Quarterly Letter, VIP SEA

Quarterly Letter from CIO, VIP Southeast Asia Chapter, Q3 2023

Dear Sponsors, Board of Advisors and Members,

We are excited to share with you our latest updates and insights as we pass the third quarter of 2023. By way of introduction, my name is Javier and I am the new Co-CIO, alongside You-Gin, for VIP SEA. This quarter has been rather eventful, both in the markets and internally within Gen Z, and we hope that this letter will provide colour on all that has went on and our view on key topics moving forward.

In Q3, we officially welcomed a new batch of analysts, and we are so excited to have fresh minds and hands on board the team! All members are working hard on their initial memos, with close collaboration between seniors and juniors, as we focus on imparting skillsets on to the next generation and creating a culture of mentorship. We are confident that with close guidance, the learning curve for new members will be less steep, and they will be able to produce high quality research as they embark on their investing journey.

This quarter, our focus was on strengthening existing efforts and introducing new initiatives. Firstly, we are furthering our efforts in Meet-The-Investor (MTI) sessions. Our members gave feedback that they have benefited greatly from speaking first-hand with experienced professionals, and we wholeheartedly agree. Our recent sessions with Alix Pasquet (Prime Macaya) and Dennis Hong (Shawspring) have captivated our members and inspired them to strive on further in their investing journey, as they delivered anecdotes and insights into their world of fund management and investing.

We are also introducing a new initiative - Z Club Academy, that seeks to provide members with a more structured curriculum that focuses on progressive training on topics related to investing. From lessons on financial modelling and valuation, to insights on the idea generation processes, to sharings from industry experts, we intend to cover the areas that we believe the members will benefit from the most. The focus will be on solidifying thought frameworks and establishing heuristics, which is critical for beginner investors.

Portfolio Update

Alibaba

Considering Alibaba's choice to divide itself into six distinct business units, it became imperative for us to delve into the underlying implications of this significant strategic move. Olivia Zhang, one of the members covering Alibaba, conducted thorough research into Alibaba's restructuring and presented her findings to us, recorded in her memo here.

Reviewing Alibaba's performance in the 2023 fiscal year, the numbers show a 1.83% year-on-year revenue increase to 86.869 billion yuan, reflecting the impacts of pandemic control measures. Notably, net profit surged by 40.42% to 65.573 billion yuan, and net profit attributable to shareholders climbed by 17.03%. This revenue breakdown reveals that core e-commerce constitutes a substantial 75.05%, while segments like cloud services, logistics, digital entertainment, and innovation contribute to the remaining shares. Shifting focus, Alibaba's adoption of the "1+6+N" organizational structure aims to enhance business autonomy, transforming the company into a holding entity concentrating on capital and asset management.

Drawing parallels with Google's 2015 reorganization, it's intriguing to consider the potential benefits of Alibaba's restructuring. Google's move led to core business concentration, independent management, and improved valuations. Could Alibaba's shift also enhance operational vitality and autonomy? The model's flexibility for independent financing and public offerings could indeed reshape the business's value and transparency. Additionally, the agility of individual subsidiaries might enable better responses to market changes and risks.

Turning to Alibaba's growth sectors, the numbers are striking. Cainiao logistics and international e-commerce shine, with Cainiao's accounts receivable soaring at an impressive compound growth rate of 84%. This aligns with government-supported trends of expanding overseas. Delving into the logistics strategy, Cainiao's "light and heavy combination" approach seems promising, allowing swift global expansion while staying nimble. Furthermore, Alibaba's emphasis on technological advancements positions it favorably in the overseas market. This may therefore be a new focal point for us as we continue holding BABA.

Taking a look at Q1 2024 results, Alibaba reported a substantial 14% year-on-year growth in revenue for the quarter ended June 30, marking its most significant annual sales increase since the September 2021 quarter. In response to this positive news, Alibaba's U.S.-traded shares surged by 4.5% in premarket trading. Alibaba's revenue reached 234.16 billion yuan ($32.29 billion), surpassing the expected 224.92 billion yuan, showcasing a 14% YoY rise. Moreover, net income attributable to ordinary shareholders amounted to 34.33 billion yuan, exceeding the anticipated 28.66 billion yuan, with an impressive 51% YoY growth.

Alibaba's core business segments also displayed promising results during the June quarter. The Taobao and Tmall Group, constituting the company's main business, recorded a 12% year-on-year revenue increase, totaling 114.95 billion yuan. Notably, the Taobao app for online shopping exhibited a 6.5% rise in daily active users in June compared to the previous year, escalating further to over 7% in July. Alibaba's strategic efforts to expand its presence in international markets yielded substantial results as well. Revenue from international commerce retail surged by an impressive 60% year on year, reaching 17.14 billion yuan in the June quarter.

Alibaba also experienced a 34% rise in revenue for its Cainiao logistics business, reaching 23.16 billion yuan, largely attributed to international demand during the same reporting period. The company's cloud business reported a 4% revenue growth, totaling 25.12 billion yuan. However, these results were somewhat hampered by reduced revenue from key customers and a decreased need for remote work, streaming, and education services following the pandemic.

Nonetheless, Alibaba observed strong demand within its cloud business for AI-related services and the training of artificial intelligence models. The company is resolute in its belief that the growth opportunities stemming from AI services are just beginning, heralding a new era driven by technological advancement. We note that Alibaba's management expressed their intention to increase investments in AI development and seize emerging business prospects. Moreover, management articulated their vision for the Taobao app to evolve into an all-encompassing intelligent hub for life and consumption, powered by AI technology.

BYD

Javier Chan, our newly-minted CIO, updated his view on BYD, which he pitched in Q1 this year following the release of new data.

Stock performance

We invested in BYD stock in end March, 2023. During this period, renewables and EV stocks have performed well in the Chinese market while most other sectors have slid. BYD has went up 26.3% since our investment while the Hang Seng Index (China Benchmark) is down -3.6%, implying alpha generation of ~30%. Delivery

Numbers

In June, BYD delivered 253k units worldwide, up 5.3% MoM. In H1’23, BYD delivered 1.3m vehicles – 2x from the same period a year ago. Industry competitive dynamics have intensified this year, with peers waging a price war. YTD, Tesla has cut Model 3 prices by 14% and Model Y prices by 10%, while BYD cut prices of the Seal by 10% in May. In Q2 2023, BYD delivered ~600k vehicles while Tesla only delivered 247k. This indicates that BYD captured almost >2x the incremental market share of Tesla despite only decreasing prices moderately. Market share is an important metric in the industry, especially in the entry-level market that BYD plays in, as on average each customer will only purchase 1 vehicle. Hence, it is crucial for the company to capture each incremental customer, as that will lock them in for the next 7-10 years once the purchase has been made. BYD has been exceeding expectations on all fronts YTD and the market has rewarded them for it. Moving forward, we should be prepared for a potential moderation in delivery numbers in response to the increasingly difficult China macroenvironment. However, these effects will likely be felt industry-wide, and I believe that on a relative basis, BYD will still be the top outperformer among other China EV players.

Costco

Cheng You Gin, yet another one of our new Deputy CIOs, also pitched Costco Wholesale Corporation (NASDAQ: COST) at our IC meeting. The following is a summary of his investment case, which can be read in full here:

Company Overview and Financial Highlights
Costco Wholesale Corporation stands as the world's third-largest retailer, operating membership warehouses across the globe, with 847 locations and 8 e-commerce websites as of 2022. Renowned for its diverse range of merchandise categories including groceries and household items, Costco follows a unique membership-based business model. In 2022, the company expanded with the opening of 26 new warehouses, 7 of which are located outside the US and Canada. The year saw a 16% increase in net sales to $223 billion, driven by a 14% rise in comparable sales and new warehouse sales. Membership fee revenue reached $4,224, up 9%, attributed to new member sign-ups, upgrades, and an increased renewal rate.

Business Segments and Industry Context

Costco's revenue primarily stems from merchandise sales, accounting for over 90%. Membership fees contribute 2% of net sales, reflecting its exclusive membership model with over 120 million members. E-commerce sales account for 7% and are facilitated through various logistics arrangements, including Costco's own depots and drop-shipping. The global retail industry, estimated at $25.8 trillion in 2022, is projected to reach $32 trillion in 2026 with a CAGR of 5.53%. The post-COVID-19 landscape has seen technology emerge as a key driver, with e-commerce playing a pivotal role in adapting to market shifts and optimizing supply chains.

Challenges and Investment Thesis

Elevated retail inventories, which surged by 17% from October 2021 to October 2022, have led to increased warehouse costs and higher supplier input costs due to marked-up products. Despite these challenges, Costco maintains its investment appeal. The ability to retain market share through its membership model, boasting a renewal rate exceeding 90%, positions it strongly. Costco's bargaining power, rooted in its size and purchasing concentration, results in lower prices for members while maintaining quality. This resonates with suppliers as they gain volume even with reduced margins. Moreover, Costco's efficient supply chain management and broad product selection drive cost advantages.

Global Expansion and Financial Strength

Costco's outward expansion remains robust, with plans to open 23 new warehouses in 2023, 10 of which will be international. A focus on China is particularly notable, with six stores set to open there by the end of 2023. The company aims to achieve a balanced warehouse distribution between the US, Canada, and international locations. Financially, Costco maintains a strong balance sheet, with favorable liquidity and solvency ratios. Its lower debt-to-equity ratio and impressive interest coverage ratios position it well in varying interest rate environments.

Valuation and Growth Potential

While Costco's current multiple surpasses historical averages, its strong growth potential could justify its valuation. With an EPS growth rate of 16.7% CAGR over the past three years, the company's forward P/E ratio could remain at 35-40x PE. Assuming a similar forward P/E ratio and earnings growth, an implied share price of $582.54 is anticipated, indicating an 11% upside potential.

We have decided to allocate 10% of our portfolio to Costco and are in the process of executing the trade.

Spotify

Javier Chan, Co-CIO of VIP SEA, initiated coverage on Spotify this quarter, which we took a position in. In our view, music is a recession proof industry, and evidence suggests that Spotify is something that should continue to do well regardless of the macroeconomic environment next year, while still providing some idiosyncratic upside risk. The following is a summary of the investment case, which can be read in full here:

In summary, we believe that there is a compelling case for Spotify to achieve their first full year of profitability by 2025. Profitability will be driven by a few levers:

Significant Improvements in Unit Economics

Price hikes will be the first lever here. Spotify raised prices this year, on the back of peers doing the same. Over the years, Spotify has shown that their subscriber base has been able to readily absorb price hikes, with minimal impact on MAU growth. In the past few years, Spotify has conducted over 50 price increases, yet as of Q2 2023, MAUs have increased by 70% since the onset of the pandemic. The recent round of price hikes is estimated to have increased Spotify’s average share of a consumer's disposable income from 0.09% to barely above 0.1%, and this change has been relatively immaterial to their loyal user base. Ultimately, the value and entertainment that Spotify provides from their product offerings has justified price increases and there is no reason to expect change.

Sustainable Cost Advantages

Spotify will be able to continue lowering direct costs by leveraging on the massive scale that they have achieved. Spotify’s direct costs comprise mainly of revenue sharing with labels and publishers for both premium and advertising revenues (84% of revenues). Spotify’s pay-per-stream on average has been trending downwards. In the past decade, Spotify’s pay-per-stream has halved. This is attributed to the sheer number of ears that Spotify has managed to attract to their platform. Being a first mover in this space, and also the player with the most comprehensive audio library, serves as Spotify’s moat. Competitors today lag behind Spotify in terms of platform features and audio offerings, and they will likely find it difficult to catch-up or replicate Spotify's success. With these measures in place, I believe that Spotify can protect their scale, and use it to negotiate better revenue sharing agreements and improve gross margins.

Improving Operational Efficiencies

In recent quarters’ earnings calls, management highlighted ongoing efforts to streamline operations and reduce costs. Year to date, Spotify announced that they were laying off 8% of their global workforce, including 200 employees in the Podcast segment. Management also seems cognizant of their overinvestment in content deals and said that the hurdle for new investments going forward will be significantly higher. During the 2022 Investor Day, management also guided that Podcasts are expected to be a 40-50% gross margin business within the next 5 years but are still in investment mode. As of 2Q23, Podcasts are on track to break even and achieve the level of margins as previously guided. Overall, management has offered reassurance by stating that operating expenses as a percentage of revenue should come down as they are not going to increase it to the same extent that they have had in past years. These are cost levers that are well within the company's control, and the company has made visible efforts to achieve this target.

Valuation and Scenario Analysis

Spotify trades at 1.5x NTM sales (at time of initiation) and is looking extremely cheap. Music as an industry is extremely resilient that should do well regardless of macroeconomic environment. Relative to other tech sectors, the sentiment here should not deteriorate as much and would allow for higher potential to outperform. I believe the max downswing from here would be at most ~30%, likely to be driven by temporary depression in sentiment due to recession fears, MAU growth slowdowns etc, but we will consider accumulating even more at those levels. This is a long-term play that we see very little likelihood of not materializing, but would still require ongoing monitoring, especially in margins and MAU growth. We value Spotify at 3x target EV/Sales, in line with historical average. This would imply a 3Y target upside of 120%, and 5Y target of 168%.

With Best Wishes,

Javier Chan

on behalf of the Value Investing Program’s Southeast Asia Chapter