Dear Partners,
We typically prefer to communicate with you twice a year or sometimes quarterly, if we find there is important information that we want to share. Given the recent market volatility and a sizable drawdown that you saw on your Q2 statements, we wanted to give you a quick update on the latest fund’s performance and, more importantly, a business update on our top portfolio holdings.
Rowan Street is up +30% since the end of Q2. Although short term fluctuations are typically meaningless and the market can very well go down from here, it is a good sign that our portfolio is rebounding very strongly as growth is coming back in favor.
Despite the uncertainty about the macroeconomic environment, we continue to invest in digital platform companies and growth-oriented innovative and disruptive firms that can execute with confidence at a very high level, take share, distance themselves from competition and come out of this environment in a much stronger competitive position on the other side. In fact, it’s these kinds of times that separate the winners from the losers.
Our top 5 positions that make up 70% of the fund have recently reported business results for the second quarter. Let’s dive into the health of their underlying businesses:
Spotify (+28% since 6/30)
Spotify reported a really strong Q2. They have re-accelerated growth in monthly active users (MAU) and are expected to reach 450 million users in Q3, which is impressive because, at their scale, it's very difficult to re-accelerate MAUs (not many platforms in the world can do that).
Although it's not an apples-to-apples comparison, below we plotted the growth in Spotify monthly users vs. Netflix (its a telling visual):
Source: Rowan Street Capital, LLC
Ad-supported users grew 22%, while ad-supported revenues grew 31%; overall revenue grew 23%. Spotify generated 9th straight quarter of positive free cash flow, averaging $250 million in trailing 12 months free cash, while continuing to heavily reinvest into the growth of their platform. Stock is currently trading at only 2x 2022 revenues and 8x gross margins.
“While the macro environment continues to present uncertainty, we are currently not seeing any material impact on our expectations for users or subscriber growth from the economic downturn.” — Daniel Ek (CEO of Spotify)
Meta Platforms (+11% since 6/30)
Meta platforms gets a lot of negative news coverage, and there has been a general negative sentiment floating around the company for some time. But let's take a look at what's “under the hood”. In recent quarter, Family of Apps daily active people hit 2.88 billion, while monthly active people grew to 3.65 billion — these are mind-boggling numbers. In the past 12 months, they earned $33.20 in revenue per user, which amounted to $118 billion in total revenues. On that, they generated almost $40 billion in operating profits (34% operating margin) and $58.5 billion in operating cash flow. That is far from a disaster!
In the most recent quarter, investors have been concerned that total revenues declined 1% (Y/Y) and are estimated to decline 6% (Y/Y) in Q3, which reflects weak advertising demand. At the same time, Meta is continuing to reinvest in its business with total expenses growing 22% (Y/Y) in Q2, which caused operating profit and earnings per share (EPS) to decrease 32%. Meta is in the midst of an economic cycle that is having a broad impact on the digital advertising business. They are being disciplined on spending while still investing in those areas that will position to drive growth as the economic environment improves. The investments they are making in Reels, discovery engine, business messaging, retooling their ads system, building out industry-leading AI technology infrastructure, and especially in helping to build the metaverse, represent enormous opportunities for their business and their partners.
Meta is a company that has shown extraordinary resilience over time. Zuck & Co. have demonstrated time and time again that they are prepared to move quickly and at scale to respond to changes in consumer behavior, the macroeconomic landscape, and the needs of their advertising partners.
Trade Desk (+77% since 6/30)
Just as a little background, we took a small 2-3% position in TTD back in March 2020 when the market collapsed. What’s interesting is that this position has grown to 15% of the fund since then organically. Winners win and they deserve to be a larger part of our portfolio because they have earned that right. One of the lessons that we had learned over the years experimenting with position sizing is that our positions should not be forced to anything larger than 10-15% of portfolio at cost. Our portfolio naturally wants to be in winners and it will concentrate itself more and more in winners if we let it. After all, it's easier to sleep at night when your largest position got that way by going up (earned that right) vs. an underperformer you keep adding to trying to prove to the market you are right.
Now on to the business results, Trade Desk had a blowout Q2! They grew revenues 35% Y/Y as they outpaced competitors and gained market share, despite the macroeconomic uncertainty. That 35% top line growth is especially impressive, given that they are comparing against prior year record growth rate of over 100% in Q2 of 2021. They also generated $139 million in adjusted EBITDA (37% of revenue). TTD is actually one of the few high growth tech companies that consistently generates strong adjusted EBITDA and free cash flow and has the financial flexibility to reinvest so they can innovate for their customers.
We continue to be very impressed with the high level of execution by the TTD’s management team. Trade Desk exudes all the traits of the compounding machine that we look for and we are happy to be long term shareholders in this company.
Topicus (+10% since 6/30)
Total revenue for the quarter was €220.6 million, an increase of 24% Y/Y. For the first six months of 2022 total revenues were €424.4 million, an increase of 19%Y/Y. The increase for both the three and six month periods compared to the same periods in the prior year is primarily attributable to growth from acquisitions as the Company experienced organic growth of 6% and 4% respectively.
Thus far, they are executing very well on their long term strategy. Now that the financial statements are much cleaner after conversion of preferred equity, it looks like they are generating very attractive returns on capital: Net Income of $86 million and Cash Flow from Operations of $176 million on $360 million in average equity capital. However, the stock remains very expensive at ~45x cash flow (we are not the only ones that recognize the long term prospects of this company), which is a big premium to Constellation Software, which trades at about 28x cash flow. Evidently, the market views Topicus as a carbon copy (European version) to Constellation Software, but still in its early days.
Shopify (+30% since 6/30)
The following quote from the Q2 earnings call by Toby Lutke (CEO) best explains the transition that Shopify’s business is going through:
“Shopify has always been a company that makes the big strategic bets our merchants demand of us. This is how we win. During the pandemic, we made a bet that retail spend would disproportionately favor e-commerce at a much higher pace than it has. Our belief was that the channel mix, the share of dollars that travel through e-commerce rather than physical retail, would permanently leap ahead. As we built for the digital leap, we stepped our efforts and expanded the company accordingly. We couldn't know for sure at the time, but we did know that if the prediction came true, we would have to rapidly scale the company to meet that future. Fast forward to now, as things have turned out differently. While the normalized rate of spend online, which is where most of our merchants' orders occur, has reset certainly higher than where it was in 2019, the rate is lower than we had planned for. In short, we overshot our prediction. Recalibrating our investments and spending, we are making sure we do not sacrifice the components we feel are critical for Shopify to remain in an enviable position in a massive growing market as an enabler of multichannel commerce.”
The graph below depicts a rocket-like ascend in e-commerce during COVID lockdowns, which is now reverting back to a more normalized longer term trend-line.
Gross Merchandise Volume (GMV) was $46.9 billion in Q2 (11% growth Y/Y), which is a significant slowdown from 40% growth in Q2 2021. However, prior to the pandemic, the GMV was at just $17.4 billion in Q1 2020 — very impressive growth over a 2 year period. Their Gross Payments Volume (GPV) increase is even more impressive. In Q2 it was at almost $25 billion, whereas prior to the pandemic it was at just $7.2 billion in Q1 2020. Total revenues growth slowed down to 16% in Q2 from a very rapid growth of 90-110% from the Q2 ’20 - Q1 ’21 time period. However, if we look at the 3 year CAGR basis, total revenues have been growing at 53% per year — a very impressive number.
We believe that Shopify still has an immense opportunity ahead as it now represents around 10% of all e-commerce in the U.S., and they continue to take market share. It seems like it should be much larger, but the retail e-commerce is currently only 15% of total retail in the U.S.
We want to thank you for your partnership and trust. Joe and I have a significant part of our net worth invested alongside you, and we are very focused on compounding the fund’s capital over the long run. We’re extremely lucky to be involved with such a great group of patient, like-minded partners. We look forward to reporting to you again next quarter.
Best regards,
Alex and Joe