Why the ‘new age’ businesses are still too expensive

I’ve been fascinated by the soaring trajectory of some of our smaller ‘new age’ companies – like A2M, PushPay, Afterpay and Kogan – whose share prices have rallied over 600 per cent since 2017. 

Take Kogan (ASX:KGN) for example – which has been the best stock performer of these businesses. Its share price has rocketed from around $1.50 just one year ago, to around $9.00 today.

Kogan was only established in 2006, and according to its Wikipedia entry, has a “portfolio of retail and services businesses including Kogan Retail (the Kogan.com and DickSmith.com.au retail websites), Kogan Marketplace, Kogan Mobile, Kogan Internet, Kogan Insurance, Kogan Health, Kogan Pet Insurance, Kogan Life Insurance and Kogan Travel.”

Despite the spread of interests, Kogan derives 90.5 per cent of its gross profit from its core e-commerce retail business selling private label and third-party products.

Based on most recent numbers, the founder Ruslan Kogan appears to be a solid operator of the core business. Through “sourcing, analytics and automation”, Kogan’s gross profit margin was 17.9 per cent at the end of FY2017, compared to 15.5 per cent the year prior.

The company has also grown various metrics strongly recently. As at June 30, 2017, the company claimed to have 955,000 active Customers – representing a 36 per cent increase from FY2016. For the six months to December 2017, revenue at the online retailer jumped 45.7 per cent to $209.62 million and reported profit was 470 per cent higher to $8.33 million. Keep in mind, however, that in the prior period there was $3 million of costs associated with the IPO. Add back those costs into the prior period and the jump in profit isn’t as high.

On 23 April, the company announced its Appendix 4C Cash Flow Statement for the quarter ended 31 March 2018 (3QFY18) and reported revenue growth of 46.1 per cent and active Customers of 1,288,000 or 5 per cent of the Australian population.

Is its future under its control?

Kogan displays growth, sound management and popularity amongst shoppers. Investment returns, however, are determined by the future prospects and we ask whether the determinants of the company’s future are beyond its control?

When Amazon announced its entry into Australia – in direct competition with incumbents like Kogan retail, the company’s response was to welcome additional competition, citing ‘online retail’ accounting for about 7.5 per cent of the total Australian retail market, compared to “20 per cent for economies with a large marketplace player ”.

As an aside, an almost identical response was offered by A2 Milk upon news the global food giant Nestle had entered the Chinese market with its own A2 protein baby-milk formula, telling DairyReporter.com it is, “uniquely positioned to benefit from expansion of the category over time.”

There is truth in the idea that new entrants can expand a category overall, and it is also true there can be advantages for the first mover.  But larger, deeper pocketed rivals find growth by brand extension or by driving innovation into entirely new markets. For the former, think of Colgate’s move from toothpaste to toothbrushes, or Nivea’s slide sideways from body care to hair care, and Gillette’s move into shaving cream from razor blades. For the latter, think Apple’s move into iPhones, which also created a halo around the Apple brand and saw Mac sales rise 16 per cent in the same year.

Provided distinctive brand equity and trust is the foundation of strong relationships with customers, the larger firm’s access to data and superior capabilities from marketing to logistics can spell trouble for smaller rivals even where they are first to market.

Just last week Amazon announced a fulfilment center would be operational in the second half of 2018 in Moorebank, South West Sydney. The location is important because it sits in the middle of one of Australia’s biggest retail markets, ensuring fast delivery to a significant proportion of its customers, many of whom may have hitherto shopped with Kogan.  Amazon’s move may also increase product selection and support more third-party sellers using Amazon’s Marketplace and Fulfilment by Amazon services.

Research results from US tech giant Pitney Bowes, showed widespread dissatisfaction among Australian shoppers with local merchants, with 88 per cent choosing to shop through overseas retailers in the past year. Almost 9 out of 10 Australians shop through offshore e-merchants.

This is reflected in data reported by foreign currency transfer provider OFX and e-commerce intelligence firm, Hitwise, showing eBay is the most popular retail website in Australia, with 20 million weekly visits, followed by Gumtree with 15 million visits. Harvey Norman, Kmart, Target, Kogan and Amazon US followed.

According to ROI.com.au, “Kogan is failing to attract the click volumes of its major competitors when consumers search for big ticket gadgets on Google. Our report shows Kogan languishing behind the likes of Harvey Norman, Dick Smith, JB Hi-Fi and even Officeworks when it comes to attracting clicks from people shopping for computers, tablets and mobile phones on Google.”

With Amazon Australia now offering goods from more than 5000 sellers — making it the fastest-growing Amazon marketplace, ahead of India – it could be more challenging for domestic e-commerce providers to continue to claim a unique selling proposition.

Perhaps this is the reason new ‘verticals’ such as mobile and pet insurance are being explored by Kogan. Kogan has, for example, entered the mobile services space and has grown gross sales from a standing start in 2016 to $3.6 million in FY2017, and Kogan has also launched an internet service (ISP) offering NBN unlimited data plans for as little as $58.90 per month.

While they are currently small divisions, they leverage the customer database Kogan has fostered, and bring to the company a stream of recurring revenues, something retailing lacks. But these new verticals are sometimes already crowded and populated by larger and more established rivals. And in the case of internet service providers, margins are also generally under pressure.

Valuation

There are a myriad of valuation methods and all provide, at best, only an estimate of value.  Valuations are dependent on the inputs and assumptions adopted. It is most definitely a case of garbage-in and garbage-out.

If you own a copy of Value.able,and accepting both public information and broker forecasts, you assume Kogan earns a long term return on its equity of, say 40 per cent (based on a broker’s forecast for reported net profit of $20 million in FY2019), which not many companies are able to achieve, and if you also assume the stated 80 per cent payout ratio remains in place, a discount rate of 10 per cent, and FY2018 balance sheet equity of $49 million (and 93.5 million shares on issue), you produce a valuation estimate well below the current share price, suggesting the shares may not be cheap.

Of course, in an expensive market many popular stocks trade above conservative valuation estimates. In such circumstances investors may look at the ‘relative’ value of Kogan versus other ‘concept’ companies and determine it is ‘relatively’ cheap. It is also the case that there can be long periods when value investing is usurped by momentum and growth styles.  When that happens, intrinsic values can appear largely irrelevant.

Another way of addressing the question of value is to reverse engineer the share price to determine what earnings per share growth rates are being implied by the market price. One can then decide whether those implied growth assumptions are reasonable.

We did this for Kogan in February this year, when the share price was $9.85. Using the 6month beta of the stock, the risk-free rate and the country risk premium for Australia available then on Bloomberg, we estimated the share price was implying earnings growth of 50 per cent in FY2019, 40 per cent in FY2020 and 33 per cent every year for the rest of the decade, after which earnings would grow at a terminal rate of 2.25 per cent.

Not many companies can achieve this, and even those that do usually experience some interruption along the way. Amazon could represent such an interruption for Kogan.

It seems like a brave new world and one may wonder whether classic value investing still has a place. We believe it does and it will continue to do so.