of Akre Capital Management was on Patrick O’Shaughnessy’s Invest Like The Best podcast. After listening to this twice in one day. I’ve taken the pleasure of transcribing a fair amount of the podcast, which I will post after this. In this post I will share some takeaways and my favorite quotes.

Some Takeaways

One of the things that’s very clear is Chuck believes in asking questions, asking simple questions. Or as he says in the podcast, have imagination and curiosity. Ask these questions: What does that mean? What does that tell you? Why is that? What business are they in? What does the business do? What’s going on?

In short: seek truth and seek an understanding. But don’t get lost in the weeds. Keep things simple. And by simplifying, try to understand the big context. The big, slower moving context.

Frequent readers will quickly guess my favorite quote: “Every day is a learning day.” I like to say “never stop learning” or, if you prefer positive language, “always be learning.”

Every day is full of opportunities to learn something new or reflect on a story or personal experience and extract new meaning. Don’t be stubborn in your thoughts. Keep and nurture an open mind.

Chuck Akre has clearly done a lot of thinking and reflecting. The podcast is full of insightful stories and lessons. Listen here: Chuck Akre – The Three-Legged Stool – [Invest Like the Best, EP.135] – Patrick O’Shaughnessy

Chuck Akre quotes

“Every day is a learning day.”

“I spend a lot of time reading, that’s how ideas bubble up in my universe.”

“We’re not smart enough to dance with all the dances.”

“Imagination and curiosity are what’s hugely important. We’ve discovered things over the years purely by being curious. And continuing to keep involved in the search process to find these exceptional businesses.”

“We usually use free cash flow return on owner’s capital.”

“Our experience is once a guy sticks his hand in your pocket, he’ll do it again.”

“If we own exceptional businesses, one of the hardest things to do is not sell them.”

The three-legged stool:

1. “Leg one is the quality of the business enterprise.”
2. “Leg two is the quality and the integrity of the people who run the business.”
3. “Leg three is what is their record and opportunity for reinvestment?”

(Business model) + (People model) + (Reinvestment model)

“Once we have all those things in place then we just aren’t willing to pay very much for these businesses.”

“Find a company with above average returns. Ask: What business is it in? If it’s above average for the business, then they are in a different business. Goal is to find out what business they are in.”

“If you read any research from Wall Street, and we read very little, there is no one who talks about that, who talks about the rates of return they are earning on their capital.”

Signs in Chuck Akre’s office:

“Everything should be made as simple as possible but no simpler.”

“The bottom line of all investing is the rate of return.”

“Follow your passion. And read like crazy. And be curious, about everything.”

“I’m always looking for ways to understand pricing power, because pricing power is key.”

“It’s a rare occasion where the CEO articulates an idea where he shows he understands the idea of compounding the economic value per share.”

“You only need to be right in your investment decisions once or twice in a career. Once or twice in a career. And the challenge is how do you identify that.”

[Talking about his clients’ capital]
“They’ve done well so we’ve done well.”

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Tencent 1Q19 Earnings

Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

Tencent announced 1q19 results on May 15. As you can see, I’m getting around to publishing my notes on Tencent’s earnings quite late here. In the future, I will post my thoughts sooner.

Key Takeaways:

  • New business segment “FinTech and Business Services”
  • Cloud services are the “business services”
  • Sales channel for business services will revolve around “showcases”
  • Content delays still impacting advertising revenue (same with iQiyi)
  • Gross Margins declining slightly, Adjusted EBITDA margins steady

New Segment: FinTech & Cloud

In China Tech Investor episode 19 we talked about Tencent’s 4Q18 earnings and I speculated the new segment would be cloud and financial services. And that I was looking forward to how they describe this.

  • New segment: “FinTech and Business Services”
    • Payments, wealth management, other Fintech services
    • Cloud services, other 2B services
  • “Others” now is production and distribution of films, TV programs, copyrights licensing, merchandise sales and others.


It’s good to occasionally make a list of what a company does, to get a feel for what a company is that is different than the corporate message.

Trying to ask “what is Tencent?” by looking at their segment revenues, you’d think they are first an Online Gaming company, second a FinTech company, and third a Social Network. And that isn’t wrong per se.

A better way to frame Tencent may be (1) a Publisher and Distributor of online games, video, and text content; (2) a Service Provider of payment, cloud, and advertising services; and (3) a Platform Owner/Operator of social networks.

This is important because the framing informs how to think about the company’s competitive positioning. (I’ll write more on this in the future.) Let’s dive into the segments given.

Fintech & Biz Services

Fintech & Cloud (as I want to call it) had an uptick in gross margins despite losing interest income on custodian money to PBOC. Mainly due to: (1) no longer giving exemptions or subsidies on cash withdrawal fees, now have a loyalty points system; and, (2) certain verticals take rates are back to a normal level, restaurants was given as an example. Shen Hon Lo (CFO) mentioned the margins will be impacted by competitive landscape as they dial up or down promotions and subsidies.

For cloud, it’s losing money on an operating basis, but certain verticals have made “decent progress”, those are: smart retail, financials, and municipal services. I think these are more like a handful of projects as opposed to “decent” adoption. This is where “2B showcases” come in. 

With the shift to 2B or “enterprise” as Tencent calls it, most people were excited for potential TAM expansion (more revenues). I’ve talked about how this is likely to lead to greater costs, hiring and training new teams to go out and sell to businesses. Tencent’s management has said as much on the call. 

They can hire a small team and have them go do the hard 2B sales work, but… “..it’s actually not that scalable, right?” says Martin Lau (P), “Every single company will need a team of tens or even hundreds of IT people to create custom-made solution.”

The WeChat Advantage

Even though it’s hard to scale “2B”, Tencent has a unique competitive position with Weixin/Wechat in Mini-Programss, Official Accounts and payments. Retailers have an easy path to “digitalization” through Wechat by utilizing advertising, Mini-Programs (MPs), payments and Official Accounts (OAs). Because Wechat is a daily must-use utility, it means retailers have increased opportunity to connect with their customers.

The obvious downside here is the potential to ‘poison the stream’. If WeChat turns into a spam sandwich, users won’t be happy. The easiest way combat this potential is giving users easy-to-use control over the “flow” of messages from OAs and MPs. Keeping users happy is far more important to WeChat’s ecosystem and worth the tradeoff of making it a bit more difficult for advertisers.

“We don’t think of WeChat as just a messaging app, we think of it more like a public utility service

Dowson Tong, Senior Executive Vice President of Tencent and President of Cloud and Smart Industries Group [1]

Online Advertising

All the big tech companies with advertising revenues have taken a hit in that revenue segment in the March quarter. In addition to the usual seasonality with advertising in 1Q, part of the reason is macro, content regulations, and specific verticals scaling back ad-spend (autos, real estate, internet services). 

James Mitchell also mentioned the “big, established but not-yet-profitable O2O companies and some internet start-ups who have curtailed their spending.” (A bit of a jab at Meituan-Dianping? LOL) On the other hand the relatively robust sectors are consumer products, games, education.

Internet Value-Added Services

“Retention for Peacekeeper Elite has been good,” as said in mid-May. We can see that because Peacekeeper Elite grossed $49.2m in May. Epic. I doubt they’ll keep that run-rate though. It could be people are making up for lost spending on PUBG mobile in China that never got monetization approval.

Source: SensorTower, Bloomberg

An important question is what kind of margin can Tencent get on Peacekeeper Elite. James Mitchell wants to see how game monetization behaves before going into that. I guess that could mean there is a revenue sharing agreement(s) with ratchets/targets. They do own a stake in PUBG creator BlueHole and have been trying to increase that stake…

James Mitchell went into details on the Season Passes. They noticed improved engagement, improved paying-ratio, and they aren’t seeing Season Passes pulling forward revenue, which means it is potentially accretive.

Group Margins

Margins had an uptick, though GM is lower YoY. The larger uptick in Net Income due to “Other gains, net” which is fair value gains of investee companies and net disposal gains from “capital activities of certain investee companies”.

Gross margins have declined but Adjusted EBITDA margins are holding steady. This compares to declining Adjusted EBITA margins at Alibaba, as they have entered, to borrow James Mitchell’s turn of phrase, the “not-yet-profitable O2O” competition.

Earnings Call Highlights

Daniel Zhang (?): “decade-long investment in FinTech and Business Services prove that our strategy of allocating capital to a range of organic investments can expand our capabilities, broaden our revenue base as well as generate sustainable profitable growth”

James Mitchell: “Looking forward, as we mentioned in the prepared remarks, we believe that there’s a convergence underway between the China game market and the rest of the world, Western game markets. That’s convergence in terms of the platforms on which people are playing games, meaning PC, console, mobile, it’s convergence in terms of the game business model meaning that the shift to the free to play games. And it’s also convergence in terms of the genres of games that people like, meaning the, for example, first-person shooter games which historically were less popular in China, have now become more popular in China. So given those convergence trends, we are more closely reviewing future games to assess whether they are suitable for global publishing as opposed to just China publishing.”

Earnings Call Q&A

Question on advertising business

JGM: In addition to macro environment, delays in several top-tier drama series were expected to be broadcast in the first quarter and were not broadcast in Q1. Negative impact on media advertising.

Within advertising revenue mix, some products have more direct competition and some have less.

“The macro environment will be whatever it will be.”

Question – Margin profile? Is fintech gross margin above 30%? Take rates on payment business?

ML: Don’t separate out cloud and fintech. Fintech is much larger %age.

Take rates are lower than global peers, similar to how credit card take rates are lower than global peers. Chinese credit cards are a better benchmark.

“I think it’s really because of the fact that the Chinese economy was actually built — the payment infrastructure was actually built at a later time and as a result, it’s somewhat reflective of a lower cost.”


iQiyi 1Q19 Earnings Notes

Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

Key takeaways:

  • Almost at 100M subscribers (grew 58% yoy in 1Q)
  • iQiyi’s advert business slowing (cyclical or secular?)
  • Some content releases are delayed (impacts advert business)
  • There were some disclosure changes in IQ’s 20-F (Grrr!)

Content Delays

English: Over the Sea I Come to See You

A show, called 带着爸爸去留学, had its broadcast date delayed. There was some speculation online that the delay was due to the US-China trade dispute. The show is about a dad and his kid going to the US to study abroad with about 90% of the show filmed in the US. Along with many others, iQiyi was supposed to broadcast in May 2019, but its release date was pushed to June 13th.

Revenues & Weak Guidance

iQiyi offered (historically) very modest guidance for 2q19. The mid-point of the range is RMB 7.1B (yellow dot in chart above) is only 15% YoY and 2% sequentially. Compared to the prior two second quarters that is a significantly low estimate. The reason given on the earnings call is content delays and continued deceleration in online advertising. Note this guidance was given halfway through 2Q.

I do not think they are aiming for an easy beat. First off, their prior estimates were fairly close. Second, their revenues have flattened in last three quarters. And finally, content delays and declining online advertising revenues could make 2Q tough for iQiyi. 

The reasons given for the declining advertising revenues make sense and are all cyclical in my opinion. The reasons given are: content delays, in-feed clean up, soft macro environment, certain verticals cutting ad budgets because of weak macro or regulations (online gaming), and higher ad inventories overall for the industry.

I believe higher ad inventories (supply) will prove to be cyclical when ad demand growth recovers. The main reason is I have a hard time imagining scenarios where demand for ad inventory does not recover, besides a long drawn-out recession.

With the content delays, one of the fears is that the delays will last a long time, or worse, be permanent.

Wang Xiaodong (CFO) responded to a question on the earnings call, saying iQiyi never had a case where content was delayed then never released. “We don’t expect that to happen.”

For this very reason, I wanted to see if 带着爸爸去留学 was released on schedule (June 13th). It was. As this free show is specifically about the US and 90% of it is filmed there, it is important sign that it got released during a time of tense US-China relations. 

(I noted one of the ads in the show was a reminder to stay safe when in the United States and to call the Chinese consulate/embassy if you experience any problems. I guess that was part of the bargain to get it released.)

As of today (17-Jun-2019), I believe fears of permanent content delays are over blown.

Segments: Gaining Subscribers, Slowing Online Advertising

Revenue is getting a boost from Member services which are up 64% YoY (8% seq), with subscribers up 58% YoY (see below). Yu Gong (CEO) attributes the rise to their quality premium content and targeted marketing campaigns. 

But… Online Advertising has been suffering since 2q18, which was the first full quarter after online games approvals were halted in March 2018. The pain in online advertising is being felt by many companies, as Elliot and I have discussed on China Tech Investor podcast.

Some may be quick to claim the growth divergence between Member Services and Online Advertising is representative of a change in iQiyi’s strategy. It is not.

Yu Gong (CEO) speaks frequently about the need for more monetization channels for online content. It is clear to me he really believes in this. He wants iQiyi to offer free content, as well as high quality original content.

Disclosure Changes

Readers will know from my Pinduoduo post that I find disclosure changes are usually a red flag (cause for concern). I usually trim positions if I’m long when I see this, or even reverse the position entirely.

What changed?

  • Changed quarterly average active users to annual average active users without providing historical comps.
  • Changed user time spent disclosure without providing historical comps.
These are not apples-to-apples…

My guess is (1) the Yanxi Palace drama released in 3Q18 was such a hit that they wanted to spread those active user figures out and (2) 4Q18 active user figures were either flat or, most likely, below 3Q18 levels.

Because this new number does not compare to prior active user disclosure, they also dropped the below table from the recent Form 20-F:

Source: Form F-1 filings

Changes like these are annoying for analysts and investors, especially when they don’t provide comparative figures.

Recently, I was asked if all disclosure changes are red flags. Short answer: no… but I’m not happy with the changes iQiyi made here.

Earnings Call Highlights

YG (CEO): “Looking ahead, we maintain a cautious outlook on advertising due to the soft macroeconomic environment in China and slower-than-expected recovery of our in-feed advertising.”

YG: “In particular, our original drama series, The Thunder, has not only been well received by all users but also highly acknowledged by government officials. And it become the first original series aired during prime time on drama channel of CCTV. Furthermore, it is expected to hit international market through RED BY HBO, which acquired the Southeast Asia licensing rights of the show.”

Note: The Thunder is 破冰行动 in Chinese and it looks particularly good.

Q&A on Advertising

Question – Content costs down sequentially almost 20% (actual -18%), trend or one-off? How do you see content costs in coming quarters?

YG: [interpreted] Major reason this quarter is delay of some of our content. Delay due to policy changes and regulatory censorship. Also related to process of content production. On regulation, I think level this year will be relatively stable compared to last year, but there are some anniversaries of political events in Q2/Q3 so will be stricter than before.

Question – Strong total subscriber growth. How do you see competitive landscape going forward? 

YG: Yes, outperformed peers in subscriber growth. Thinks attributable to very strong original content offered in the first quarter. But there’s also something related to the scheduling of the content, how to balance mix of content to be aired and bench-marking to what other companies are offering.

WXD (CFO): “But however, as I just said, we’ll remain very cautious on the forecast of the entire advertising business in the next few quarters or even next 2 years because of the relatively weak macro environment.”

Question – Can you dissect the advertising business performance, what’s driving bearish view on advertising business in 2Q?

YG: Three revenue drivers: one Subscriptions, two is advertising. Two factors impacting advertising revenue. (1) is the content delay as mentioned. (2) is, as everybody knows, the softer macro environment. As a result, certain verticals have lowered their ad budget. In advertising iQiyi has in-feed advertising, we did some cleanup later half of last year, that’s another drag. “In addition, because of the in-feed ad inventory side, the overall inventory is coming up from all of the industry, but on the other hand demand, is not so upbeat. As a result, the CPM is returning trend to a normal level.”

Third revenue driver is other business, which “contain a lot of IP derivative revenues including game and other IP-related revenues, which can be potentially a long-term driver for us.

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CTI27 Notes – Alibaba 4Q19

Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

This post covers Alibaba’s considered Hong Kong listing, BABA’s May share price decline, declining EBITA margins, “margin drag” segments, and concludes with thoughts on the growing “wallet share” strategy of ecosystem apps.

These notes were prepared for episode 27 of China Tech Investor podcast, recorded on June 6, 2019. These notes were prepared before Alibaba released their 20-F on June 6, 2019.

Listen to China Tech Investor podcast on iTunes, anchor.fm or your favorite podcast app.

Recent News & Share Price Decline

  • Alibaba’s HK listing looking even smarter right now, with Marco Rubio’s proposed law [1] to have companies listed in the US adhere to US accounting standards & oversight or be de-listed.
    • Comment: This will likely lead to a de-listing spree of the quality US-listed Chinese companies because the accounting oversight is a regulator-to-regulator matter. The quality Chinese companies would likely relist in either Hong Kong or possibly the New Tech Board being launched in the mainland if it goes well.
  • 4Q19 earnings release [2] filed on May 15th 2019, discussed below
  • 2019 Form 20-F [3] filed with the SEC on June 6th 2019

Alibaba’s share price has seen a 24.2% decline since the Trump Tariff Tweet.

Source: Bloomberg, Hullx annotations

Share price decline likely impacted by:

  1. Trump’s tweet [3]: “325 Billion Dollars of additional goods sent to us by China remain untaxed, but will be shortly, at a rate of 25%… The Trade Deal with China continues, but too slowly, as they attempt to renegotiate. No!”
  2. Declining margins

What’s going on at Alibaba?

So their revenue has been growing like gangbusters. The past 12 quarters had YoY revenue growth of 41% or higher. The lowest was 41% in Q3’19 (Dec’2018 quarter). The average has been 56%. The highest was 61%, which happened 3 times in the last 12 quarters. Nothing short of amazing.

Source: Company filings, Hullx calculations

Moving down to EBITA (no Depreciation in there). It’s also amazing, but the range of YoY growth is larger, from 1% to 71% in past 12 quarters. Average is 32%.

Source: Company filings, Hullx calculations

What’s more important is the EBITA Margin. In the most recent quarter, we are looking at 22% EBITA margin, or 28% on FY basis. That compares to a year ago 27% quarterly, and 39% FY basis. So we’re seeing declining EBITA margins.

Now the question is why?

EBITA has components, and Alibaba breaks them out (thank you). And we can look there. And we see what I’ll call “Margin Drag” in the Cloud, Digital media, and Innovation Initiatives segments. That’s negative EBITA Margin. 

  • Cloud has been improving (getting less negative), from -41% in March 3 years ago, to -5% in most recent FY period.
  • Digital media has been worsening.
  • Innovation initiatives is a bit all over, but usually worse than -100% margin

We also see a declining trend in Core Commerce EBITA margin from above 60% in FY2016-2017 to 42% in FY2019. 

This is most recently driven by consolidation of Local Consumer Services, New Retail, Direct import, and Cainiao Network. (BTW, this consolidation helps revenue growth, but because these are loss-making business segments, it hurts EBITA). We’re looking at a negative EBITA of RMB 25.4B for these businesses for FY2019. We don’t have much historical disclosure around these, but that’s compared to negative RMB 8.8B a year ago.
In order to remove these impacts, Alibaba presents a special adjusted EBITA called “Marketplace-based core commerce adjusted EBITA” (MbccaEBITA). This figure has grown 31% YoY.

While that growth is great, the MbccaEBITA margin has declined from 49% to 43%. So the margin decline is also impacted by something else. 

What that is exactly, is difficult to determine. It’s probably related to international expansion & Lazada switching from 1P to 3P. Though, it could also be mixture of macro, competition (Pinduoduo), traffic costs, or something else. Welcome any feedback here.

Earnings Call Highlights

Joe Tsai chimed in on general macro concerns in China. Saying Alibaba benefits from long-term secular trends. He sees a long-term shift to service-oriented economy (last 5 years losing manufacturing jobs) that is driving disposable income growth and continuous consumption. The “domestic consumption driven economy”. 

Competition with Pinduoduo was an unspoken theme on the call.

  • Expansion into T3 and lower cities. 70% of new users were from T3 or lower. But will be conservative on monetizing the traffic from these new users.
  • Daniel Zhang: Taobao is positioned as a consumer community, value prop is in-depth selections and discovery – and the *fun* of discovery. While Tmall is very high-quality product and services with high degree of certainty.

Daniel Zhang: Ele.me is an important on-demand delivery network, serves not only ele.me but also other businesses, like recent Starbucks collaboration. // Hmm, Starbucks is food, like ele.me, hard to see how that’s really a *new* area. More that it can form the basis of a business relationship with a company like Starbucks.

Maggie Wu: Less focused on margins, more focused on profit growth. // Getting bigger, making more RMB as opposed to operating more profitably. 

Concluding Thoughts

There’s a general trend in e-commerce in China to gain consumers “wallet share”. This is the goal driving the ‘ecosystem e-commerce apps’. I think the idea is to get a larger piece of consumers consumption onto their platform/ecosystem, where it can be collected and analyzed. The final goal being to sell marketing services with better efficiency (ROI). It is yet to be seen whether this works and I don’t see anywhere on the planet that has figured out a profitable business model for 3rd party delivery, ride hailing, etc. I hope these companies have (1) analyzed the incremental unit economics and (2) are seeing incremental improvement or even better, profitability. 

What’s obvious is the margin destruction will continue for the foreseeable future for Alibaba. How far will Ali go? How far will their competitors go? How much capital will be deployed in the fight? And what will be the treasure for the winner(s)? 


CTI26 Notes – Pinduoduo 1Q19 – Disclosure changes, coupons, and take rates

Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

These notes are for China Tech Investor podcast episode 26, listen on overcast or anchor.fm.

Pinduoduo announced earnings on May 20th 2019. But, before we jump in, let’s look at some excerpts from their SEC filings.

Disclosure changes

“Furthermore, we offer coupons from time to time to stimulate buyer engagement on our platform.” (page 58, Form 20-F filed 24 April 2019)

Sales and marketing expenses. Sales and marketing expenses consist primarily of online and offline advertising, promotion and coupon expenses, as well as payroll, employee benefits and other related expenses associated with sales and marketing. We expect our sales and marketing expenses to increase in absolute amounts in the foreseeable future as we seek to increase our brand awareness.” (page 78, Form 20-F filed 24 April 2019)

New Disclosure

Form 20-F filed 24 April 2019:

  • Page 81: “Sales and marketing expenses. Our sales and marketing expenses increased substantially from RMB1,344.6 million in 2017 to RMB13,441.8 million (US$1,955.0 million) in 2018, primarily attributable to increases of RMB11,608.2 million in advertising expenses and promotion and coupon expenses. The increase in advertising expenses and promotion and coupon expenses were focused on building our brand awareness and driving user growth and engagement on our platform.”
  • Page F-26: “Advertising expenditures are expensed when incurred. Total amount of advertising expenditures and incentive programs recognized in sales and marketing expenses were RMB113,691, RMB1,259,610 and RMB12,867,833 (US$1,871,549) for the years ended December 31, 2016, 2017 and 2018, respectively.”

Old Disclosure

Form 20-F filed 26 July 2018:

  • “In order to promote its online marketplace and attract more registered consumers, the Group at its own discretion issues coupons to consumers. These coupons can be used in future purchases of eligible merchandise offered on the Group’s marketplace to reduce purchase price that are not specific to any merchant. As the consumers are required to make future purchases of the merchants’ merchandise to redeem the coupons, the Group recognizes the amounts of redeemed coupons as marketing expenses when future purchases are made. During the years ended December 31, 2016 and 2017, the Group recorded marketing expenses related to the coupons of RMB76,679 and RMB321,531 (US$51,260), respectively.”
  • “Advertising expenditures are expensed when incurred and are included in sales and marketing expenses, which amounted to RMB32,867 and RMB907,250 (US$144,636) for the years ended December 31, 2016 and 2017, respectively.”

Did you see that? They changed (or removed) their disclosure of “promotion and coupon expenses” by combining it with “advertising expenses”. Here’s a table that tracks the numbers across three separate filings.

Source: Company filings, Hullx calculations


I previously mentioned how you could find the amount of coupons & promotions (a.k.a. ‘incentive programs’) in their sales & marketing expenses. You had to dig, but it was there. Pinduoduo has obfuscated that away. It is now grouped with “advertising expenses” and is called “advertising expenditures and incentive programs”, which is 96% of sales and marketing total expense. So, why even disclose this?

To me, this is a Red Flag, these changes are carefully considered, they are not accidental. Increasing obfuscation shows, at the very least, a lack of respect for shareholders. Previous disclosure indicated (see table above) the amount related to “coupons and credits” was 32% of revenues for first 9 months of 2018, up from 18% of revenues for full year 2017. In my opinion, 32% is significant and deserves to be disclosed separately.

I can only speculate, but I believe coupons [and credits] as a percent of revenue will continue its increasing trend to above 40% for full-year 2019.

In Q1’2019 Pinduoduo had a revenues of RMB 4.5 B, which was up 228% YoY but down 20% sequentially. Their first sequential drop in revenues. But, this is the same seq decline (20%) for Alibaba and quite normal in the March quarter for e-commerce in China because that is when Chinese New Year occurs.

Source: Company filings

On the Earnings Call, Colin Huang said their marketing expenses should be viewed as investments rather than expenses. The idea being that they get a return on investment in their marketing spend. I presume he means over-time they’ll get a return on marketing spend. Like all things in the future, there is uncertainty.

I note that no analyst asked about incentive programs, promotions or coupons on the earnings call.

Take Rates

Trailing 12 month take rate was 2.92%, up from 1.56% a year ago and up from 2.78% in Q4 2018.

I’ve been trying to estimate their quarterly numbers to see if there are any indicators there, but it’s not easy (and probably overkill). PDD makes this a bit difficult because they only announce certain metrics on a trailing 12 month basis. These metrics are “GMV”, Active buyers, and Spend per buyer.

So I’ve played around with my assumptions and got something I’m somewhat satisfied with. It’s not perfect, I’d prefer actual numbers of course. I have two sets of assumptions, and I’m not sure if either is correct:

  1. Where the Quarterly “GMV” sequential percent change roughly matches up with the revenue sequential percent change, and
  2. Where the quarterly Active Buyers sequential percent change roughly matches up with sequential percent change in Average MAU for that quarter.

I played around with a lot of other assumptions, and the majority of them show that the quarterly take rate peaked in Q2’18. (Take rate is revenues divided by “GMV”.) That is (or could be) significant because, if it is true, unless Q2’19’s take rate matches or is better, we should see a sequential decline in trailing 12 month take rate. That would be a first for Pinduoduo.

While doing this analysis I was curious what Alibaba’s take rates were like when they were growing. So I went back to Alibaba’s filings and they averaged around 2.44% per quarter in the 16 quarters from Jun-2011 to Mar-2015 with a high of 3.05% in Dec-13 quarter. For 12M ended Mar-2019 Alibaba’s take rate was 4.5%. [Note: I said 5.65% on the podcast, but that was wrong!]

For comparison, Alibaba’s annual active customers is 654 million for Mar-2019 versus 443.3 million for Pinduoduo in the same period. Also, Alibaba’s mobile MAUs were 721 million in Mar-2019 quarter versus 289.7 million for Pinduoduo.

Interestingly, Alibaba’s annual active customers is BELOW MAUs, which Pinduoduo’s is ABOVE (and always has been). But that wasn’t always the case:

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CTI26 Notes – Baidu 1Q19 – Building a flywheel

Disclaimer: These notes are shared for informational and educational purposes only. THIS IS NOT INVESTMENT ADVICE.

These notes are for China Tech Investor podcast episode 26, listen on overcast or anchor.fm.

Quick note about format. We covered two companies in this episode. I’ve decided to separately post the notes for each company, so they will be searchable by tag. — That’s all.

Baidu announced Q4’2018 results on May 16 2019 [1] and sharply traded down. It was their first loss since 2005 and their search executive resigned. They’ve been trending down since their high of 284 literally 1 year ago, May 16 2018. A 60% drop!

Baidu – BIDU

It traded around $114 yesterday. The last time it was in this range was the flash crash of Aug 24 2015. Before that it was July 2013, almost 6 years ago!
And, you know what’s funny? Back in 2013 between 7/24 and 7/25, there was a gap from $113.88 to $120.26, more than $4 gap. In trading, there’s a saying, “Gaps eventually get filled” or “Gaps get tested”. Well, here it is, almost 6 years later, the gap is getting filled.

Baidu 6Y chart

What happened back then? It was their Q2 2013 earnings which had revenues up 38.6% YoY.

“Our market-leading technology, innovative new products and unrivaled customer value proposition will keep us at the heart of the Internet in China.”

Robin Li quoted in Baidu’s 2Q13 ER

Hard to argue that Baidu is at the heart of the internet in China. The “internet” moved to mobile and Baidu didn’t get the message much later.

Anyway, they’ve been trending down since their high of 284 literally 1 year before this recent earnings, May 16 2018.

You might ask, what is going on?

Let’s start with a look at some changes Baidu has been making. They are (1) building an ecosystem in Baidu App (2) with a focus on two buzz-words: “feed” and “mini programs“. A “feed” needs a constant source of content (preferably organic), so they have Baijiahao for text and Haokan for video.

My guess is they are trying to build a “flywheel” here. Where content pulls people in, gives them time-killer videos, answers their questions, and those interactions then feed their recommendation engine and maybe tells them what users are searching for, they then provide those results or build structured data portals around those areas, bringing more people in and so on.

But, there are headwinds.

  • “Content” is being heavily scrutinized in China.
  • Online gaming has come under regulatory pressure in the last 12+ months.
  • VCs are cutting back, which impacts marketing spend by startups.

The largest segment of Baidu’s revenues is Online Marketing Services. They sell advertising. It will be vital for Baidu to build this flywheel and get it turning at high speed–no easy task.

Baidu sees weakness in online gaming, financial services, real estate and autos.

Mentioned they are looking into reducing costs, the previously announced RMB 1B of additional Opex will be reduced.

Guidance is lower, to flat, taking out iQiyi. Q2 guiding revenue of RMB 25.1B to 26.6B.


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