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.”

Thanks for reading. If you want to be notified of new posts, please subscribe. I welcome your thoughts and comments. Continue the conversation in the comments, on Twitter @jameshullx or on LinkedIn.

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.

Segments

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.”

Sources

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.

Thanks for reading. If you want to be notified of new posts, please subscribe. I welcome your thoughts and comments. Continue the conversation in the comments, on Twitter @jameshullx or on LinkedIn.

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)? 

Sources:

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

Coupons

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:

Thanks for reading. If you want to be notified of new posts, please subscribe. I welcome your thoughts and comments. Continue the conversation in the comments, on Twitter @jameshullx or on LinkedIn.

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.

Sources:

Thanks for reading. If you want to be notified of new posts, please subscribe. I welcome your thoughts and comments. Continue the conversation in the comments, on Twitter @jameshullx or on LinkedIn.

Trade War as Prisoner’s Dilemma

A trade war is like a Prisoner’s Dilemma game gone wrong.

  • (1) Trust between both sides has eroded.
  • (2) They cannot communicate effectively.
  • (3) They decide to forego cooperation and defect.
  • (4) And, by foregoing cooperation both sides are hurt.

In a prisoner’s dilemma game, two players are separated (can’t communicate) and given two choices: cooperate or defect. The only winning outcome is when both players choose to cooperate. 

There is a special kind of prisoner’s dilemma game, where the game is repeated many times over and the players can remember the other player’s actions. This means past rounds matter, reputation matters. In these prisoner’s dilemma games, a winning strategy emerges: Tit-for-Tat.

How Tit-for-Tat wins Prisoner’s Dilemma games

First off, the Tit-for-Tat strategies that win are slightly modified. They have a function that tries to break a negative ‘defection’ cycle by forgiving the other party and making the first move to cooperate. 

Forget injuries, never forget kindness

More specifically the winning strategies tend to be: “nice (never the first to defect), retaliating (willing to defect), forgiving (willing to attempt to regain trust by breaking a defection cycle), and non-envious (not specifically attempt to outscore individual opponents)”[1]. I’m going to focus on forgiving because that is where the cycle gets broken.

In a standard Tit-for-Tat strategy you copy the move of your opponent. If they defect : you defect, if they cooperate : you cooperate. This easily turns into a negative cycle, where both sides keep defecting (and spending a lot of extra time in jail).

The negative cycle is broken first by forgiveness and second by extending a hand (attempting cooperation). One side decides to forgive and tries cooperation for two rounds.

Why two rounds? Because the players don’t know the other player’s action until after the round. The first round forgiveness is the signal. The second round is the real chance for cooperation:

  • If the other side cooperates, the negative cycle is broken. (Hurrah!)
  • If the other side refuses cooperation, in the next round (the third) the forgiving player switches back to escalation. The negative cycle continues.

Here’s some food for thought on forgiveness:

  • “记人之善,忘人之过” – 三国志 forget injuries, never forget kindness.
  • “We must develop and maintain the capacity to forgive. He who is devoid of the power to forgive is devoid of the power to love. There is some good in the worst of us and some evil in the best of us. When we discover this, we are less prone to hate our enemies.” – Martin Luther King, Jr.
  • “To forgive is to set a prisoner free and discover that the prisoner was you.” – Lewis B. Smedes

Forgiveness is the intentional and voluntary process by which a victim undergoes a change in feelings and attitude regarding an offense, lets go of negative emotions such as vengefulness, forswears recompense from or punishment of the offender, however legally or morally justified it might be, and with an increased ability to wish the offender well.

Wikipedia [2]

Thanks for reading. If you want to be notified of new posts, please subscribe. I welcome your thoughts and comments. Continue the conversation in the comments, on Twitter @jameshullx or on LinkedIn.