This issue contains highlights from Copart’s and Sea Limited’s recent earnings calls, and curated core ideas from David Barber’s legendary 1997 speech "Delivering Shareholder Value".
Halma: Delivering Shareholder Value
Halma is one of the most successful serial acquirers ever, having grown its EPS by ~15% CAGR over the last 46 years. We’ve taken a closer look at the foundation of this incredible performance.
1. There are distinct differences between taking a short- vs a long-term view
Let me refute any unintended implication that our methodology within Halma is either conventional or derivative. Like any other very successful company, we can identify strong elements of individuality, even uniqueness in our individual approach to business and I hope that some of this emerges from my talk.
The second point, whilst also perhaps obvious, is more fundamental. In preparing this talk, I was struck again and again by the differences between the short-term and the long-term approach to building shareholder value. This is a very conventional comment when applied to investors and financial institutions. How often have we heard debates about the City’s so-called ‘short-termism’. It is less conventional as a comment when applied to the management of a trading business. Nevertheless, I believe that there are fundamental differences between selecting a short-term route and a long-term route.
There tends to exist a tacit assumption that these are closely related, that a successful short-term exercise in increasing shareholder value inevitably is a step towards a long-term increase in value. In instance after instance I found myself having to observe that this was not the inevitable case. That often the two routes point in totally opposite directions and a specific choice needs to be made between them.
2. Difference between price and value
A number of examples of this emerge later in my exposition but just to drive the point home, let me take just one ‘Mickey Mouse’ scenario. Imagine you either as an investor or as a public company chairman owned Microsoft with a P/E of 40. In theory you could sell part of Microsoft and use the proceeds to buy a company we can call British Metal Bashing Limited with a P/E. of 12. The arithmetical outcome would be a huge increase in your earnings per share. You have certainly enhanced shareholder value in the short term but have you got a better company? Could you just bear that example in mind because I come back to it later in my talk. At this stage I am just using it to illustrate that there can be a dichotomy between short- and long-term strategies. Short-term can end up saying ‘sell Microsoft’. Long-term says ‘keep it’. That's the Warren Buffet approach.
Nor am I suggesting that long-termism is the only route. Short-termism is a perfectly valid alternative. It must be because it is obviously the route followed by many companies and many institutions. What I am saying is that there is often a fundamental difference in strategy and in tactics between the two routes. The key thing is to decide where you are - which route is being followed.
3. The question every CEO should ask him/herself
This is self-evident if you are an institutional investor. But it is an equally important decision if you are the chief executive of a group. How do you see yourself creating shareholder value? Are you aiming for short-term, transaction-related value creation or for long-term, building-related value creation? Both approaches are valid, both can be spectacularly successful but they are very different.
It won’t surprise you to learn that at Halma we chose the long-term view, aiming from the start to build slowly and carefully, very much with an eye to the future. Obviously this is the approach which will be the theme of my talk today.
4. Analysts are caught up in short-term expectations
It also seems self-evident to me that lying behind such a vision has to be a sound mathematical/financial model. This should cover a decent period ahead, maybe five years, and it should set out very clearly the logic and the arithmetic of how you actually plan to get from Point ‘A’ to Point ‘B’.
It continually surprises me how little this aspect is explored at meetings with institutions and potential investors. In 25 years’ experience of meeting institutions and analysts, I have rarely been questioned on this topic. Questions tend to focus on past results and perhaps just a little on short-term prospects, maybe one year ahead. Rarely do they look at the underlying financial arithmetic which should underpin longer-term company plans. And yet I see this as absolutely crucial to building shareholder value, if indeed those institutions are themselves seeking to create long-term value.
5. Halma’s strategy was shaped by the inflationary environment of the 1970s
At this point we have to take a little trip down memory lane. Halma’s own long-term planning and its financial modeling were radically shaped by our having to live through the events of the mid-1970s. I know that to many people here today that must almost count as pre-history.
There was a kind of economic blizzard which lasted about four years from 1973 to 1977. The Stock Market was in shock. We were producing a string of sensationally good results at Halma but at one stage our P/E ratio was less than four. Inflation was running at 17% per annum and the banks couldn’t or didn’t want to lend money.
Against that background we deliberately chose to develop a group which would be completely self-financing but which would also be able to sustain a growth in EPS in the range of 20%-30% compound per annum or, as we later defined it, 15% plus inflation. This latter target was our overriding corporate objective.
6. David puts a lot of emphasis on simplicity and clarity
Although the financial model might involve very detailed arithmetic, the salient points arising from it must be simple and easily understood. It is enormously helpful if top management can keep the main features and objectives always in their minds. Then any detailed or tactical issue which emerges can be judged simply and quickly on the basis of whether it helps or hinders you in achieving your targets.
If the targets are too complex then this quick mental reference can be very difficult to achieve. One can easily see that this is a difficulty which bedevils any large organisation. An extreme example is central government where almost every decision has a positive impact on one major objective but has a negative impact on some other major objective.
This need for clarity and simplicity does make me nervous about some of the more sophisticated measures, including some covered at this conference. It is very easy to get bogged down by acronyms. When someone say E.V. to you, does he mean economic value or does he mean enterprise value, and so on and so on.
7. The crucial difference between differently funded acquisitions
The alternative and short-term route of course is to restructure the Group in a strategic way, probably through diversification based on acquisition. This can obviously be done. It has been done successfully many times, it can have dramatic results, but it is essentially a high-risk strategy.
This brings us neatly to the subject of growth by acquisition. The Halma Group is perceived as one which has grown by acquisition and has an unusually successful acquisition record. What lies behind this? We need first to agree on some definitions. I see a fundamental difference between acquisitions funded by share issues and those funded by internal funds.
At the very outset with Halma we decided that since our overriding objective was to increase earnings per share, our best policy was not to issue any more shares. That sounds crazy to many people. The conventional view and the road most people choose towards success is to establish a high rating for their shares and then issue them.
8. Staying inside one's circle of competence
The obvious conclusion is that the risk in acquisitions can be hugely reduced if you are already highly expert in the field. In Halma it has always been our policy to operate at this end of the spectrum where the risk is least. That is to say where we are already expert in the business which we are buying. If you buy a business which is a replica of one you already own and manage successfully, then you are in a good position to check whether or not you have a good deal. Having gone back to check our own figures, I find that this was the case for 70% of the individual businesses we have bought over the past 15 years. Where we do move into a newish field, we do so very cautiously and, wherever we can, we will buy small so as to reduce the scale of the risk.
The opposite is also true. The less knowledge you have of the target company’s market or product area, the higher your risk. By definition, therefore, the highest risk acquisitions are those which lead to diversification.
Copart Inc Q3 2023
Insights on Copart’s global marketplace, their owner’s mindset, how they are increasing margins and returns on capital, and lastly, on a long-term orientation as a competitive advantage.
*Service revenues +10.6%
*Vehicle sales +0.6%
Gross profit +10.8%
Operating income +12.4%
Net income +25.8%
-> Vehicle prices likely to stabilize faster than repair costs will: The insurance industry continues to experience radical change across a multitude of dimensions, including across-the-board inflation as reflected in their rising combined ratios. They and we are observing an apparent reversion to increasing total loss frequency trends. According to CCC, total loss frequency bottomed at 17% or thereabouts in the second calendar quarter of 2022 and has subsequently rebounded to 19% in the first calendar quarter of 2023, the third consecutive sequential quarterly increase. We anticipate that vehicle prices will likely stabilize or soften faster than repair costs will, which will drive total loss frequency to pre-COVID levels and beyond. We see new vehicle prices as a leading indicator for the used vehicle market. Kelley Blue Book data, in particular, indicates that average retail transaction prices for new vehicles in March of 2023, and were below MSRP for the first time in nearly 2 years. The long-term drivers of total loss frequency, of course, remain unchanged. First, repairs are more expensive and less attractive over time due to increasing accident severity, vehicle complexity, labor costs and rental car costs; and two, salvage economics are more attractive because the fastest-growing economies in the world in Central and South America, Africa and Eastern Europe lean on our damaged vehicles to provide the mobility they need. – Jeff Liaw, Co-CEO (01:44)
-> The importance of Copart’s global marketplace: Another theme that emerged is that our insurance clients continue to experience hiring and retention challenges for their own workforces, which we believe will have them leaning more heavily on trusted partners like us to provide additional services, including virtual inspection, loan payoff, title procurement services, among others. Our clients also expressed strong interest engaging with our image recognition tools and machine learning algorithms to enable better decision-making and importantly, faster decision-making. For a vehicle that will ultimately be totaled, insurance companies often incur literally thousands of dollars in towing, storage, estimating tear down costs and appraiser labor, much of which could have been mitigated with streamlined decision-making. Our meetings with our clients also underscore the importance of our global marketplace in providing superior salvage returns to the insurance industry. – Jeff Liaw, Co-CEO (03:41)
-> Adding velocity to its auction marketplace flywheel: For several quarters now, we've reported on our progress with our noninsurance customers, particularly in the bank and finance fleet and rental segments, which we collectively call Blue Car. We drove ongoing growth in our third quarter of approximately 7% year-over-year despite a still constrained supply base. Likewise, we grew our dealer volume by nearly 5% year-over-year as well. We view these additional customer segments as examples of our ability to leverage our existing infrastructure to add both mass and velocity to the flywheel of our auction marketplace. – Jeff Liaw, Co-CEO (05:26)
-> A long-term orientation as a competitive advantage: Our evergreen position is that we take our responsibility as stewards of capital seriously and evaluate prospective investments with an owner's mindset because we are owners; from Willis Johnson, our Founder, to our newest employees who elect to participate in our employee stock ownership program. We prioritize investing in our core business, land and technology, in particular. Secondly, we consider strategic extensions that leverage our key capabilities as is evident from our conservative M&A track record, these opportunities generally must meet a very high bar. And as we have done episodically but very substantially over the years, we ultimately return excess cash flow to our investors and subject to how the tax code evolves, generally in the form of share buybacks. Regarding where we stand specifically today, I do want to emphasize how the strength of our balance sheet empowers and differentiates Copart. In comparison to other participants in our industry, we do not prioritize interest payments, debt paydown, dividends or massive cost reduction initiatives. We can deploy our resources, specifically our capital and our management bandwidth, to prioritizing the long-term prosperity and satisfaction of our clients. Three simple examples. First, we can continue investing in our owned real estate portfolio which provides strong durable protection against an inflationary environment and also ensures the sustainability of our service model for the next 50 years. Second, we can provide superior service to our clients and catastrophic events, even when doing so requires substantial capital investments in technology, trucks, land and people. And third, we can invest in the tech platform and marketing resources that create and sustain our global buyer base. In short, we believe our long-term orientation is in itself a distinct competitive advantage. – Jeff Liaw, Co-CEO (07:07)
-> Believe they can continue to increase margins and return on capital over time: As noted previously, over the last 3 years, we have seen pressures from inflation primarily across labor and transportation costs. More recently, we have observed some attenuation in these expenses, particularly around transportation, which was partially driven by reductions to the cost of diesel, which has experienced a 20% decline year-over-year. In addition, we are constantly seeking to optimize our operational processes by leveraging technology and automation, which we expect will drive efficiency across the organization and help mitigate longer-term cost pressures. Finally, while we experienced increases in labor costs over the last 12 months, we have viewed a significant portion of this as a direct investment in our employees and as an investment to support best-in-class service for our customers. We believe we can continue to increase margins and return on capital over time as we pursue our consistent investment discipline, focusing on our real estate, logistics and technology assets to ensure we are positioned to scale appropriately to meet the demand of our customers. – Leah Stearns, CFO (11:56)
-> Still in the first or second inning of the international expansion: Our liquidity, I think, has grown over time. We've become a more compelling platform for them to enroll in and to pursue vehicles than we were 10 years ago. The one correction or modification I'd make to your comments is that the expansion into the international arena has not just been in the past couple of years. That's been a decade-long endeavor. It so happens that the evolving mix of vehicles driven in part by total -- rising total loss frequency, which means the cars are better and less damaged as well as our pursuit of cars from noninsurance sellers has naturally grown that buyer base. I'd say in terms of -- in the baseball analogy, we're in the first or second inning because the fastest-growing economies are still -- they will continue to outpace growth in Western Europe, the U.S., Japan, Canada, et cetera, the established economies where people have vehicles will increasingly provide those vehicles perhaps older, perhaps a damage perhaps neither to the economies that demand more mobility. Cars divided by population remain very high in the origin countries where we operate our auctions and remain very low in the destination countries that buy them. – Jeff Liaw, Co-CEO (17:33)
Sea Limited Q1 2023
Strong results for Shopee, trends for Garena and Free Fire have turned positive, and why margins will not be a problem.
*Garena (q/q bookings) -15%
Gross profit +21%
Adj. EBITDA $507M (-509)
EPS $0.15 (-1.04)
-> Strong results for Shopee despite the macro environment: Shopee's business remained resilient, and we have made significant progress in deepening our competitive moat by strengthening our cost leadership and uplifting the user experience. In the first quarter of 2023, GAAP revenue was $2.1 billion, up 36% year-on-year, driven by deeper monetization. Core Marketplace revenue increased by 54% year-over-year to $1.2 billion due to an increase in transaction-based fees and advertising revenue. Adjusted EBITDA was $208 million, improving from a loss of $743 million from last year. The improvement was driven by increased monetization and greater operating cost efficiency. For our Asia market, we achieved an adjusted EBITDA of $276 million during the quarter, improving substantially from a loss of $408 million in the same period last year. In our other markets, the adjusted EBITDA loss was $68 million, narrowing meaningfully from last year when losses were $335 million. Contribution margin loss per order in Brazil improved by 77% year-on-year to reach $0.34, reflecting better monetization and higher efficiency in our sales and marketing expense. As we see significant opportunities in the market, we plan to continue to invest in capturing more of these opportunities in Brazil. – Forrest Li, Founder, Chairman & Group CEO (00:05:05)
-> Continuing to expand the logistics fleet: We continue to enhance our logistics cost leadership and deliver experience by improving the capacity and integration of our in-house logistics arm, while continuing to work closely with our third-party logistics partners. We introduced more automation to our delivery services. Thanks to these efforts, we have managed to bring down average delivery time by more than half a day across our markets within the first quarter. We are also expanding the buyer coverage of our logistics services across our markets. In our largest market, Indonesia, which consists of more than 10,000 islands, 95% of our buyer base is now covered by our delivery services. In Brazil, we already have 8 distribution and sorting centers with the most recent expansion in Northeast Brazil. We have also been working to expand our first and last mile hubs in the market. In recent months, we opened 50 new hubs to further strengthen our logistics capabilities. In addition, we are looking carefully at every stage of the customer journey and improving our processes, policies and services to enhance the user experience. – Forrest Li, Founder, Chairman & Group CEO (00:07:04)
-> Trends for Garena and Free Fire have turned positive: Now let's discuss digital entertainment. As previously shared, Garena continued to focus on improving gameplay and creating a stronger community for our games first and foremost. While there was some weakening in monetization, mainly as a result of lower paying user ratio, we saw some initial signs of improvement in our quarterly active user base, which increased from 485 million last quarter to 492 million in the first quarter. In April, we also observed a positive user trend with Free Fire achieving a new peak in monthly active users in the last 8 months period. While we are mindful of seasonality effects we are pleased to see this as a positive sign for Free Fire, which remains one of the largest mobile games in the world. We will continue to monitor closely for trends going forward. – Forrest Li, Founder, Chairman & Group CEO (00:12:23)
-> New all-time high for Arena of Valor: As we strengthened our efforts in enhancing gameplay and user engagement, we have received positive responses from our user community on a number of initiatives we launched to make the game experience smoother. These initiatives include game package size optimization and gameplay like reduction with an emphasis on devices commonly used in our market. Our users have indicated that these recent changes are highly responsive to their feedback and share that they are enjoying a better gameplay experience as a result. Our second largest game, Arena of Valor showed strong performance, especially during the Lunar New Year period. The game once again achieved a new peak in quarterly active users and bookings after more than 6 years since its launch. We believe this is a further indication of our ability to engage users for the long term with solid monetization. At the same time, our pipeline remains healthy and we will be launching some new titles in the coming months. We have opened pre-registration for Undawn an open world survival game, which we will publish across Southeast Asia in the coming months. We will also be publishing Black Clover Mobile, a collection RPG mobile title based on the popular anime series Black Clover across a number of markets globally. Pre-registrations are expected to open within the first half of the year, following the conclusion of a closed better task held last year. – Forrest Li, Founder, Chairman & Group CEO (00:13:53)
-> SeaMoney performance: Lastly, moving on to our digital financial services business. We are enhancing our operations and risk management capabilities while improving the user experience for Seamoney. We have also been working to diversify our fintech product offerings, both on and off the Shopee platform and across different markets to enhance user stickiness. Seamoney's GAAP revenue was $413 million in the first quarter of 2023, up 75% year-on-year. Adjusted EBITDA was $99 million during the quarter, a substantial improvement from a loss of $125 million in the first quarter of 2022. This was driven by both strong top line growth and our ongoing efforts to optimize costs and improve efficiency, particularly around sales and marketing expenses. On digital wallet, we continued to expand ShopeePay's use cases. For instance, it recently became a payment method for ecom services in our Southeast Asia market. On credit, as of the end of the first quarter of 2023, the total loans receivable on our balance sheet was $2 billion, net of a lower for credit loss of $281 million. Nonperforming loans past due by more than 90 days as a percentage of our total gross loans receivable remained stable at around 2%. During the quarter, we continued to diversify the sources of funding for our credit business. In addition to funding through our own bank deposits, we have seen increased volume funded through channeling arrangements or electoral asset-backed facilities with local and regional banks. – Forrest Li, Founder, Chairman & Group CEO (00:16:03)
-> Can turn to break even in Brazil when they want to: Brazil, of course, remains a growth market for us. As we mentioned earlier, we see significant opportunities there. We've only been in Brazil for 4 years. So it's a relatively early market for us. However, we have achieved a very significant scale being one of the leading e-commerce players, especially on the local to local e-commerce marketplace, targeting the mass market segment in that country. And given our scale and operational efficiency, we have already achieved there, we believe we can break even any time, but we may continue to choose to invest in the market to capture the significant long-term opportunities we observe in the market. So that's a quick capture of the overall trend. In terms of the strategies, for e-commerce, as we shared before, we think the long-term opportunities for both our Asian markets as well as Latin American markets, are very significant, given the strong and positive demographic features, the store penetration under development of infrastructure and offline retail, which give more opportunity for digital penetration to go even further beyond. – Wang Yanjun, Group Chief Corporate Officer (00:27:32)
-> “If we want to achieve high margin, it’s doable”: In terms of the EBITDA margin for e-commerce, I think that, as I shared while we're not immediately targeting to push the envelope to maximize margin, we think as a leading marketplace player, the margin you generally see in different markets or a leading marketplace player can also be achievable by us. And in different markets, we have seen even at this early stage where we just turned it profitable for only a couple of quarters. We have seen a very healthy EBITDA over revenue margin even towards more than 30%, 40% in some of the markets. So the margin is not the biggest concern for us. If we want to achieve high margin, it's doable. The question is, how do we maximize the long-term profitability and maximize the opportunity we can capture in this region and in all our markets. Because we really continue to see significant opportunity. So our focus is on the long term and not immediate margin expansion. But having the support of healthy margins also give us more resources to allocate across different markets and from period-to-period, into investing in different markets and to even further strengthen our ecosystem. [...] So again, we're not particularly worried about the margin. I think it's more about how we build a healthy long-term ecosystem that will maximize the long-term profitable growth of our business. – Wang Yanjun, Group Chief Corporate Officer (00:46:35)