Escape Velocity: When will High Growers Cross the Chasm?
Escape Velocity: When will High Growers Cross the Chasm?
How do we know when a next-gen company has become a staple enterprise like Amazon, 3M, or Nike? By Benjamin Tan
I am a fan of Costco (COST 0.00) and count myself as one of the 123mn cardholders. Most of us renew our membership religiously every year, drawn to its low-priced (but curated) merchandise and motivated by the thrills of discovering new, unexpected bargains while shopping.
The stock, however, is no bargain. Despite slower revenue growth in the single digits and thin margins (albeit intentionally), Costco trades almost 20x forward EV/2023e EBITDA with a dividend yield of less than 1%.
There are valid justifications for its valuation, and they are predicated on Costco’s almost intransigent place in the world of consumer retail. The company, currently the sixth-largest retailer in the world, grosses more than $200bn per year. It has a footprint of over 800 warehouses and counts 68mn households as members. Despite competition from online shopping and Amazon (AMZN 0.00), Costco has held its own and continues to grow its largely bricks-and-mortar business.
In other words, Costco has more than crossed the chasm, and accordingly, its stock commands a high price. There is safety in numbers and a price to pay for that safety.
Newbies in Retail
On the other end of the retail spectrum, emerging names are risky investments that may or may not work out. Take Allbirds (BIRD 0.00) as an example: the company was recently in the news for reporting underwhelming financial results and guiding for first quarter 2023 topline to fall by 20% to 28%. The decline in sales was unexpected for a company so early on its expansion track, and a stark contrast to its high-flying days when revenue grew by 30% per annum (on average) between 2018 and 2021. Allbirds has announced a series of new strategic initiatives to revive growth, cut costs, and improve capital efficiencies. That is an awful lot of lofty goals to balance.
For fiscal year 2022, Allbirds earned almost $300mn in revenue, but it is already looking like a late-stage Jenga. Survival odds are deemed to be low, as reflected in its current market valuation of less than $200mn. In contrast, Lululemon (LULU 0.00) - a similar lifestyle-driven brand that has gone mainstream - will rake in roughly $8bn of sales for the year ending January 2023. Lululemon has a market capitalization of around $40bn, implying an enterprise valuation close to 5x sales and almost 20x EV/2023e EBITDA.
Software Eats the World and Each Other Too
When it comes to the technology sector, stalwarts like Oracle (ORCL 0.00) and Microsoft (MSFT 0.00) have proven to endure, with defensible annual revenues exceeding $40bn and $200bn, respectively. When fear runs rampant in the markets, investors gravitate towards these GAAP profitable, safer names.
On the other hand, we have next-generation SaaS names like Snowflake (SNOW 0.00), which aims to become an indispensable technology platform of the future. For the year ended January 31, 2023, Snowflake earned $2bn in revenue; current enterprise valuation is above 20x that amount. This implies high market confidence in Snowflake to perpetuate its growth trajectory. To justify its current price tag, Snowflake will have to generate enough sustainable free cashflows down the road and become a version of Big Tech. Markets are also assuming that Snowflake will fend off intense competition, retain its technological edge, and keep growing as a standalone entity, versus getting swallowed by an existing giant.
A Revenue Threshold that Indicates Escape Velocity?
With $2bn in revenue and growing, has Snowflake done enough to ensure its place as a SaaS platform as ubiquitous as say, Salesforce (CRM 0.00), which generates $30bn+ of sales per year? In other words, has Snowflake reached escape velocity, freed itself of existential crisis, and now on its way to becoming a mainstream platform for data cloud?
While a topline of $2bn and having close to 8,000 customers - including 573 from Forbes Global 2000 - sound like Snowflake has indeed crossed the chasm, technology is a tricky sector. Change is a constant, and names like Microsoft and Oracles are anomalies that have thrived far longer than their peers from yesteryears. Survival in technology is almost an exception, not the rule. Even Microsoft and Oracle have had to pivot hard into cloud-based businesses, and pay high prices gobbling up M&A targets to revive their prior fortunes built on hardware-based technologies.
In other words, there may not be an escape velocity in technology. Everything is up for grabs, although having heft does confer greater resources to withstand tough times. Many technology companies are now squeezing vendors for discounts, and it is likely that larger enterprises will enjoy better pricing. With scale also comes larger cashflows and more resilient balance sheets, which can absorb continuing investments towards R&D and marketing to maintain technological edge and retain customers, without needing to overly conserve for survival. Just look at Microsoft’s recent $10bn investment in OpenAI (creator of ChatGPT) to remain at the forefront of generative artificial intelligence, even as the wider technology industry is pulling back.
Size Matters and Investing in Innovation is Endless
Witness how Amazon, even as the leading e-commerce giant, continues to make heavy investments in the business. By relentlessly extending into adjacencies - including advertising, private labels, streaming movies and shows, music, logistics - Amazon ensures that merchants and customers remain loyal to its marketplace. I know I will retain my Prime membership for years to come, because I am too entangled (habitually, emotionally, mentally) with Amazon. Simply put, I am locked in.
In summary, companies in any sector has to keep thrusting upwards, reinvesting profits for constant reinventions to stay relevant. Product innovation, cross-sells, upsells, horizontal and vertical acquisitions, cost efficiencies, marketing, and ingestion of more customer data to create data gravity, are some of the ways to prevent growth engines from stalling. At the same time, execution needs to be solid to balance growth against capital preservation and profitability during leaner times.
No easy task, but there may be no escaping the gravitational pull of complacencies and competition. Even traditional retailer Costco has to constantly refresh and expand its merchandise, extract endless cost efficiencies, lean into e-commerce, and offer loss-leaders (like those hotdogs) to keep its customers engaged. Otherwise, Costco risks crashing back to earth, like so many retail giants - including Sears and JCPenney - before it.
(Author wears Allbirds shoes, but is neither invested in BIRD 0.00 nor wielded to them)
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