In recent months, President Donald Trump has repeatedly claimed that Amazon exhibits monopolistic tendencies. The jury is out as to whether this is the case, but Amazon certainly monopolizes ecommerce news.
This changed briefly last month, when a consortium of private-equity firms announced an acquisition of CommerceHub Inc. for $1.1B. Commercehub gives businesses a core dropship solution that allows the outsourcing of the burden of shipping and warehousing. Commercehub achieves infrastructural economies of scale not feasible for smaller retailers, and passes these cost savings onto its customers.
The oft-mentioned decline of retail has served as a tailwind for the dropship business, as struggling retailers realize they must achieve at scale shipping and handling cost savings that are not achievable independently. Commercehub not only benefits from the decline of traditional brick and mortar sales, but also from the dovetail of the paired rise of ecommerce.
Mark Walker of Seven Pillars Capital presciently submitted a long on the stock to SumZero March 5th, the day before the acquisition.
Luke Schiefelbein, SumZero: What about CommerceHub initially caught your eye as a value investor? What catalyzed your entrance into the position?
Mark Walker, Seven Pillars Capital: We are attracted to companies that enjoy genuinely interactive network effects. As the number of network participants on a platform increases arithmetically, the number of interactions between them increases geometrically, creating switching costs through the higher per-user utility of the platform. This can lead to winner-take-most outcomes, creating assets which are extremely difficult to replicate and, with appropriate managerial nurturing, can lead to tremendous economic value creation.
In our view CommerceHub’s software as a service ecommerce solution has these attributes. CommerceHub enables retailers to sell a broad selection of products without the cost of buying, storing and shipping inventory by leveraging a network of 10 thousand ‘dropship’-capable suppliers. The platform is mature enough to provide assurance as to the clear benefits to retailers and suppliers, but there is still clearly significant scope for growing the platform with minimal capital requirements, widening the moat with each new customer win. Retailers and their end customers benefit from dropshipping in two ways: (1) wider product assortment and (2) lower inventory warehousing and distribution costs and faster delivery times. This potentially helps ecommerce businesses to compete more effectively with Amazon. Legacy software that dealt with point-to-point connections between retailers and suppliers is not well suited for a dropshipping model, as access to real time supplier inventory is required. CommerceHub onboards suppliers in a few weeks, vs. months spent by retailers manually onboarding suppliers under a legacy supply chain model.
CommerceHub’s network is a hub model that replaces the requirement for multiple point-to-point connections between retailers and suppliers. Customer acquisition cost requirements are far lower than typical SaaS business models; CommerceHub acquires the retailers, who then bring their suppliers onto the platform. CommerceHub does not acquire suppliers, but it generates revenue from them.
The business seems to have a fairly reliable low cost growth opportunity. The total addressable market should expand as ecommerce penetration grows from a low base. US ecommerce has grown from $5bn to $400bn over the last 20 years, yet ecommerce remains less than 10% of total retail sales. Faced with the prospect of expanding SKUs from 100 thousand per store to one million via a website, dropshipping may entice retailers to accelerate the transition online and accelerate the pace of ecommerce penetration growth.
We initially looked at the business in September 2017. Our conclusion at that time was that this was a very high quality business with a compelling emerging moat, especially the core dropship solution, which enjoys strong and growing network effects, likely long runway for growth and negligible capital requirements given CommerceHub’s low customer acquisition costs. However, despite poor sellside coverage, at $22.5 the valuation seemed to incorporate these qualities.
Adjusted EBITDA margin as reported by the company was 38%. Removing $11mn of stock based compensation lowered this to 26%, a level we felt underestimated the normal profitability of the business as the CommerceHub for Brands initiative was loss making but generated 10-12% of revenues. The magnitude of losses were not disclosed but core dropship incremental margins are likely to be high given the platform business model and low customer acquisition costs. On an estimated steady state EBITDA of c.$30mn the stock traded at 30x EV/EBITDA. We estimated that the market cap of c.$900mn at that time was c.35x FCF.
CommerceHub didn’t strike us as a business whose normal steady state or maintenance FCF was depressed due to material capital redeployment, as growth is inexpensive by virtue of the network effects. So as great a business as it was, we felt at that time that very high business quality and growth prospects were broadly reflected in a market price that implied an enterprise value 9x revenues and a <3% FCF yield. We seek investments in companies which can earn sustainably high economic returns on capital investments, can reinvest substantially all of these profits into positive NPV projects, and which are trading at a modest multiple of current intrinsic value. An entry point of closer c.25x FCF would provide a downside scenario in which we would have a good chance of making positive annual return; this was one third lower than the quoted market cap at that time.
Given the nature of CommerceHub’s retailer customers we also felt that it might be worth waiting for some customer loss, retail slump or other road bump that might create an opportunity to invest at a more modest multiple of current intrinsic value. Fast forward to March 2018 and the market offered just such an opportunity. CommerceHub reported impressive FY17 results; customer and revenue growth had increased in the mid-teens and FCF generation had materially positively inflected. But the stock was down as much as 15% because of an undisclosed customer loss in the fourth quarter and exposure to the Toys R Us store closures. The depth of our research on the name six months prior allowed us to do a quick back of the envelope calculation: trailing 12 month FCF was $36mn. Adjusting for our post-tax stock based compensation estimate of $7mn, this was $29mn. Post the sell off the quoted market cap of $730mn was 25x this number, creating the entry point at which we felt the odds of achieving a satisfactory investment result were weighted in our favour.
Schiefelbein: What was the market missing? What are your thoughts on the PE consortium’s bid price?
Walker: Guessing what the market is thinking is not a part of our investment process. The market is a complex function of the analysis, trading views, temperament, behavioural and other non-fundamental influences on its vast array of participants. We feel that spending time trying to aggregate those influences is a low return-on-intellectual-effort exercise. Having said this, we will carefully review the bear thesis on a particular name and discuss ways in which we could permanently erode the capital of our investors.
Over the course of an investing lifetime we expect to benefit from the short term investment horizons of the majority of the market’s participants. While the informational source of edge for professional investors has decreased over time, the shortening of security holding periods has increased the advantage of time arbitrage for long term investors. One of the cornerstones of our investment philosophy is a belief in the advantage that a long term mind-set affords to patient investors with patient capital. This long term mindset, we hope, enables us to invest into uncertain near term outlooks, which the market overly discounts to create compelling entry points to buy phenomenal businesses with outstanding long term prospects. We believe this was the case with CommerceHub.
Schiefelbein: What key metrics should investors be paying attention to as your thesis matures? What differentiates CommerceHub from other dropship and hosted integration companies?
Walker: New retailer wins are important indicators of the relevance of CommerceHub’s core dropshipping proposition. Low customer acquisition costs as a percentage of sales is an important signal of CommerceHub’s supplier appeal. Increasing penetration of dropshipping within existing retailer relationships, and retailers which have left CommerceHub to build their own platforms are all factors which can inform investors about CommerceHub’s ongoing ecommerce relevance.
Dropship barriers to entry have restricted competition. CommerceHub has a network of 50 retailers and 10 thousand suppliers. This network is a hub model that replaces the requirement for multiple point-to-point connections between retailers and suppliers. There is no competitor providing the range of services CommerceHub provides. The main competitors to CommerceHub’s dropshipping service are traditional legacy solutions; Electronic Data Interchange (EDI) systems connecting suppliers to retailers on a point-to-point basis. CommerceHub’s ‘hub’-based model seems superior and it would be reasonable to assume that these legacy networks continue to become disrupted. As the network becomes larger, so too does the cost benefit to the customer. The other main category of competition is other SaaS companies: SPS Commerce partners with suppliers rather than retailers to allow suppliers to more efficiently ship goods to retailers’ warehouses in compliance with retailers’ requirements, or to dropship directly to a retailer’s customer, when the retailer is using in house dropshipping software, vs. CommerceHub’s dropshipping software. Most of SPS’s supplier customers also use CommerceHub software. The goal seems to be to disrupt legacy point-to-point systems rather than CommerceHub and SPS fighting each other for market share of as yet a small but potentially very large market.
In addition to the core dropshipping business CommerceHub has a second service called CommerceHub for Brands. Companies that sell directly to consumers via their own website can use CommerceHub for Brands to list and promote their products on other demand channels such as Google Shopping, Yahoo Shopping, Pinterest and Facebook. CommerceHub for Brands faces tougher competition: Channel Advisor provides the same services as CommerceHub for Brands and is 10 times larger. Market nascence likely means there is room for both to grow and despite CommerceHub’s smaller scale in these supplier services it has the advantage of being able to leverage existing dropship relationships; it therefore spends significantly less on sales and marketing vs. Channel Advisor. There are also a number of smaller competitors in the space. CommerceHub for Brands seems like a good business; it benefits from traditional SaaS moat sources: learning curves and switching costs. But it isn’t a platform business model, and therefore doesn’t enjoy the powerful network effects that are central to the core dropship solution.
Schiefelbein: How vulnerable is CommerceHub to the increasing centralization of ecommerce by giants like Amazon?
Walker: Dropshipping penetration of ecommerce should grow as ecommerce players seek to compete with Amazon’s product assortment and cost and logistics advantages. Dropshipping can level the playing field with Amazon without the substantial infrastructure investments that company has made over many years. Long term customers of CommerceHub still only use dropshipping for 30-50% of their online sales. For many retailers dropshipping penetration is less than 10% of online sales. Given the benefits of dropshipping it seems logical that this penetration will increase over time.
For brands that wish to decrease reliance on retailers and sell products directly to consumers, CommerceHub for Brands can help them to achieve this goal. The internet and social media have expanded the number of ways in which brands can interact with customers. CommerceHub for Brands allows vendors to replicate their product lists and promotion across multiple demand channels directly, bypassing retailers.
We recognise that Amazon may be able to overcome the entry barriers to create a dropshipping platform. The motivation to make it easier for ecommerce rivals to compete is not obvious, but if management thought that dropshipping penetration growth was inevitable perhaps they may seek to profit from it.
Schiefelbein: Is there a downside risk of CommerceHub’s core business being eroded by IBM and MANH’s new order management systems? Does CommerceHub have a real moat?
Walker: These order management systems are designed to help retailers manage their omnichannel distribution as physical stores are increasingly used to advertise products, provide customers with a sales point of contact to experience and return goods, without the need to incur working capital costs including the storage of inventory. Thus stores can be part of a retailer’s omnichannel approach to provide customers with a more enjoyable shopping experience. By helping brick and mortar stores to profitably survive in an increasingly online world, it seems to us that these solutions may serve to support the health of a cross-section of CommerceHub’s addressable customer base.
Emerging moats can be a double-edged sword. The Holy Grail in long term investing is to identify a compounder before the market has given the business credit for a durable moat. The more quantitative evidence there is for the presence of a strong and sustainable set of competitive advantages, the more richly valued the company is likely to be, tipping the odds of earning a satisfactory return on our equity investment against us should the future unfold in a less favourable way than expected. With CommerceHub we felt that its scale advantage was significant vs. a number of other dropship competitors such as Modalyst, Doba, Dropship Direct, Wholesale Central and Megagoods, and as the company continues to add retailers, this scale advantage should continue to widen.
Schiefelbein: What are your thoughts on CommerceHub being taken private? What are the implications of the deal and what do you see as the future of the company?
Walker: The private equity buyers have secured a good deal. In some ways this type of business is better suited in private ownership; this might create an environment in which management can focus on making the most sensible strategic and capital allocation decisions in the pursuit of long term business owner value creation. The stock market’s near term ‘voting machine’ makes it more difficult for business managers to have the capacity to suffer short term in order to strengthen the company’s unfair business advantages in the pursuit of lasting value creation.
Schiefelbein: Where else do you see value in the market today? Where else does your fund focus?
Walker: We are looking for businesses that can sustainably create value through their own efforts. This means finding companies that can earn economic profits in excess of the cost of the capital employed to generate those profits. We want companies that can do this sustainably. In the absence of lasting unfair advantages, the entry of new capital and intelligent effort will drive returns towards to the cost of capital. This capital cycle economic theory is academically and empirically broadly accepted.
There are two ways to potentially profit from this capital cycle. The first is to invest in the mean reversion of returns to cost of capital levels. This requires the ability to time the entry and exit of capital within an industry, and the catalysts that might give rise to a change in returns on capital e.g. the closure of factories, industry consolidation or bankruptcies. In addition this requires ‘renting’ the stock for a period of the capital cycle when the market is extrapolating forward financial performance that is likely to mean revert. For these two reasons, this approach is inconsistent with an investment programme which has long term business ownership as the cornerstone of its investment philosophy.
The second approach is to identify companies whose supernormal profit potential is larger and more sustainable than the market believes. This is consistent with the recognition that patient temperament and capital are important sources of edge in executing a long term investment strategy.
Assessment of business quality involves gathering evidence that supports or refutes the existence of an economic moat, developing an understanding of the factors that have created this moat and whether the moat is likely to narrow or widen in the future. This involves a close examination of management’s incentives and capital allocation ability. Management must be able to sensibly compare the value of various capital allocation choices. A rigid cash use ranking will not do. Dividends are value destructive if they are made in lieu of available positive NPV investments. Share repurchases are value destructive if shares are acquired at market quotations materially above intrinsic value. Asset growth shrinks per share business value if incremental cash returns are below the opportunity cost of capital.
While an appreciation of frameworks such as Porter’s Five Forces is useful in understanding competitive dynamics within various industries, it is important to safeguard against an overly prescriptive employment of these frameworks. Sometimes investors seem very keen to apply a ready-made label to the source of a company’s moat e.g. switching costs, network effects, intangible assets, cost advantages and so forth. Again, an understanding of these models and how they can give rise to unfair advantages is helpful, but that understanding is accompanied by the risk that investors thoughtlessly reach for the label that fits without really understanding from first principles how the company generates value for its owners. In addition, disruption across various industries is calling into question the relevance of previously accepted moat sources. See for example the current debate about brand value in the consumer staples space. Changing distribution models, from supermarket shelves to Amazon/Alexa ordering mechanisms, are calling into question the equity of brands which serve to lower search costs. In addition, the de-linearization of TV viewing has impaired consumer staples companies’ scale advantage in purchasing globally consumed TV advertising to reinforce brand advantage. This has resulted in the strong emergence of challenger brands such as Dollar Shave Club and BrewDog. And as we have discussed, in retail the emergence of platform business models such as dropshipping and virtual inventory solutions are connecting vendors directly to consumers, obviating the requirements for retailer warehousing, lowering the barriers to entry in online retail by eroding the SKU variety advantages of incumbents.
We believe that this first principles investment approach, accompanied by concentrated investment portfolios and a global opportunity set, should allow us to find materially undervalued companies through all points in the market or business cycle. While investments are not led by a top-down desire to be invested in certain regions, we have been finding value in UK mid-caps, possibly as a result of Brexit induced macroeconomic uncertainty.
Schiefelbein: Would you say that SumZero is a large part of your research process?
Walker: We use SumZero in a number of ways. One: we use it as a source of ideas and a library of research to gather data and perspectives on companies we own or prospective investment candidates. Two: to open our ideas and research to intelligent criticism and analytical enquiry from thoughtful investors. Three: to cultivate relationships with likeminded and intellectually generous long term value investors around the world. Four: to market our firm to interested and compatible long term capital allocators.