By examining potential governance issues at Airbnb, this substack blog suggests that COVID-19 may be more tumultuous for private markets than public ones. Airbnb's problems emanate from a recent (expensive) debt issuance, during which investors demanded a series of governance and cost-cutting measures. What may be more unusual - and concerning - is that independent directors joined those calls. "It's not often you see reports of independent directors being the ones leading the charge on cost cuts and rationalization, especially in VC-funded companies. Most board friction occurs between founders and investors so to see independent directors get involved is unique and raises more questions." Pushing through cost rationalizations during a time of weakness may suggest that investors are not pleased with the direction of the company. Importantly, the author thinks that CEO Brian Chesky has not adequately communicated with stakeholders and that vision casting for the long term has therefore failed, for now. "Pursuing a 'long term' vision is not simply a top down mandate. It requires buy-in from all stakeholders, especially the employees. It also requires authenticity or cynicism and loss of confidence takes root."
ABOUT Beach Reads
Welcome to Beach Reads, a collection of interesting links that we at WCM have come across and want to share. The goal of this publication is to engage with a broader audience in order to better ourselves and others. Feel free to email us at firstname.lastname@example.org with any thoughts or feedback, and click here to subscribe!
01. Business Updates - Airbnb and Zoom
In the work-from-home world, Zoom has become both a professional tool and a social media service. I've used it to connect with my team, research partners, friends, and family. And yet, despite wide-spread adoption and the rise in the stock price, some think the company's success may be short lived. This Medium post challenges Zoom's moat, arguing that other tools such as Slack have stronger network effects than Zoom. "Zoom's virality and product quality have helped it grow rapidly. However, it had to sacrifice network effects in order to accomplish this. The definition of a network effect is that the value of a product increases as more users are added to the network. Network effects are the strongest form of defensibility because the presence of other users on the network prevents churn. But in Zoom's case, its USP is built on enabling frictionless communication with users who are not on the network. In other words, the value of Zoom's product is the same irrespective of whether a user is communicating with another user or a non-user. As a result, Zoom has no network effects whatsoever, i.e. it is a tool, not a network." Put another way, Zoom is in a bit of a Catch-22: To grow, and grow quickly, it must depend on virality. However, to be sustainable, it must figure out a way to implement network effects. In a year or two, it'll be interesting to see what has come of Zoom, especially compared to other tools such as Slack and Microsoft Teams.
02. Software Stocks
Among a deluge of earnings reports this week will be results from large software companies such as ServiceNow and Atlassian, among others. Investors will keenly watch how resilient their earnings are and how "recurring" such subscription revenue models really are. In the last Beach Reads, I featured a podcast where Atreides Chief Investment Officer Gavin Baker highlighted this potential downside risk. This time around, Gavin is out with a Medium post that walks through five variables that may impact how resilient a recurring revenue model really is through this recession. "My instinct is that software contracts will be at best comparable to first-lien debt and that software payment terms will change significantly as a result of this recession. I suspect that fewer customers will pay cash up front and that we will see payment terms lengthen significantly. A slowdown in revenue growth accompanied by a potential paradigm shift in working capital will have a substantial impact on software companies that are burning a significant amount of cash. Generating at least $1 of free cash flow has never been more important and getting to that magic first $1 just became much harder." While perhaps stalled for the time being, we'll get a much better idea of what recurring revenue looks like in coming weeks. However, the long-term health of these companies will ultimately depend on the state of the economy, regardless of their revenue model.
Different recessions, different stock performance. The resilience of software stocks through recent market volatility has come as a surprise to many, especially after revenue multiples fell by 75% during the great financial crisis. The Financial Times recently compared the bull and bear cases on the sector. For bulls, software companies are critical to business functioning and will continue to enjoy strong tailwinds, whereas bears believe that new contracts will disappear and take a while to resurface. However, those businesses that create a win-win by focusing on the lifetime value of customers, and helping them through the crisis while remaining afloat themselves, may prove to be the most resilient. "Any temporary dent to revenue, however, might not be significant as long as the coronavirus collapse does not lead to widespread customer bankruptcies. Cloud software companies manage their businesses to maximise the lifetime value of their customers, said Tien Tzuo, chief executive of Zuora, whose technology is used by other companies to support subscription operations. As a result, he added, helping a financially strapped customer through a difficult period might not end up having much impact on the longer-term value of that customer."
03. Retail: Amazon Private label, DTCing through COVID-19, and retail charts
While recent articles about Amazon have focused on the retailer's role through COVID-19, this WSJ expose alleges some potentially unsavory tactics by the company in its private label business. According to the article, Amazon employees can use information about products hosted on the marketplace – that they should not have access to – to help develop private label products. "Such information can help Amazon decide how to price an item, which features to copy or whether to enter a product segment based on its earning potential." These alleged practices have led some businesses to lean more on platforms like Shopify rather than Amazon.
The carnage in direct-to-consumer land (DTC) has been well documented through Beach Reads. While COVID-19 is accelerating this trend, there are a number of ways that DTC brands can weather the storm, highlighted in this Medium article. One of the most interesting (and underutilized) ways that DTC brands can stay in business is through strong consumer engagement that leads to product or brand communities: "In an undisrupted economy, building a strong community around content allows DTCs to reduce their reliance on paid advertising in order to scale the brand. In the current climate, the role of content is critical in creating a sense of connection and community with customers. In any case, keeping existing customers engaged and connected pays far more dividends, considering that acquiring new customers is five times more expensive than getting an existing customer to repurchase." Content creation and customer engagement likely have a significant positive impact on customer acquisition costs, thanks to referrals, while also increasing long-term value (more engaged customers likely stickier). Brands that are currently challenged would likely do well by focusing on customers - businesses that do so successfully should come out of this recession stronger than before.
If you are interested in checking out the new normal in ecomm, fashion, brick-and-mortar, etc., this article includes a number of charts that detail the changes to retail brought on by COVID-19. One of the most interesting juxtapositions is that omni-channel seems to be doing better than pure-play ecommerce - take a look.
04. Investing Philosophy: Li Lu and Terry Smith
This fantastic piece by Li Lu outlines the investment philosophy of the founder and Chairman of Himalaya Capital, which once managed some of Charlie Munger's fortune. Rather than about "value" investing, per se, I instead found this translation of a speech at Peking University's Guanghua School of Management to read more as an ode to investing - a piece that uplifts the professional and makes it out to be more of a calling than a career. One portion that struck me was Li Lu's definition of investing vs. speculating. Essentially, while putting money into a company with a proven track record allows your investment to grow along with its profits over time, speculation is always a zero-sum outcome as everyone's wins and losses inevitably cancel out. The idea that speculating is a zero-sum game, while investing is not, is a powerful insight, as is Li Lu's assessment of the critical impact of culture on returns, told through an anecdote about two adjacent gas stations, one run by a family who go out of their way to be the best they can be for every customer, the other run by an under-incentivized employee. Guess which wins?
In the last edition of Beach Reads, I included a link to the Fundsmith annual shareholders' meeting. Last week, the FT profiled Terry Smith and his fund, highlighting the investment approach of the firm: "Fundsmith invests in mature companies with strong balance sheets and established brands, which are capable of reinvesting their profits and compounding value for investors over time, while excluding cyclical sectors, such as mining and financials." These are the hallmarks of businesses owned by a good quality growth investment firm. On a more personal note, the author features Terry's colorful demeanor: "Mr Smith's willingness to sail against the wind is part of the reason investors flock to him. In his stockbroking days he turned heads by issuing a 'sell' recommendation for Barclays while working for its in-house research arm. He later won notoriety when he published Accounting For Growth, a book critiquing accounting practices at companies that included direct clients of his then-employer, UBS (which subsequently fired him)."
05. Fiscal Stimulus
Collaborative Fund's Morgan Housel recently wrote a piece that helps put the ballooning US government debt load (as a result of COVID-19 stimulus) in perspective. I included similar links in Beach Reads two weeks ago, but Morgan takes a different approach in his analysis. Morgan argues that, unlike people, who have a finite debt horizon, governments have an infinite debt horizon and can grow their way out of debt, rather than simply pay it off: "This isn't intuitive because it doesn't apply to people. When a person takes out a mortgage or a car loan, there's a repayment date. But that's only because people have finite careers and lifespans, so there's an 'end date' where all debts have to be repaid. Countries (and to some extent companies) are different. They have indefinite lives. So they can remain indebted indefinitely, even with rising debt." There is some evidence that downturns stimulate entrepreneurship and innovation - let's hope that is the case post-COVID, so that we can continue to grow out of debt. What if some stimulus was specifically earmarked for innovation?
06. Reflections: Building the new world and how discomfort induces creativity
Just under a month ago, JPMorgan CEO Jamie Dimon issued a call to arms, asking the American people to work together, take responsibility and be forces of positive change. More recently, Marc Andreessen published his own rallying cry, focusing on returning America to a nation of builders. Andreesen envisions "futuristic" dreams of supersonic jets, high speed trains, and flying cars becoming reality, so long as we overcome a number of problems: "The problem is desire. We need to 'want' these things. The problem is inertia. We need to want these things more than we want to prevent these things. The problem is regulatory capture. We need to want new companies to build these things, even if incumbents don't like it, even if only to force the incumbents to build these things. And the problem is will. We need to build these things. And we need to separate the imperative to build these things from ideology and politics. Both sides need to contribute to building." While perhaps a bit provocative, Andreessen makes solid points. Especially in a post-COVID world with high unemployment, the time to build is now. "Building is how we reboot the American dream. The things we build in huge quantities, like computers and TVs, drop rapidly in price. The things we don't, like housing, schools, and hospitals, skyrocket in price. What's the American dream? The opportunity to have a home of your own, and a family you can provide for. We need to break the rapidly escalating price curves for housing, education, and healthcare, to make sure that every American can realize the dream, and the only way to do that is to build."
Institutionalizing creativity in professional organizations is incredibly difficult. Some books, like Ed Catmull's "Creativity Inc.," provide glimpses into creative companies; however, it almost always seems that an intangible secret sauce is at play. In this article, published by Insead, the author outlines some ways that creativity can be encouraged in businesses. One important standard is that there be psychological safety in organizations: "For professionals, a supportive culture is especially important, because going out on a limb with an unlikely idea carries heavy perceived risks...An atmosphere of psychological safety – where people generally feel less threatened and defensive – helps to tame this conservative bias." Once psychological safety is established, an interesting external force seems to push creativity: discomfort. "Creativity...thrives upon small doses of discomfort. A company, therefore, needn't be a paradise of peace to coax creative ideas out of the shadows – it can purposefully jolt them out by launching minor disruptions against a backdrop of psychological safety." Those industries that are fundamentally creative - Hollywood studios, video games, architecture firms, etc. - would all likely benefit from being intentional about creativity, rather than waiting for strokes of genius.
Disclaimer: To the extent that Beach Reads discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. The companies and or securities referenced and discussed do not constitute an offer nor recommendation to buy, sell or hold such security, and the information may not be current. The companies identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the companies identified was or will be profitable. Beach Reads does not constitute a recommendation or a statement of opinion, or a report of either of those things and does not, and is not intended, to take into account the particular investment objectives, financial conditions, or needs of individual clients.