Curated Insights 2019.11.01

GrubHub shareholder letter (October 2019)

A common fallacy in this business is that an avalanche of volume, food or otherwise, will drive logistics costs down materially. Bottom line is that you need to pay someone enough money to drive to the restaurant, pick up food and drive it to a diner. That takes time and drivers need to be appropriately paid for their time or they will find another opportunity. At some point, delivery drones and robots may reduce the cost of fulfillment, but it will be a long time before the capital costs and ongoing operating expenses are less than the cost of paying someone for 30-45 minutes of their time. Delivery/logistics is valuable to us because it increases potential restaurant inventory and order volume, not because it improves per order economics.

Earlier, we talked about the great progress we are making with enterprise brands. We love working with large enterprise brands because they help drive new diners to our platform and keep diners from going to other platforms. That said, the biggest enterprise brands don’t need Grubhub to bring them new diners in the same way independents and small chains do because they spend billions a year on developing their own brands. What they need most is a driver to take the food to their diners. And, as we just noted, that isn’t cheap, or particularly scalable, so the unit economics and long term profit outlook for our business would look very different if a majority of our business was coming from large enterprise brands.

Life of pie: A closer look at the Domino’s Pizza system

The key to operating a successful Domino’s master franchise is to have the Domino’s brand stand out against all the other pizza options that are available in the marketplace. In other words, the brand has to be put to work to generate demand, which can only be achieved with significant marketing spend. Tv is still quite important for Domino’s and generally requires a significant advertising budget. That budget has to be levered on a good number of restaurants in order to make sure the marketing expenses stay at a reasonable level per store.

Every new market that’s entered starts more or less from scratch, with limited consumer awareness and entrenched behavior that benefits the incumbents. This is why it is so difficult for a new Domino’s market to get to a scale that makes economic sense. Once you manage to reach that scale that the flywheel can start spinning, because at that point the business can self-generate its growth through reinvestment in marketing.

It appears that the entire Domino’s franchise has come under a bit of pressure from aggregators like Takeaway, Uber Eats, Grubhub and Doordash, which are oftentimes operating at a loss. Since the aggregators are providing access to technology platforms that many small operators would not be able to afford or operate on their own, they’ve essentially levelled the playing field for pizza restaurants again. In my opinion this has decreased Domino’s Pizza’s advantage in the mobile ordering space. Domino’s Pizza Inc.’s CEO conceded recently that the aggregators are indeed having an effect on their same store sales growth (item below). For now I have no strong conviction on Domino’s but it is a business with some fascinating developments.

Schwab kills commissions to feed its flywheel of scale

“ we did not expect such a swift reaction in the sense that we thought that we come out with IBKR Lite as an additional offering and that we go on for a while, and will attract some customers and then eventually, other people will start reducing and maybe all go to zero. So this — this very swift reaction was a surprise to us.” – Thomas Peterffy, Founder and Chairman, Interactive Brokers Group (IBKR), 3Q 2019 Earnings Call

We believe Schwab’s business stands to benefit the most because of the relatively small impact to its revenue and income and the broad, efficient set of high quality service it offers to clients. While the commission cuts mean Schwab offers an even more compelling value to its customers for its existing suite of high quality services, a disadvantaged competitor like TD Ameritrade is trying to figure out how to charge for its “premium” services for customers, effectively raising prices for service in other ways and depressing its value proposition.

Decades of experience indicates the companies offering higher value propositions win more customers. By continuing to pursue aggressive reinvestment in both client service and technological efficiency, Schwab can continue to leverage its growing scale to further improve upon the value proposition it provides clients while continuing to drive down its expense (efficiency) ratio. We believe the gap in differentiation will only get wider now that the smaller competitors are much weakened financially, which is why it made sense for Schwab to be so aggressive in cutting commissions both in 2017 and again October 2019.

An Elastic technical review

Elastic isn’t building a cloud side and a on-prem side to their platform like MDB is. It’s all Elastic Stack in the Elastic Cloud, just hosted at whatever cloud provider the customer desires, and managed by the finest experts one could find — thems that wrote it! There isn’t tooling appearing in Elastic Cloud that isn’t in core platform, unlike MDB with their Stitch serverless platform. However, the downside is that their Elastic Stack releases must bundle the proprietary modules side-by-side with the open-source products.

One striking difference as I walked through the product line, is the number of use cases it solves that DO NOT INVOLVE CODE. MDB is for developers only, to embed into their application stack. Elastic is for that, but also for non-developers to use without needing any custom development. IT can hook up Beats for monitoring infrastructure or network traffic. Enterprise users can feed in datasets with Logstash, for staff to query, visualize, or apply ML in Kibana. I expect this trend to continue, as it really opens up the applicability as to who can use the product line.

Best of all, Elastic is making exciting moves that are moving their company beyond being a do-it-yourself tool provider.


Third Point’s Q3 letter: EssilorLuxottica thesis

Our analysis of potential merger synergies points to over €1 billion in additional profit through efficiencies and revenue growth, almost double the Company’s current targets. In the near‐term, this will be driven by cross‐selling to wholesale customers, insourcing lens procurement, and supply chain efficiencies. The longer‐term opportunity to disrupt the industry value chain is even more appealing: combining lens and frame to shrink raw material need and waste, reducing shipping costs by merging prescription labs with global distribution hubs, and providing a true omni‐channel sales offering. These initiatives will transform the way glasses are sold, significantly improving the customer experience.


Ensemble Capital client call transcript: Mastercard update

While you might hear about how merchants pay 2% or more in credit card fees, Visa and Mastercard are only collecting about 1/20th of that fee, with the banks, the ones taking the credit risk, earning the bulk of the fee.


Ensemble Capital client call transcript: Tiffany & Co update

Tiffany is one of just a few global American luxury brands and the casual observer cannot tell a Tiffany diamond engagement ring from one purchased elsewhere. There’s no room on a diamond for logo placement, after all.

As a company, Tiffany is older than Cartier (founded in 1847), Louis Vuitton (founded in 1854), and Burberry (founded in 1856). This durability matters in luxury because it communicates a brand’s ability to endure all kinds of major socioeconomic changes and remain relevant over successive generations. It also communicates a certain timelessness of core products that remain in fashion despite intermittent fads and trends.

The advertising industry has a problem: People hate ads

“It’s harder to reach audiences, the cost of marketing is going up, the number of channels has exponentially proliferated and the cost to cover all of those channels has proliferated,” Jay Pattisall, the lead author of the report, said in an interview. “It’s a continual pressure for marketers — we’re no longer just creating advertising campaigns three or four times a year and running them across a few networks and print.”

That includes automation and machine learning technologies, which Forrester expects will transform 80 percent of agency jobs by 2030. In July, JPMorgan Chase announced a deal with the ad tech company Persado that would use artificial intelligence to write marketing copy.

Steven Moy, the chief executive of the Barbarian agency, said that multiyear contracts had shortened, with budgets tightening and performance metrics becoming more stringent.

For the first time ever next year, Facebook, Google, YouTube and other online platforms are expected to soak up the majority of advertising dollars, according to WARC.

Last year, 78 percent of members of the Association of National Advertisers had an in-house agency, up from 58 percent in 2013 and 42 percent in 2008.

Curated Insights 2019.10.11

Three big things: The most important forces shaping the world

Lower births are a global phenomenon, particularly in the developed world. And while America ages and population growth slows, the rest of the world’s major economies turn into a Florida retirement community and population growth in many cases is on track to turn negative.

When people talk about what nation will own the next century they point to leadership in AI and Machine Learning, where China looks so competitive. But it’s staggeringly hard to grow an economy when you lose a fifth of your working-age population in a single generation. China could invent something as big as the next internet, but when mixed with its demographics have an economy that muddles along. Europe, Japan, and South Korea are the same or worse.

Demographics will slow America’s economy, but they’re a five-alarm fire for other countries. So even assuming equal levels of productivity growth, the U.S. is head and shoulders better off than other developed nations, just given its demographics alone. America could drop the ball on technology while China/Europe/Japan make all the right moves, and America could still remain a much larger and more powerful economy.

TechCrunch founder Michael Arrington recently wrote: “I thought Twitter was driving us apart, but I’m slowly starting to think half of you always hated the other half but never knew it until Twitter.” This is a good point that highlights something easy to overlook: 1) everyone belongs to a tribe, 2) those tribes sometimes fundamentally disagree with one another, 3) that’s fine if those tribes keep their distance, 4) the internet increasingly assures that they don’t. Opening your mind to different perspectives is good and necessary. But when fundamental, unshakable views that used to be contained within tribes expose themselves to different tribes, people become shocked to learn that what’s sacred to them isn’t always a universal truth. The range of political opinions has always been extreme, but what we’ve seen over the last decade is what happens when the warm blanket of ideological ignorance is removed.

The best economic news no one wants to talk about

So, let’s play a game of wish-casting. Imagine a world where wage growth was truly stagnant only for workers in high-wage industries, such as medicine and consulting. Imagine a labor market where earnings growth for low-wage workers, such as those who work in retail and restaurants, had doubled in the past five years. Imagine an economy where wages for the poorest Americans were rising twice as fast as hourly earnings for high-wage earners. It turns out that all three of those things are happening right now.

One reason you haven’t heard this economic narrative may be that it’s inconvenient for members of both political parties to talk about, especially at a time when economic analysis has, like everything else, become a proxy for political orientation. For Democrats, the idea that low-income workers could be benefiting from a 2019 economy feels dangerously close to giving the president credit for something. This isn’t just poor motivated reasoning; it also attributes way too much power to the American president, who exerts very little control over the domestic economy. Meanwhile, corporate-friendly outlets, such as The Wall Street Journal’s editorial pages, have reported on this phenomenon. But they’ve used it as an opportunity to take a shot at “the slow-growth Obama years” rather than a way to argue for the extraordinary benefits of tight labor markets for the poor, much less for the virtues of minimum-wage laws.

Democrats don’t want to talk about low-income wage growth, because it feels too close to saying, “Good things can happen while Trump is president”; and Republicans don’t want to talk about the reason behind it, because it’s dangerously close to saying, “Our singular fixation with corporate-tax rates is foolish and Keynes was right.”

But good things can happen while Trump is president, and Keynes was right. “Tighter labor markets sure are good for workers who work in low-wage industries,” Bunker told me. “This recovery has not been spectacular. But if we let the labor market get stronger for a long time, you will see these results.”

Charles Schwab and the new broker wars

Schwab now derives more than half of its revenue from net interest income, and the company estimates that it will lose $75 million to $150 million in revenue for every quarter-point cut by the Federal Reserve. If we get four more cuts over the next 12 months, Schwab could lose $600 million, about 6% of its estimated $10.6 billion total.

“People underestimate how much the economics of Schwab’s business comes from investing client cash,” says Steven Chubak, an analyst with Wolfe Research. “Rising rates were a very good story for them, but rates may now be going in the other direction, and that will create headwinds,” says Devin Ryan, an analyst with JMP Securities.

Schwab can withstand the revenue loss. It is one of the most broadly diversified brokerages, including asset-management, custodial, and back-office services for institutional investors. Based in San Francisco, the firm oversees $3.7 trillion in client assets, including $1.55 trillion custodied by registered investment advisor firms, or RIAs. Schwab is the largest RIA custodian in the country. The company sponsors mutual funds and exchange-traded funds. Its Intelligent Portfolios service—automated managed accounts of ETFs—has grown into the largest robo-advisor with $30 billion in assets.

The big profit center for Schwab is now its bank. With more than $276 billion in assets, Schwab Bank is larger than Ally Financial, KeyCorp, and Fifth Third Bancorp, according to S&P Global Market Intelligence. Schwab Bank recently crossed a regulatory threshold, subjecting it to stiffer federal stress-test, capital, and liquidity requirements.

As rates increased in recent years, Schwab Bank became the tail that wags the company dog. Net interest revenue from the bank amounted to $5.8 billion, or 57% of Schwab’s total revenue of $10.1 billion in 2018, up 36% year over year. Management and administrative fees were 32% of revenue in 2018, with trading and related revenue rounding out the pie.

Schwab’s revenue base now looks well balanced between RIA sources (such as custodial fees) and retail brokerage, Chubak says. The company’s low-cost ETFs and robo-advisory service are marketplace winners. Schwab recently rolled out a premium subscription advisory service offering “unlimited guidance” for $30 a month and a one-time planning fee of $300. Schwab CEO Bettinger said on a recent call with analysts that the premium subscription service “seems to have really taken off in terms of client interest and response.”

Schwab’s platform for RIAs is considered one of the strongest suites of tools and software in the industry. And it is benefiting as advisors break away from Wall Street brokerage houses. The trend has been going on for a decade, but it may be gaining momentum. Bettinger said recently that the breakaway RIA trend began “to pick up a bit again in the second quarter.” Schwab recently launched an upgraded version of its portfolio-management software to compete more effectively.

“Schwab’s competitive strength is their enormous stronghold on the advisor community,” says Thomas Peterffy, chairman of Interactive Brokers. “They have cultivated that for years.” The RIA industry is also consolidating into firms with 50 to 100 advisors, says Chip Roame, managing partner of Tiburon Strategic Advisors, a financial consulting firm. That’s good news for Schwab, since larger firms with more trading, analytics, and custodial requirements are likely to bring assets to the firm.

The tech stock that Apple, AMD, and Nvidia can’t do without

TSMC’s client list includes the world’s top technology companies, such as Apple (AAPL), Qualcomm (QCOM), Huawei Technologies, Nvidia (NVDA), and Advanced Micro Devices (AMD). They all rely on TSMC to make the most demanding chips used in smartphones, servers, artificial intelligence applications, and networking devices.

JPMorgan estimates that TSMC accounts for about 50% of the world’s foundry revenues and 80% to 90% of the industry’s profits.

TSMC has consolidated its market share in recent years because its foundries were the first to offer 7-nanometer chip production at significant volume. Smaller chips offer greater performance and improved power efficiency. The entire chip industry is rapidly trying to get to a 7nm (and lower) manufacturing process, but most manufacturers have yet to make the transition. Intel (INTC), which fabricates most of its own chips, is unlikely to have 7nm products before 2021.