The best-in-class

Chichén Itzá, Yucatán MX

Today I’m laying out my first-ever investing framework, and would love to hear your feedback or thoughts. It’s a lightweight, heuristic approach that works particularly well for B2B software. Here it is: standalone, best-in-class products are a delight and a reliable starting point for a profitable investment. Let me explain:

In the universe of technology companies, you can find a real bounty of business models, not to mention products that are inherently complicated or highly subject-matter specific. Think, for instance, about Zapier. You have to have some familiarity with APIs at a minimum, and preferably an informed perspective on product integrations and use cases. Who is the customer? Who builds the integrations? Sure, the thought exercise would have been worth getting into Zapier several years ago – this is, after all, just one evaluation framework – but you can see that the upfront contextual work takes some effort, and not everything needs to be hard from the get-go.

Now, think about Slack. I’m using an example almost everybody is familiar with, and it’s a shining example of my ideal “standalone best-in-class” company. With Slack, the product is simple: it’s a messenger application. The business model? Simple: B2B SaaS, mostly self-service (in the early years, at least). And most critically, how important is the need it serves? Workplace communication tools might not have the gravitas of e.g. cybersecurity, but they are mission critical, and almost any company needs them. This also makes the product sticky, since it requires some implementation and buy-in from the team. And finally, Slack has a massive addressable market that they can eventually monetise in other ways. What I’ve laid out is basically the quick check I would run on this type of company. If it passes the initial test, you can go deeper and start to form conviction around the market and strategy, the product, and the founder(s).

Four principles

(1) Sell something real and valuable.

How critical is the need? This is why business applications fit into this theme so well – businesses have all kinds of critical needs, and that makes them reliable customers. This criterion inevitably ties to product/market fit (PMF), but I don’t think it precludes investing pre-PMF. It’s more of a gauge on the complexity of the solution, with a bias towards products with straightforward, delightful solutions.

Square and Shopify fit this thread nicely, since a business literally can’t exist without a way to accept money. Delivering a critical need simplifies product development to some extent, because you’re no longer asking “how do I make this product valuable enough to keep paying for?” Instead, you’re solving for “why should I keep paying for this product versus a competitor?” As long as the product has a sufficiently large TAM, you have the possibility of a viable business. 

What makes this principle difficult is that most valuable services or products are already being sold. The hard work of entrepreneurship, then, is finding technological or societal inflection points with the potential to create new categories. For example: Kavak is a marketplace for buying used cars in Latin America. It was founded in 2016, and you could easily point to Beepi’s demise just a year later as a bad omen for the whole concept. But while Beepi has been described as “good idea, bad execution”, Kavak caught onto a couple critical needs in the LatAm market: the need for credit (not widely available), and a need for protection against fraud. Kavak’s approach created unique value and set them up for success. And it’s a great example of a best-in-class company that fits into B2C and marketplace (as opposed to B2B SaaS, where I usually apply this framework).

(2) Integrate into the tech stack if possible

I’m looking for “stickiness” to drive better retention and strong utilisation of the product (i.e. engagement). This can go at least a couple ways: 

  • Products built into the codebase (e.g. via SDK/API), serving a critical function within your tech stack. Stripe and Twilio are good examples
  • Products that serve as a node for information, aggregating many sources of data. I put companies like Slack, Snowflake, and Airtable in this category

In either case, the products obviously have to be high quality and responsive to customer needs – otherwise engagement won’t follow. I’ll also note that not every product fits neatly into this criterion. Loom is a great example – the product is useful enough to stand on its own, and much of their success has come without penetrating the tech stack in a meaningful way. But as an early winner, Loom must now build some moat – and indeed, they have loomSDK in a public Beta as of this writing.

(3) Short sales cycles

The standalone best-in-class concept has a bias towards simplicity, so I lean towards products that can accommodate a short sales cycle or have a self-serve channel. This is probably the least important principle, because plenty of companies with a longer sales cycle have phenomenal businesses, and otherwise fit my principles neatly. Snowflake, for example, is enterprise software and has a salesforce to match, but otherwise makes a great best-in-class business.

This principle tries to get at something deeper: flexibility. How much of a chore is it to deploy this product? In my mind, Palantir is the antithesis of this principle – that’s why it’s often described as a “consulting” business. It requires teams of engineers and highly-contextual solutions, and that’s tough to scale.

So, the best-in-class skews towards simplicity. Think about deploying Carta, for example – it’s a standalone product fulfilling a critical function (equity management), but it plays nice with your accounting software. And I don’t want to get ahead of myself here, but while you’re in Carta you can also ask them to do a 409a valuation, a requirement for private companies to issue stock-based compensation. That leads me to the final principle… 

(4) Expand your use cases and LTV

The best-in-class establishes a “beachhead” from which a more diversified business can be built. I’ve used the term standalone many times in this post, but we ideally want to have several avenues for longer-term growth. So unless the standalone product has a massive core market, ancillary businesses are a critical lever over time. This can be boiled down to one of the simplest business concepts: horizontal vs. vertical expansion. Unless you’re in a declining or sleepy market, you probably aren’t buying competitors to build out a business (horizontal expansion). Instead, companies can go after LTV (lifetime value) expansion by offering complementary products or services (vertical expansion). 

This principle is critical well before a company reaches scale with their core product, because once growth plateaus it’s a tough exercise to bend the curve upward again. I saw this tension firsthand at Dropbox, which has struggled to gain traction outside of the core file sync and share functionality. Dropbox checks every box on the best-in-class framework except LTV, and while their HelloSign acquisition was a promising step in the right direction, it hasn’t answered all the questions around their growth story.

Another amazing best-in-class company I see facing this problem is Zendesk. Having built a renowned customer service platform, they’re now working on a sales-focused CRM – basically going after a slice of the market Salesforce created and dominates. This is a bold approach, and if any company is set up for success, I do think Zendesk could be the one. The TAM is massive and they have the credibility to win customers – my sense is that we’ll start to see early signals in their 2021 sales results.

It’s about the business model

The best-in-class is a broad framework, and I laid out a reasonable variety of examples here. Crucially, it seeks to avoid convoluted businesses that don’t solve for a clear problem – it evaluates the business model and the problem-market fit. Importantly though, it doesn’t correct for an inadequate management team, the most important factor for most investors.

A bigger challenge emerges when we apply this framework to early stage products, because the best startups tend to create something new and unexpected, without a clear precedent. Especially pre-traction, this could be tricky. Taking all of this context into account, I’ll share a deeper analysis of some best-in-class companies in a future post. Thanks for reading!


Correlation is Bad News for US Equity Investors


Photo: Wikipedia
Santorini – bring Euros.

I submitted a report last fall based on research by Dr. Bruno Solnik, a Professor Emeritus at HEC. My research, much like Dr. Solnik’s, finds strong correlation in international markets, diminishing the benefits of international diversification. To put this in practical terms, your US equities have probably taken a big hit this week as a direct result of the Greek crisis. This may not be a big surprise, since crises around the world tend to have some impact on US markets, but it begs the question: why such a high degree of correlation?

If you read my report, you will notice that correlation between European and US equity markets increased 58% from 1971 through 2011. The MSCI regional indices used include mid-to-large cap companies, providing us a rich sample of stocks to track. Interestingly, there exists a small positive relationship between volatility and correlation. This relationship becomes most pronounced during times of crisis – perhaps the most notable examples are the outbreak of the Yom Kippur War, the Asian Financial Crisis in 1997, and the most recent financial crisis in 2008. In other words, when one market falls others follow to a great extent.

While I don’t necessarily believe we are witnessing the beginning of a financial meltdown – certainly not in the US – the Greek crisis that is unfolding this week has prompted me to reexamine my research. Most of my stockholdings are in the US, and they have taken a bit of a dive as the trouble in Europe unfolds. I’ve sought to use recent data to understand where correlation is and where it is headed.

I used two index funds, the Vanguard FTSE Europe ETF ($VGK) and the Vanguard Total Stock Market ETF ($VTI) to track European and American equity markets (respectively) over the past eleven months. The results aren’t easy to read, but notice that after major dips in the market – and the markets usually fall in synch – correlation shoots up. Because correlation is a trailing measure using the last 20 days of data, the series should be mentally shifted very slightly to the left.

Volatility and Correlation in US and European Equity Markets

Once more data comes through (this graph only captures the market through last Sunday, the 26th of June), we should start to see a bigger decline in world markets and corresponding spike in correlation.

We would need to conduct a more in-depth study to understand the true impact of the Greek crisis – or any other world event for that matter – on US companies. But it seems likely that troubles abroad are having a hyperbolic effect on American equity markets. For example: El Pollo Loco Holdings ($LOCO), with no restaurants outside of the United States and minimal exposure to overseas headwinds, ended Friday down over 1%. Alibaba Group, a hyped-up stock getting the vast majority of its revenue from China, is down over 2.5%. Despite the tremendous demand worldwide for Chinese goods that certainly drives some of Alibaba’s business, the Greek crisis wouldn’t seem to warrant a $5.5 billion drop in market capitalisation.

While any business is affected by events around the world, I am inclined to believe that situations like the crisis in Greece pump systematic risk into equity markets beyond what is normal or sustainable. Investors should be prepared to see more declines in US stocks over the short term. If the Greek crisis subsides, however, US equity valuations may continue on their frothy rise for some time yet.

A note on methodology: Volatility and correlation are calculated in this article using 10 days of trailing data. My report, on the other hand, covers a longer period of time – that methodology can be found on page 1 of the PDF.

Why big companies love solar energy investments

Here comes the sun

The Nellis Solar Power Plant in Nevada, deployed by SunPower and financed by MMA Renewable Ventures; the Nellis Air Force Base buys the energy produced under a power purchase agreement (PPA).
Source: Wikipedia, US Air Force

Did you know that Google has a team dedicated to making investments in solar energy projects? I got to meet some people on the group during my time as an intern, and while I found their work to be super exciting, I didn’t think to ask why there would be such a group at Google. As a summer analyst with Credit Suisse this summer, I found that the firm also has a small team dedicated to deploying the bank’s capital to finance renewable energy projects. Making balance sheet investments of this sort is quite rare for a company like CS, so I began connecting the dots. There’s a reason for everything in business, and this principal investment activity is no exception.

Thank you Uncle Sam

The answer comes down to federal incentives around investments in solar projects. Chief among these is the Investment Tax Credit (ITC), which allows a buyer to take a tax credit on 30% of the cost of the solar project. In addition, the buyer can depreciate the investment over five years using the Modified Accelerated Cost Recovery System (MACRS). This is valuable because while under normal circumstances a solar power facility would be depreciated over 30 or more years, the accelerated depreciation creates a large tax shield in just five years. If we look at $100 in depreciation as a tax deduction – which is intrinsically valuable – the time value of money applies to it just as it would to a cash flow. In other words, taking all that depreciation over a shorter period of time creates more value for a company.

Most buyers of solar power systems don’t have a big enough tax liability to take full advantage of the 30% tax credit. Take SolarCity for example, which still has negative operating income: if the company kept and deferred the tax benefits of building its solar systems, it would take years to be able realise any tax shield, by which point its value would be significantly discounted. For a company like Google, which paid nearly $2.3bn in tax last year, the opportunity to earn some tax benefit makes sense.

Most industrial-scale solar projects, then, are primarily funded by a tax equity investor who receives payments from the end consumer. A solar power company like SunPower or Sunrun builds the facility for the investor (e.g. Google, Credit Suisse, or Goldman Sachs to name a few), who then receives payments from the end-user through a lease or power purchase agreement (PPA). If you want to dig a bit deeper into the specific structures used, this article might be helpful.

Solar panels dot the roofs of the GoogleplexSource: Austin McKinley, Wikipedia

Solar panels dot the roofs of the Googleplex
Source: Austin McKinley, Wikipedia

Must all good things end?

In 2016, the federal subsidy on solar power will decline from 30% to 10%. This could have a major effect on the solar industry, as tax equity investors would have a diminished incentive to put money into these projects, raising costs of capital and ultimately making solar energy less attractive to the ultimate buyer. While it’s plausible that the government could extend the higher tax benefit, does anybody want to bet on the government actually doing something?

Wind power might be a good indicator of the future of a reduced-subsidy solar industry might look like. Windmill owners received 2.3 cents per kilowatt-hour produced through the Production Tax Credit (PTC) before it expired in 2013, and investment went from adding over 12,000 megawatts of capacity in 2012 to less than 2,000 in 2013. Congressional debate on renewing the incentive has been blocked by conservative Republicans and Democrats, who are often backed by petroleum companies (there’s something politicians come together over – money!). A proposal to renew subsidies on solar energy might have a similar fate should it find its way into Congress in 2016.

Should these incentives even be in place, though? They distort the market for energy and cultivate an industry heavily dependent on the government. When the incentives are cut back in solar, new projects will likely stall and higher costs of production will be passed on to utilities. Utilities in turn, must seek out the most efficient sources of energy and may end up reverting to coal and other fossil fuels.

It’s hard to consider the implications of subsidised renewables without recognising that fossil fuels are also subsidised. Billions of dollars in state and federal incentives go to oil, gas, and coal each year, and clean energy advocates often point to this data in a push for more “green” subsidies. The reality is that, while fossil fuels receive more subsidies in agreggate, renewables are much more heavily subsidised on a per-unit basis. According to this WSJ opinion piece, coal is subsidised at about 0.05¢ (or $0.0005) per kilowatt-hour, while wind gets 5¢ per kWh and solar gets 77¢ per kWh.

The ITC for solar power is extremely generous at 30%, and I wouldn’t count on the federal government moving to keep it that high past 2016. So, what will happen to tax equity investing? Google’s last wind power investment was in December of 2013 – just before the 2.3¢ per kWh incentive ran out. A 10% tax credit for solar investments may not be enough for large corporate players like Google and Credit Suisse to stay involved in this space. Independent financing companies may fill some of the void, and securitisation of renewable energy receivables may create a deeper capital market for this type of liability.

Companies investing in large-scale renewable energy projects have had an important role in the development of alternatives to fossil fuels. Without the ITC for solar and PTC for wind, renewables might still be prohibitively expensive in the US. It remains to be seen how solar project finance evolves post-2016.

The Business of Gambling: Part 2

The gaming industry is facing a few major shifts that could spell big change for some companies. This piece examines these opportunities and the positions taken by major US-based casino operators. The coming years may cement the positions of heavyweights like Las Vegas Sands, but it could also be a chance for a company like MGM Resorts International to globalise and come out ahead.

Online Gambling

One of the biggest issues facing gaming companies in the US market is the issue of legalised online gambling. This is a major opportunity and threat to the brick-and-mortar casino business, and the issue has divided the major players. Las Vegas Sands head Sheldon Adelson has been a vocal opponent of legalisation, promising to spend “whatever it takes” to stop this from becoming a reality. He has spearheaded a “six-figure advertising campaign” through his advocacy group, the Coalition to Stop Internet Gambling, according to FT and the Associated Press. Mr. Adelson has the tacit support of Steve Wynn, who has been lukewarm on online gaming for some time. MGM and Caesars have taken the opposite approach, advocating for legalisation through the American Gaming Association (AGA). These companies both sorely need a growth-driving market, and they may sense an opportunity to gain an edge on their larger, more Asian-focused rivals.

So, which is the right course of action for casino operators? This strikes me as a case of Pascal’s Wager. Caesars and MGM are investing in infrastructure to prepare for the possibility of widespread online gaming (Caesars already operates a few websites in New Jersey). If this becomes a widespread reality, they will be in a favourable competitive position to capture a sizeable share of the market and benefit from its growth opportunities. If online gaming is not legalised widely, the companies will have some sunk costs. Think of it like a long call option – the downside has a floor (the amount of money the company invests in online gaming), while the upside is limitless, so to speak (see Fig. 1). Wynn and LVS, on the other hand, are avoiding investment in online gaming – the equivalent of no position, so no upside or downside. If it is legalised, they will be forced to choose either to pour money into an online presence or to miss out on the market altogether. Either way, they lose. As second-movers in such competitive business, they would capture smaller market shares, and missing online gaming completely would be like Microsoft not investing in mobile technology. Mr. Adelson and his cohort is taking a big risk by opposing online gaming.

The lobby against betting online claims that online gaming should be blocked because it could be used by criminal organisations to launder money. This is disingenuous. Messrs. Adelson and Wynn are concerned that online gaming will harm business for their casinos in Las Vegas and throughout the US. Most research does not seem to corroborate this fear. A recent article in Businessweek cites an Econsult Solutions report suggesting that online gambling in Pennsylvania could collect about $110 million in taxes per year through online gambling, “largely without cannibalising casinos’ existing businesses.” This sentiment is echoed in other consultancy reports that I (unfortunately) cannot cite in this article.

Mr. Adelson’s stand against online gaming leaves a bad taste in my mouth. He has spent millions lobbying politicians under the flimsy premise of protecting Americans. On a Bloomberg News video on YouTube, Mr. Adelson insists that money is “not the consideration,” talking instead about how children would gamble online and compares legalisation of online gambling to legalising heroin. The casino magnate has even allied himself with conservative Christian groups opposed to gambling to push his agenda. The whole ordeal makes Mr. Adelson seem untrustworthy. As we say in Mexico, mañoso – slick, tricky, or cheating are the closest translations I can think of.

Next Stop Japan

Japan presents an opportunity for the ‘next Macau’ to take shape. The government seems poised to adopt legislation legalising gambling ahead of the 2020 Summer Olympics, and licences will likely be awarded in Tokyo and Osaka. This untapped market is expected to be worth more than Singapore and could surpass Nevada to become the world’s number two gaming market. This makes Japan a massive opportunity for whichever company nabs a licence. The large, affluent domestic market makes this a solid case of “build it, and they will come.” While some high-roller Japanese gamblers are currently travelling to Korea, Macau, or Singapore to gamble, thousands more would be compelled to spend money if the casino were a short train ride away. Bloomberg also notes that Abenomics has weakened the Yen, making overseas vacations more expensive for Japanese citizens (see Fig. 2).

Source: Bloomberg Fig. 2

Source: Bloomberg
Fig. 2: The Yen has weakened against the US Dollar

If MGM or Caesars can secure financing, building a resort in Japan might be a grand power-play to expand in Asia. Caesars appears to be making plans for a potential development in Tokyo, while MGM has drawn up proposals for a resort in Osaka. The potential growth of such a market would markedly improve these companies’ competitive positions. Caesars has no properties in Asia, while MGM has just one casino in Macau. Unfortunately, neither of these players is equipped to be competitive in the fight for licences that will inevitably play out if gaming legislation passes. Japanese officials have shown a desire to work with casino operators that have experience with integrated resorts of the kind found in Singapore. Integrated resorts are designed to cater to a wider demographic, featuring a spa or theme park in addition to casino facilities. This means Las Vegas Sands and Genting Singapore – owners of the two resorts in Singapore – may have an advantage in courting the Japanese government for licences. The risks for MGM and Caesars could be compounded by the financing hurdles of such a project, which could bind them under unfavourable debt arrangement and eat into profits. Both companies are highly-levered, and more debt would present a major credit risk. Nonetheless, owning a property in a major market like Japan could make a huge difference for these companies.

Of course, Las Vegas Sands is making bold moves to secure the favour of Japanese officials. Mr. Adelson has pledged to spend $10 billion on the market, hoping to secure a licence in Tokyo. This may be theatre: Reuters cites a recent Morgan Stanley report predicting that a resort costing over $5 billion would “offer a return on investment of below 20 percent due to rising costs and a struggle to attract enough high-rolling Chinese VIP customers.” Regardless of how much money winds up being spent, it is clear that Las Vegas Sands has a major advantage in Japan. Less-sophisticated companies may be left with fewer licences to battle over.

Casinos in the US: Beating a Dead Sick Horse

Here’s an idea I don’t like as much: opening resorts in every one-horse town from Pennsylvania to Oregon and hoping more gamblers will materialise and deepen the US market. The Sands Bethlehem (in Pennsylvania), the MGM Grand Detroit, and plans for a Wynn resort in Everett, Massachusetts – these are all fine ideas, but the market won’t define companies the way Macau did. At some point, gamblers may have so many local options that they will avoid Las Vegas altogether. Some observers have suggested that the market is saturated – looking at revenue per casino does not support this assertion outright, but it does seem that growth in revenue per casino is levelling out. The number of casinos in the US has only grown about 2% since 2005, and revenue per casino has increased a solid 12% since then. Again, growth does seem to be decelerating, but saturation may be some years off. As resorts get more expensive and return get smaller, though, I would opine that casinos in the US market won’t be a very attractive market in the next few years. There are plenty of struggling casinos to illustrate that point: Atlantic City has been in decline for some time, and this article highlights casino troubles in a number of other states. The market doesn’t have great prospects, so casino operators would probably be better served by investing in international markets.

Fig. 3

Fig. 3

The gaming industry is in an interesting situation. While the US market is mature and lacklustre, global opportunities (Japan, at the moment) could be a major source of growth in the years to come. Casino operators should focus heavily on competing in these new markets to maintain growth and diversify their businesses. Macau was a defining investment for Las Vegas Sands, and Japan could pose a similar opportunity for the companies that are successful there. The growth this fresh market would deliver can’t be matched by online gaming or casinos in the US. Time will tell if MGM or Caesars seize on the moment.

Disclosure: In early 2015, I took positions in Las Vegas Sands Corp and Caesars Acquisition Corp.

The Business of Gambling: Part 1


Las Vegas

The Las Vegas Strip

If you’ve ever been to Vegas, you might think you have an idea of what the gaming industry looks like. Just two companies seem to dominate the Strip: MGM Resorts International owns the Bellagio, the Mirage, the Mandalay Bay, Aria, and the MGM Grand (among others); while Planet Hollywood, Paris, Bally’s, and Caesars Palace are just a few of the properties owned by Caesars Entertainment Corp. Conversely, Wynn Resorts Limited only owns two Strip properties (the Wynn and the Encore), while Las Vegas Sands Corp has the Venetian and the Palazzo.

Like the quixotic world that is Las Vegas, though, the gaming industry is not all that it seems. The biggest casino operators are defined not by their Las Vegas properties, but by their holdings in Macau – this is relatively common knowledge, but you would never guess the real juggernauts from a visit to Vegas. While MGM and Caesars dominate the Las Vegas Strip, they are far behind competitors that have built a strong business in China. Indeed, there seems to be a strong positive correlation between the percent of adjusted EBITDA earned outside of the US (read: Macau and Singapore) and a company’s interest coverage ratio – that is, the companies with a greater exposure to Asia are in a stronger financial situation and better able to pay off debt (see fig. 1). This is a pretty weak statistical observation (small sample size), and interest coverage may be a controversial metric to use since it depends on financing mix (which varies by company) – but this scratches the surface as far as the factors that have driven success or failure for gaming companies in the last decade or more.


Fig. 1

The Sands Storm

Las Vegas Sands makes less than 12% of its adjusted EBITDA in the United States and has the largest enterprise value of the companies we are examining (it is the largest casino operator in the world). Under founder Sheldon Adelson, Sands opened the first foreign-owned casino in Macau in 2004. The company kept up the pace of development, opening the Venetian Macau in 2007, the Marina Bay Sands (Singapore) in 2010, and the Sands Cotai Central in 2012. These properties are tremendously successful – the Venetian Macao reports a 91.9% occupancy rate and the Marina Bay Sands an astonishing 98.9% occupancy rate, according to the company’s most recent annual report. The average daily rate at the Marina Bay Sands is a steep $355, higher than all but one of the company’s properties (the Four Seasons Macao). By comparison, its Las Vegas resorts have a 86.1% occupancy rate with a modest average nightly rate of $203.

Marina Bay Sands

Photo: Marina Bay Sands
The Marina Bay Sands in Singapore

Sands is far from finished in China. The Parisian Macao is under construction and expected to open in late 2015. This could be an opportunity to cement the company’s hold on the Cotai Strip with an iconic landmark associated with Vegas. Sands may also be poised to begin targeting mass-market gamblers, a demographic traditionally underserved in Macau. A recent Wall Street Journal article notes that average minimum bets in the territory have climbed to HK$1,000 ($129 USD) for non-VIP gamblers. This is astonishingly high, and the market for low-rollers could be a major source of growth for the company in the next few years. There are also major risks to catering to wealthy mainland Chinese VIPs, who may use Macau as a money-laundering hub.

Caesars – Too Much Debt to be Cool

I lost quite a bit of money at Bally’s (a Caesars property on the Las Vegas Strip for you newbies) on a recent vacation. In light of this analysis, I may have done the company a small favour. Caesars Entertainment Corp is in a heap of trouble due largely to its enormous $24 billion mound of debt. The company just recently sold some of its properties to a subsidiary, Caesars Growth Partners LLC, to gain access to some much-needed cash. Restructuring is inevitable at this point, and there is a high risk of bankruptcy in the next two or three years. Robert Cyran wrote for Reuters Breakingviews a few days ago, “The company’s EBITDA is just about covering interest payments. That leaves little if any to update hotel rooms and gambling dens in ultra-competitive Las Vegas.” This is a very important point, and Paris Las Vegas is a perfect example of how this debt issue is destroying Caesars’ business. The hotel is gorgeous from the outside and the miniature Eiffel Tower is a Vegas landmark. Visitors, however, complain of outdated rooms and décor, which distract from the property’s style and ideal location.

Paris Las Vegas Room

Photo: TripAdvisor
A room in the Paris Las Vegas property

Caesars has missed out on the explosive growth of the Macau gambling market. Total property EBITDA has floundered around $2B for the last three years without a clear uptrend, and with interest and principal payments always around the corner, Caesars is certainly running out of options. Looking at EBIT yields a worse picture – depreciation is depressing operating income, signalling much-needed capital expenditure may be neglected as assets are depleted. This all means the company is in a terrible position to invest in Macau: observers have begun questioning when the territory will near saturation, and procuring permits and licences for such an endeavour would be burdensome to say the least. With precious little capital to invest, Caesars may not get to build a palace in Macau any time soon.

Google Finance

Source: Google Finance
The financial picture for Caesars looks bleak

I also must note that Caesars’ financial troubles are largely a legacy of its 2008 leveraged buyout by private equity firms TPG Capital and Apollo Global Management. According to documents filed to the SEC by Harrah’s Entertainment, Inc (the company name at the time), the deal put “approximately $10.7 billion of debt” on what would eventually become Caesars Entertainment Corp. The LBO could not have come at a worse time, as the financial crisis would soon devastate the Las Vegas gaming industry and property market. In July of 2008, the Financial Times quoted analyst Kim Noland as saying, “Harrah’s leveraged buyout piled on debt just as operating results started to weaken.” Earlier, in October of 2006 as the deal was beginning to take shape, the FT had reported that “a private equity takeover of Harrah’s would would be the first large bet that more debt can be piled on to gambling companies without incurring significant risks.” It is now clear that LBOs may not be suited for the gaming industry. The buyout can’t take all the blame – the 2008 recession certainly made things much worse for Harrah’s – but I don’t anticipate seeing private equity shops going after casino operators again any time soon*.

(By the way, read my previous article about why Guitar Center’s LBO went wrong here.)

My next post in this series will focus on the direction the gaming industry is headed, opportunities and threats, and what they mean for these companies.

* = It came to my attention that Blackstone Group LP acquired the Cosmopolitan, a casino resort in Las Vegas, on Thursday (15 May). At $1.7B, this deal is relatively small. No debt has been piled onto Cosmo yet (this was not an LBO), and Blackstone bought a property, not a whole company. I would argue that my point stands.

Disclosure: In early 2015, I took positions in Las Vegas Sands Corp and Caesars Acquisition Corp.

What can ECB easing do for you?

The European Central Bank in Frankfurt

The European Central Bank in Frankfurt

Mario Draghi has been warming up to the prospect of quantitative easing (QE) at the ECB as growth and inflation remain stubbornly low in the EU. While it is far from certain that the ECB will begin large-scale easing, this course of action would undoubtedly create opportunities for investors in the Euro market.

On 6 March 2009, the S&P500 hit its lowest point in the financial crisis. Just months earlier, in December of 2008, the Federal Reserve had begun buying up securities on the open market. As the economic recovery dragged on, asset purchases continued and the stock market rose. Today, the S&P500 has recovered well over 150% and QE is winding down steadily.

I don’t want to get into a debate about QE. Regardless of the extent to which it is helpful or harmful to markets in the long run, it is clear that QE buoys asset prices. This can be observed pretty easily by comparing the historical price of the S&P 500 to the Fed’s balance sheet. This comparison is nothing new, but it is quite timely since history does repeat itself.


The coefficient of correlation for these two data series is an exceedingly high 0.93. Furthermore, standard deviation is nearly the same as a fraction of each mean, at 17.64% of the mean for the S&P500 and 17.39% of the mean for the Fed balance sheet. This correlation is absent in the pre-QE data (the coefficient drops below 0.5).

If the ECB undertakes QE, this would almost guarantee a medium-term surge in European equity markets. Mario Draghi has now expressed willingness on behalf of the entire central bank’s board to take action if growth and inflation remain subdued. This would present a very favourable scenario for investors.

Mulberry: the perils of lowering prices

The company must not succumb to profit-chasing through lower prices.

ImageMulberry Group plc

Mulberry Group plc’s latest profit warning comes with a promise to regain market share through lower-priced products. The company has had a rough period, losing two-thirds of its market value in the last two years. The blame has fallen squarely on Bruno Guillon, the company’s former CEO who stepped down in March. Mr. Guillon, previously at Hermès International SA, attempted to price Mulberry’s products further upmarket with broadly negative results.

As the company pledges to roll out less-expensive product lines, I am compelled to point out the significant risks to this strategy. Mulberry has emphasised its intention to offer lower-priced handbags and accessories while maintaining its most expensive lines unchanged. This strategy risks devaluing the brand, squeezing margins, and depressing long-term growth.

The best example of a cheapened brand is Coach, Inc. This company has chased profits by offering handbags and accessories across a broad range of consumer segments. Indeed, one can buy a Coach bag for as little as $100, and shoes can be had for even less. This strategy has made Coach a highly visible brand among high school girls and less-affluent young women. This demographic has driven plenty of growth, but the company’s margins have remained stagnant or shrunk in the last years (see Fig. 1).


Fig. 1 (Google Finance)

Fig. 1 (Google Finance)

Another factor tarnishing the Coach brand is the company’s distribution. Outlet stores make up over 20% of the company’s direct retail presence, and Coach products are sold in Macy’s, Zappo’s, and other relatively low-cost retailers. Pursuing the affordable luxury segment is a competitive struggle, and Coach has sacrificed the appeal of its flagship high-margin products in its thirst for growth. In the race to capture this market, Michael Kors and Kate Spade have fared demonstrably better. Just look at stock appreciation over the last two years (Fig. 2).

Figure 2 (Google Finance)

Figure 2 (Google Finance)

Mulberry’s situation isn’t too bad overall. Operating income soared in 2011 and 2012, and the 1.92% dip in revenue seen in 2013 was pretty minor. Cost of sales had the biggest impact on the bottom line, increasing by 6.42%. This can be attributed to the company’s high-end strategy under Guillon, which required more expensive storefronts in prime locations. I should note that working capital and net current assets have been increasing steadily despite the fluctuations in bottom-line performance.

One brand that has successfully offered products at a range of prices is Burberry Group plc. This retailer divides its offering into three segments: Burberry Brit at the lowest end, targeting a younger demographic; Burberry London, featuring traditional luxury formalwear; and Burberry Prorsum, which features the brand’s runway styles at the highest price point. This strategy has yielded margins above 20% for the last three years and growth has been very steady (Fig. 3).


Source: Burberry Group plc

Mulberry is a relatively small company, and it may be unfair to compare it to these giants. That being said, the impression that the brand makes among global consumers as it becomes more well-known cannot be easily mended. I would advise Mulberry to lower prices enough to bring back antagonised customers, and no more. Expanding the company’s offering to low-cost segments could be done in the future through acquisitions (this would be infeasible under the company’s current size and cash position) Alternatively, the company could be an attractive acquisition target. Regardless, Mulberry should stay true to its identity. Cheapening the product may drive some growth in the short term, but value lies in the long-run success of the brand.


Guitar Center: The Last Song?

Seeing my old stomping ground Guitar Center in the news a few months ago was a major blast from the past. I instantly remembered spending hours in the store on San Mateo Street down the road from Coronado Mall in Albuquerque. I remembered buying my used Epiphone Explorer with the upgraded pickups and poring over the walls crammed with guitars of every kind. I am admittedly sad to see the company struggling today.

Guitar Center provides a great case study of how a leveraged buyout (LBO) can go quite wrong. With $1.6 billion in junk bonds outstanding – much of it originating from the company’s takeover by Bain Capital in 2007 – the company is struggling under its tremendous debt load and amid poor sales performance. As the company has slipped into the red over the last year and its cash pile has shrunk, the prospect of making interest payments has dimmed. In other words, the company is very close to bankruptcy.

What went wrong at Guitar Center, then? At the time of the deal, Credit Suisse analyst Gary Balter said the transaction seemed “like the perfect LBO.” He cited the company’s “dominant retail position” while pointing out that earnings still lagged behind other “high service” retail business segments. This was a good opportunity for Bain Capital to leverage (no pun intended) the strong Guitar Center franchise to improve the company’s operational performance.

The problem with Guitar Center is that it has clung to an antiquated business model, with 373 storefronts (as of December 2013) across the country according to CFO Tim Martin. To make matters worse, guitars don’t sell as well as they used to. Think about that one – does Kanye use a guitar? What about Katy Perry? Now that music can be made with a computer, expensive physical instruments have certainly lost some appeal.

Mr. Martin seems to be under the impression that he is not accountable for the company’s financial troubles. Of the impending crisis he says, “you can take a look at the financing aspect of it, but at the end of the day, that’s the owners of the company’s problem.” He goes on to argue that the company’s cash flow-positive stores would prevent creditors from seeking to liquidate the company.

The negotiations with Ares Management (owner of most of the debt) to take over Guitar Center are no doubt indicative of the long-term promise this company has. However, if the current executive team hasn’t made proper strides to modernise the company, they may all be sacked very soon. It’s also very likely that the new owners will close underperforming stores, leading to significant job losses.

It’s safe to say Bain Capital’s takeover of Guitar Center has fallen short of expectations. While the company might have appeared stable enough to handle $2.1 billion in debt in 2007, changes in the consumer market for music instruments have made survival of GC in its current state all but impossible. Now, it could be Ares’ turn to revitalise this retailer. If they take the right steps to bring this company into the 21st century, we may yet live to visit a Guitar Center well into the future.


Welcome to my website/blog. As you might have noticed in this page’s title, I’m into capital markets, Latin America, and tech. I’ll be writing about all three on here. Hopefully, my ideas will become more robust as I get into my work over the summer.