WWE Valuation: The Corporate Governance Mayhem

After valuing a wine company in my last post, I traverse the media and entertainment space and zoom in on the wrestling behemoth WWE- a company which triggers nostalgia and a trip down memory lane to school days where the discussion among friends (often heated) was whether the shows are scripted or not. Enthralled as a young consumer with iconic characters and entertaining over the top storylines, it's time now to leverage the valuation lens and dissect the business and the numbers. WWE has been in the news recently and not for the right reasons- there have been allegations of misconduct by the CEO which has led to forced changes in the top management. However, the market has largely shrugged off such concerns with the stock rebounding post these revelations and generating year-to-date shareholder returns of ~ 35%. Is this scandal stemming out of larger governance issues or is the company an attractive proposition based on the numbers and narrative? It's time to enter the ring and build the value journey of the pioneer in "wrestling sports entertainment".

The Rise of an Empire

WWE's beginning goes back to 1950s when it was started by Jess McMahon as Capitol Wrestling Corporation under the umbrella of National Wrestling Alliance which also included other wrestling corporations. The real inflection point for the company came in the late 1970s when Vince McMahon Sr. ceded control to his son Vince K. McMahon who eventually bought him out and renamed the organisation as WWF. Vince's vision to take wrestling national through TV and pay per views ushered in the start of golden era in the 80s with wrestlers like Hulk Hogan becoming household names. The launch of Monday night Raw and Smackdown in the subsequent decade along with new talent pipeline and rising stars like Dwayne "The Rock" Johnson and Stone Cold Steve Austin further cemented WWF's position in sports entertainment. While competition heated up and some talent defected to WCW, the company continued it's ascendancy by publicly listing in 1999 and eventually acquiring WCW in early 2000's to become the largest Wrestling Sports Entertainment company in the world.

While the operating model has evolved over time, the company breaks down it's entertainment business into three revenue streams as per latest 2021 10K:

+ Media- The largest division which primarily includes licensing fees from distribution of Raw, Smackdown and NXT. This segment also includes pay-per-view and licensing fees from domestic distribution of WWE network content through Peacock streaming service in collaboration with NBCU along with advertising and sponsorship.

+ Consumer Products- Merchandising of WWE products i.e. video games, apparel and toys with revenue generation through licensing and direct to consumer sales. 

+ Live Events- This segment consists of revenue from ticket sales of domestic and international live event touring schedules and travel packages with live events .

 

Shareholder returns and operating performance

Given the long public history of WWE, I start by looking at the share price trajectory over time and compare it to the broader index and sector. The price movement across last two decades can largely be broken down across 3 time horizons:

+ The "Meh" Phase (2002 to 2012)- Shareholder returns prior to 2012 are nothing to write home about with the company slightly underperforming the index and S&P 500. While the company signed new license agreements with NBCUniversal during this time period and earnings met or exceeded wall street expectations, shareholder value creation became stagnant as a cut in dividend and drop in pay-per view and live events over this decade reflected in the market expectations. 

+ The Surge and the fall (2012-2020)- The price surge first began in 2013 based on speculation of a new domestic TV deal till 2019 with NBCUniversal with analysts anticipating an increase by 2-3x in value vs previous deal and an increase in subscriber base for WWE network (OTT platform for online streaming) to ~ 1 Million subscribers.  However, the stock price plummeted by ~ 50% when the final deal negotiated was significantly lower than expectations and subscriber count fell way short of target. The exact same story repeated itself in 2018- the impending broadcast deal renewal next year with major networks became the anchor point for price spike. While the company delivered this time with a 3.5x increase in value for the new 5 year agreement with Fox and USA network, an influx of bad news in 2019 i.e. quarterly loss due to absence of talent, struggle to complete a TV rights deal in Middle East and surprise ouster of key executives alienated Wall Street and drove the decline of ~ 50% from it's 52 week high. In spite of the fall, the company comfortably outperformed the sector and broad market over this time horizon.

+ The Pandemic era (2020-2022)- The onset of COVID-19 had a significant impact on live events with decline in price reflecting the market drawdown in March 2020. However, the company was able to mitigate some of the impact with government in Florida classifying the business as "Essential Services" which enabled production of shows behind closed doors. WWE also made a strategic pivot in 2021 to shut down WWE network in US and license programming to Peacock, the NBC streaming service at a deal valued at more than $1 Billion for 5 years. The upside trajectory post COVID-19 has been largely volatile but market has rewarded the company for series of earnings outperformance driven by tv rights fees and resurgence in live event sales even after the misconduct episode (more on that later).

The operating metrics of the company over last five years throw up some interesting insights. The single digit revenue growth and decline in revenue from live events even before the pandemic corresponds to drop in stock price over the same period. The renewed domestic licensing deal for domestic distribution in US under media segment propel overall revenue growth and spike in operating margins. The media revenues increase over time based on contractual escalations and pivot to online streaming through Peacock, the company has witnessed resurgence in merchandise sales and ticket sales post pandemic and higher margins across these segments. While the company has made efforts to expand it's geographic presence in countries like India and Saudi Arabia, it primarily remains a US company with 80% of revenue generation from North America.

In terms of viewership, the trends across it's product offerings are not ideal. RAW and Smackdown have witnessed decline in viewership over last 5 years with RAW in particular dropping by almost 30%. While this coincides with the broader decline in TV viewership and the shift of consumers to streaming services, the pre-pandemic slide has also been attributed to lack of consumer engagement on storylines and character development. On the streaming front, WWE network was able to garner 1.2 million subscribers but the challenging economics of the online streaming business eventually made the network shutdown in the US and licensed content to Peacock, the NBCU service.

The Hush Money Saga

WWE has never been a poster child for exemplary governance standards. In fact, the company has been plagued with poor protection for shareholder interests over time which does not inspire confidence as a shareholder. The below page captures multiple corporate governance red flags for investors:

If you are a WWE shareholder, the illusion of shareholder interest protection and power to hold managers accountable quickly dissipates based on the above data. While the company scores terribly on overall score and audit/risk along with shareholder rights on the relative ISS scorecard vs industry, I think the kicker is the split class of shares. Class B shares with a voting power of 10x vs class A are effectively owned by Vince McMahon and his family either directly or through trusts. Moreover, there is also a conversion trigger to class A if  any of these class B shares are transferred outside of McMahon family. Is WWE only company to do it? The answer is no- there are examples in tech where companies (Snap, Facebook, Google) have blatantly done this and got away with it. However, the fact remains that you or I as a potential shareholder essentially don't have a say in how the company is run. In other words, the interest of the McMahon family will supersede the interests of common stockholders in running the business. 

Won't institutional shareholders step in and vote against the management when required? They don't have a great track record to prove it- research (Source: Damodaran) has shown that institutional investors have largely sided with the management on resolutions. Something that stood out from the data was activist investor ownership- 22% of stock is owned by activist investors based on varying degree of activism. While these are database classifications, is the threat of potential activist action real for WWE? Like with all things, it falls into the realm of possibility but we are yet to see any evidence on that front. Also, given the stock and performance jump recently, I doubt an activist takeover would be a reasonable proposition.

The Scandal: Favours, Payments and NDAs

The news of sexual misconduct broke out in June this year when the Wall Street Journal reported that the board is investigating a secret settlement of $3 Million involving CEO Vince McMahon and an ex-employee with whom he had an affair. The board's investigation started in April found out other instances of  hush money with former WWE female employees and subsequent non-disclosure agreements executed to prohibit discussion of the relationship which also involved accusations against John Laurinaitis, the head of talent relations at WWE. The annotated stock chart highlights these revelations along with share price movements over this time period:

The initial knee jerk reaction of the market is evident with stock price declining by 3% post initial reports in Mid June (interestingly, there are insider trading allegations as well with ~ 2 million shares being sold just before publication of the WSJ article). The true extent of the scandal became evident in the following weeks and is startling- $12 million of payments were made over almost last two decades  accompanied by strict non-disclosure agreements leading to resignation of Vince McMahon as CEO and Chairman. This is truly a watershed moment in WWE's history- a larger than life CEO who has been synonymous with the company and the brand over decades. Moreover, Vince was heavily involved on the content creation side and personally intervened to create story lines for characters. The step down was also prompted by regulatory scrutiny with SEC and Federal prosecutors launching an investigation. Did the stock price plummet? Market expectations were largely immune and there was no backlash either from the business partners of the company or Wall Street. In fact, Wall Street was busy drafting the next storyline for the company- a potential acquisition target  post departure of Vince and truly following the motto of "Show me the Money". And the stock price is up by ~ 5% since the initial WSJ report came out- the strong Q2 FY22 earnings release diminished by overall macro environment but brushing aside any larger cultural concerns across organisation for now. 

The WWE Story: Summer Slam or Pinfall?

Based on the company history, operating performance and the recent governance issues, my business story for the company will revolve across the following key themes:

+ Media rights: Gold rush to continue WWE's revenue stream is dominated by TV licensing deals and the company has established a sizeable viewership base over time. In spite of the ratings decline, the generated content is an attractive proposition for broadcasting companies as reflected by the 2019 US deal below negotiated at almost 3.6x in value vs the previous agreement. The company is also expanding clinching agreements outside US with a new multi-year online streaming deal signed for Australia in September 2022. With the US rights to be renewed again in 2024, the jewel of the WWE empire will continue to rake in higher revenues and drive group profitability. 

+ WWE Universe: The size trade off works  The company's shutting down of WWE network as it's own strategy was a clear recognition that the plan to transition to a tech company model hadn't worked and it remains a content creation company. This should pay off in the long run- they don't have to keep reinvesting in technology as a streaming service and still get a share of the pie through the Peacock collaboration. From a content creation lens, would the company indirectly compete with the likes of Netflix and Disney Plus to draw eyeballs? WWE's business model borders more on entertainment rather than sports after all. I believe the potential market for WWE will continue to remain a small one compared to other content creation companies but not a bad thing necessarily- a small (on a relative basis) profitable market with a loyal user base is much better than a large footprint with mounting losses.

+  AEW: Resurrection of the competition All Elite Wrestling (AEW) has emerged as a WWE alternative with a simple value proposition: current pro wrestling has become too scripted with distractions galore and there is appetite for unscripted raw wrestling. The initial live event which included some of former WWE stars sold out in a few hours and subsequently a broadcasting deal was struck through TNT network (part of WarnerMedia). The jury is still out on whether unscripted shows can work on a regular basis but a serious competitor enough to challenge WWE has emerged after almost two decades of undisputed dominance.

+ Me, Myself and I: Vince McMahon company forever? Even with Vince no longer the CEO or Chairman, the holding structure and corporate governance scorecard makes one thing quite clear: WWE is a company run of, by and for the McMahon family. It also represents one of those larger than life CEO scenarios where the distinction between the company and the CEO is non-existent. After all, Vince McMahon has been the face of the company for decades and heavily influenced character storylines and scripts. Will the influence diminish post departure? With Stephanie McMahon at the helm and the skewed voting rights through Class B stock ownership, WWE will continue to remain firmly under family control. 

+ Women Wrestling: The next growth catalyst Women's wrestling has shown significant growth with WWE promoting new stars and positioning female wrestlers in the main match in WrestleMania, it's flagship annual event. With women sports events globally attracting more fans and sponsors, this could become a key enabler for the company to expand WWE Universe and further drive penetration among young demographic, especially female consumers.

+ Acquirer Who? The M&A whispers Post the scandal and Vince McMahon's departure, there have been speculation on the company being a potential M&A target. But it is hard to see who will be the potential suitor and what will be the strategic fit: in the new era of slowing growth, rising interest rates and overleveraged corporate balance sheets, the chances of acquisition remain slim for now. With a current enterprise value of around USD 7 Billion, significant firepower and alignment from the majority shareholders (no prizes for guessing who) would be required to takeover the company. 

The WWE Narrative

"WWE is an entertainment company which will continue to dominate the professional wrestling space through it's established fan base. The company's competitive position will enable it to drive growth and profitability by monetising content through lucrative licensing arrangements on TV networks and online streaming. Reinvestment needs will be in line with the industry averages and there is no imminent default risk. The dilution of shareholder rights through poor corporate governance will be a drag on value creation over time" 

Crunching the Numbers

+ Revenue growth- To estimate future revenues for WWE, I split the growth trajectories into two time periods: Pre-Media rights renewal in 2024 and post. For the first two years, the growth is in line with the five year CAGR of ~ 7% from 2018-22. For the next 3 years of the high growth phase, the growth rate is 12%- an assumption that WWE would be able to attract broadcasters and charge top dollar for licensing deals, particularly in the US domestic market. This is also broadly in line with the growth spike in 2019 when the current broadcasting arrangement was signed. Post the high growth phase, growth would decline and eventually be in line with current risk free rate in perpetuity. From an absolute dollars standpoint, revenues grow by more than 2x over the forecast horizon and translate into $2.9 Billion in Year 10. 

+ Operating margins-  The current pre-tax operating margins for WWE are ~ 25%, a significant step up and ~2x of pre-pandemic margins. I assume this to continue forward and margins to stay at 25%- in line with aggregate margins for the media and entertainment industry. This assumption might be on the lower side- the revenue spike should translate into higher profitability after 2024. While wrestling with the uncertainty, I will keep the margin profile as status quo and attempt to capture the variation in my simulation analysis.

+ Reinvestment- The proxy for reinvestment would be capital turnover ratio i.e. sales divided by invested capital. The current sales to capital ratio for WWE is 2.0 as the company has high capital efficiency which means that for every dollar invested in the business, the company generates $2 in sales. I assume the ratio to stay constant at 2.0 over the forecast period- the company has high capital efficiency historically and most of the funds are invested in PP&E and leases. Content creation costs remain low as live event programming costs are expensed when events are first broadcast. The capital turnover assumption translates into an average return on invested capital (ROIC) of ~ 39% over forecast period, significantly higher than the cost of capital for WWE.

Cost of Capital

The current cost of capital is ~ 9.2% for the company, with capital largely funded through equity. In the rising interest rates environment due to inflation, this captures company's higher required rate of return on existing projects. The cost of capital would gradually transition to median cost of capital for US firms in stable growth phase.

From Operating Value to Equity Value

Using a 10 year explicit forecast period, I project out the free cash flows for first 5 years of high growth, transition period from year 6-10 and stable growth period post 10. For the terminal value, growth is capped at the current risk free rate i.e. 3.9%, ROIC of ~ 25% and cost of capital of ~ 9%. This is where I bring the corporate governance part of my story into numbers- I reduce the ROIC-WACC spread in perpetuity from 38% to 25% to account for the ongoing governance issues in the company. Can it be another number than 25% and are there other ways to incorporate this? Absolutely! I think the key is to bring it into the numbers on an ongoing basis and account for the fact that the focus of corporate decisions would be to serve family interest. The impact on value is not substantial- it knocks of  ~ $200 Million of value as at an already high ROIC, it's growth and margin assumptions that are key value drivers for the company.  Discounting the expected free cash flows at the cost of capital, the value of operating assets for WWE is $5.6 Billion Taking out debt, adding back cash and marketable securities and dividing by the shares outstanding gives me a value per share of  $71/ share which is ~ 3% lower than current share price of $73/share. 

Factoring in the uncertainty

Rather than drawing insights just from point estimates, I attempt to capture the variation in my key assumptions through Monte Carlo Simulation by assigning probability distributions to revenue growth from year 3 to year 5 (Triangular), operating margin in year 10 (Uniform) and cost of capital (Normal). This helps me in incorporating the wide values around these key drivers . After 500K simulations, the median share price is $79/share, which suggests a potential upside of  ~ 10%.  If you believe that WWE will be able to further monetize content and translate it into higher margins, there are scenarios where the value can range from $80 to $100 at the higher end of spectrum. The short answer is that based on fundamentals, there is merit in expecting stock outperformance vs current market price.

Final Thoughts

While WWE's character narratives are blown out of proportion, the current business story is actually backed up by the numbers- it's a company structured around monetising content with a large and loyal fan base. However, the next set of challenges for the company are around the corner that warrant swift action rather than complacency-  departure of Vince McMahon, decline in TV viewership, rise of AEW as a challenger and diminishing returns on talent development vs previous generation superstars. In spite of his departure, Vince McMahon will continue to exert his influence through his shareholding and daughter Stephanie who is the Co-CEO. I believe markets have largely overlooked the corporate governance story as WWE has delivered on shareholder returns and operating performance with some blips across the way- will they be so generous in the post Vince era if the company doesn't meet implied expectations? As we find that out in the next chapter of the company's journey, Delivering on their tag line of "Then, Now, Forever, Together" might be imperative now more than ever.

WWE valuation model

 

Note: The content on this blog reflects the personal views of the author and should not be considered as an investment advice or recommendation. 

Sula Vineyards IPO: I drink and I know things

Sula Vineyards, an Indian wine company, filed for their IPO in July this year amidst the market turbulence. With new issuances hitting an all time low in H1 22, this is an interesting proposition for the Indian market after a bunch of disastrous tech IPO's over the last couple of years. The valuation is a going to be a steep learning curve for me- I am not a wine connoisseur and know very little about the dynamics of the wine market or the difference between a Chardonnay and a Sauvignon Blanc. However, this lack of information might not be a bad thing after all as it helps reduce my bias in the process. With that being said, I take inspiration from one of my favourite characters from Game of Thrones i.e. Tyrion Lannister ("I drink and I know things") and dive into the realm of value creation for Sula.

Company history and overview

Sula Vineyards was founded in 1999 by Rajeev Samant, an expat working with Oracle in the US who returned to India in the 90s. A visit to his native land in Nashik brought the idea of growing wine grapes which subsequently led to working in a small winery in California for 3 months and then translated into the birth of Sula- a wine company which would symbolize rich Indian heritage. Over the last few years, Sula has become the largest wine seller and producer in the country and captured a market share in excess of 50% and across variants i.e. red, white and sparkling through strong brand recognition and a diverse portfolio catering to different price points. Moreover, the company has been the dominant player across four price segments in the market through 56 wine labels and with high market share in the "Elite" and "Premium" category. 

The company generates revenues primarily through two sources: the "core business" which involves production, distribution and sale of wines and "wine tourism business" which is more of an experience complementing the core business and includes service revenues from wine tourism i.e. resorts and tasting rooms. This also reflects in the revenue split with wine tourism business generating less than 10% of revenues over across years. Below is the historical revenue trajectory along with split for revenue from operations reported by the company in the prospectus:

Note that revenue growth has declined due to the pandemic and lockdowns over last couple of years but the post COVID recovery is yet to be completed- F22 revenues are at 87% of pre-covid levels. The increased share of premium wines within the portfolio and strategic pivot to increase penetration of own brands vs third party brands drive the F22 sales growth.  The company also benefits from tax subsidy- a VAT benefit from the state of Maharashtra under Wine Incentive Promotion Subsidy scheme wherein 80% of the VAT paid is refunded which they have included as other operating revenues. With the bulk of installed capacity in the state, the increase in manufactured goods in the state is directly correlated to the incentive realised. 

In terms of inorganic growth, Sula has sparingly acquired assets of different wineries over the last 5 years with the acquisition of Heritage winery assets diversifying manufacturing operations to state of Karnataka with significantly lower taxes and duties. However, not all M&A activity has played out as intended with divestiture of majority stake in the beer business over last year. 

The wine market diagnostic

To get a sense of the potential growth opportunity for Sula, I start by looking at the estimates and consumption patterns for the alcohol beverages and wine market in India and globally. The global alcohol consumption is estimated to reach 6.6 litres in 2025 with spirits dominating in terms of pure alcohol contribution. However, beer is the most popular alcohol beverage from a consumption standpoint with wine and sprits almost at an equal standing. 

The country view of alcohol consumption reveals some interesting insights. While most of the major developed nations have considerable wine consumption, the wine consumption for developing countries remains low. In case of India, the overall consumption of wine is less than 1% vs 13% global average with 90% consumption coming from spirits. The obvious comparison with China is tempting but reflects the stark difference between two countries- total consumption for China is 4x more than India and wine consumption is 40x higher. While the company argues and positions this as a huge growth opportunity, I'm cautious in sharing their optimism on swift changes in consumer tastes and preferences. China has a higher per capita disposable income and bulk of the sales occur through ecommerce online marketplaces which isn't the case in India. Moreover, there is evidence of lack of wine knowledge and a considerable learning curve resulting in fewer new wine drinkers entering the market which is going to be a significant barrier for the Indian market as well.

The Indian alcohol market size is estimated to be $33 Billion in 2020. While the overall market has declined in 2021, it is expected to grow at an annualised rate of 11% with the potential market size of $43 Billion in 2025. In terms of category, 2/3rd of the market is currently captured by Indian made foreign liquor (IMFL) followed by country liquor and beer. The Indian wine market, although nascent vs other beverages, is expected to grow at a CAGR of 20% from 2021 and reach a total value of $425 Million (INR 32 Billion) in 2025. Based on the information provided in the prospectus (pain in the neck with more than 400 pages) and google search, the key themes for the Indian wine industry can be summarised below:

+ High concentration across market share and consumption- The Indian 100% grape wine market is dominated by 2-3 players which contribute ~ 80% in value terms- Sula, Fratelli Wines and Grover Zampa. The top wine producing states of Maharashtra and Karnataka are also the top consuming states with ~ 57% of the total market. With the consumption heavily skewed, low penetration is a challenge with wine consumption predominately restricted to metro cities. This outlines the challenge of educating the consumers and creating awareness in Tier 1 cities and beyond which is going to be an uphill task.

+ Growth momentum driven by premium segment- The growth trajectory of the wine market over the last few years has been driven by the top end of the value spectrum (in sync with global trends) as cheaper fortified wines lose market share at the expense of 100% grapes wines. Based on the price  cohorts below, the elite and premium  segments are expected to outgrow other segments over the next 5 years with all major players addressing the demand through higher portfolio options of elite and premium wines.

+ On-trade vs Off-trade consumption- Alcohol consumption in India is primarily through two channels- On trade which refers to consumption at hotels and restaurants whereas Off trade sales occur through supermarkets and licensed liquor shops. While on-trade channel declined due to lockdowns, it is expected to gain prominence over the next few years in sync with premium segment growth. Wine pairing with food significantly leverages on trade channels and serves as first touchpoint for new wine consumers- an increase in on-trade wine consumption is expected to have a cascading sales impact on off-trade channel as well. 

+ Diminishing returns for foreign wine players - The share of imported wines has remained considerable with 17% of market in 2020 and projected decline to 13% in 2025. Australia is leading country of import in terms of volume and the rest of the market is fragmented. Imported wines face stiff challenge vs domestic players as high import duty of 150%  makes them less competitive. Alcohol giants like Diageo and Pernod Ricard have tried to locally manufacture wines and entered the domestic market but faced multiple roadblocks in penetration and scaling up and finally exited the space to focus on their spirts business.

+The labyrinthine of regulations- The regulatory complexity of Indian alcohol market cannot be understated. Each state has their own excise policy along with variation in legal drinking age limit and various duties etc. Moreover, advertising of alcoholic drinks is prohibited directly or indirectly in India which inhibits avenues to reach mass audiences through different media channels. This will be a considerable roadblock for alcoholic drinks like wine which require high consumer education to increase penetration.

Shaping the Sula business story

Before I explicitly lay out my narrative for Sula, I believe it's imperative to highlight the IPO issuance and use of subsequent proceeds. The company does not plan to issue any new shares with the offer of sale of 25.5 Million shares for existing investors in the company to cash out. This indicates that the company's confidence in the cash generation potential of the business to fund future growth at least in the short term and the listing largely providing access to capital markets and putting the wine business on the map.

While the company lays out plethora of information on the business nuances across the prospectus (which pulls you in different directions), the below points standout:

+ Production cycle and facilities- The harvest period for grapes is restricted to 4 months from December to March 2020 followed by fermentation and ageing. While the below info graph from the prospectus summarises the production process in a nutshell, two key things stand grab my attention: the long gestation period across the value chain especially for premium wines which are aged in oak barrels. The second thing which stems out is a high cash conversion cycle- the long gestation period would lead to a high days inventory outstanding which means a lot of cash of the business is tied down in working capital.

The manufacturing capabilities are spread across 6 wineries with all of them located in Maharashtra and Karnataka. With an installed capacity at 14.5 Million litres, capacity utilisation for FY22 at 80% post the lockdown drop to 65% in 2021 with resurgence and demand and additional supply through York Winery acquisition.

+ Procurement and Distribution- Sula has de-risked supply through execution of long-term grape contracts with farmers for up to 12 years for almost 84% of the vineyards. The company also has an expansive distribution network in play with presence in 25 states and 6 Union Territories in India. The sales channels are split through On-Trade, Off-Trade and Direct to customer sales through wine tourism business with secondary sales dominated by off-trade channels. On the Wine Tourism side, the company operates two vineyard resorts with sales driven by room revenue, F&B and sale of wine/liquor.

I also took a quick look at the financial summary provided and highlight the bridge to EBIT along with some key KPI's below:

Note that EBIT margin improvement from cost standpoint is largely driven by cost of goods improvement whereas most of the other components have not seen material variation over last three years. The strategic shift through discontinuation of third party unprofitable brands, cost rationalisation across raw materials and packaging and divestiture of PADPL, the beer and spirits subsidiary reasons drive this positive trend. The upward margin trajectory is slightly offset in FY22 by higher other operating and wine processing expenses. Something that sticks out though is the cash conversion trajectory-  large chunks of capital remains tied in inventory and payables with average cash conversion time worsening over time. The other key insight is that the company currently generates returns below the cost of capital- something that I need to keep in mind while building my endgame.

After an exhausting prospectus read and google search to get a flavour of the business and industry, I have the foundation for my Sula narrative which will play out across the following dimensions:

+ Market dominance through mainstream wine adoption- Sula's initial foray in the wine market over 26 years back and subsequent transformation of wine has enabled it to be a market leader in the domestic wine industry with strong competitive advantages across the value chain and a product portfolio that caters to the entire wine market. With a wide distribution network and strong penetration through on-trade and off-trade routes, I expect them to consolidate their market leadership going forward at the expense of other domestic players i.e. Grover Zampa and Fratelli wines which only have 10% of installed capacity vs Sula.

+ Industry tailwinds and strategy shift to drive margin uplift- The transition of industry trends and company product mix to premium wine categories should drive higher profitability going forward (in line with last 3 years) along with cost efficiencies. However, this also creates a dilemma- will the high premium prices be a stumbling block to market expansion, especially in a price sensitive market like India which is highly dominated by spirits? The company would also directly compete with foreign wines which might 

+ Imported wines: Trade deals to drive resurgence? While the share of imported wines has been low, there might be an impetus in the next 5-10 years with import duties drastically reducing for the same. A case in point here is Australia: with the recent Australian-India free trade pact signed, the duties on imported Australian wines go down significantly after the pact is enabled which makes them highly price competitive to elite and premium offerings from Sula. The good news for Sula is that the impact of this change might be diluted by the fact that major tax reduction comes only after 10 years.

+ Customer penetration: Between rock and a hard place Wine market expansion is critical for Sula to achieve it's growth ambition but customer education is going to be an uphill task. To Sula's credit, they have tried to workaround the mass media advertising prohibition through innovative marketing concepts and live experiences like wine tourism business, product placement in TV shows and Sula festival. But the fact remains that most of the consumption is concentrated in a few metro cities with very low penetration beyond. With wine already behind the eight ball to spirits in India, Sula will have to continue to evolve selling proposition of wine vs other alcohols and leverage new avenues for customer outreach and consumption.

The Sula Narrative

"Sula is a wine company which will maintain its leadership in a growing market through brand recognition, scale and competitive advantages across the value chain. The company is well positioned to drive higher profitability through pivot from value to premium segments along with  industry tailwinds. Capital intensity will remain high but move towards industry average over time and default risk remains low. While Sula will continue to drive visibility through experience driven marketing, the steep learning curve for wines and limited wine penetration beyond major cities will remain significant hurdles  vs other alcoholic beverages" 

Connecting the numbers

+ Revenue growth- The growth estimates for Sula are primarily driven by two key assumptions- the size of the wine industry and company's market share. As per the prospectus, the domestic wine industry is expected to grow at a CAGR of 23% from 2021 with total market size of INR 25 Billion in 2025. Based on my narrative, I assume that the company will continue to be the market leader, and give them a market share of 55% in 2025. In rupee terms, this implies revenues of 13.8 Billion which transitions to grow at economy growth rate of 4.6% in year 10. Over a 10 year horizon, revenues increase by almost 10x to INR 39 Billion. This might be a bit optimistic but I believe that if the market size grows as expected, then Sula should be able to capture a large piece of the pie based on their market position vs competition. 

+ Operating margins-  The current pre-tax operating margins for Sula are ~ 22%. For the endgame, I assume a pre-tax operating margin of 28% in year 10 which is in-line with the average margin for alcoholic beverage companies. This is not a clean sample based number as it will have mix of companies with different alcohol businesses rather than pure-play wine companies but hopefully the larger sample should work in my favour. The shift to higher end spectrum of wine portfolio propelled by changes in industry dynamics and pricing power by leveraging it's brand name should help Sula further accelerate profit trajectory. To keep things simplistic, I assume that margins follows a linear increase towards the target margin over the 10 year forecast period.  

+ Reinvestment- The proxy for reinvestment would be capital turnover ratio and  the wine business is quite capital intensive with high working capital requirements. The current sales to capital ratio for Sula is 0.7 which means that for every rupee invested in the business, the company generates 0.7 rupees in sales. I assume the ratio to stay constant at 0.7 initially but eventually transition to 1.3 in year 10. While ROIC is below cost of capital currently, the higher capital efficiency along with margin improvement means that I am assuming a positive ROIC-WACC value spread of ~ 7% in perpetuity, in line with industry averages.

Cost of Capital

The cost of capital for Sula is 12.4% in Indian rupees. Note that the key input of market value of equity of INR 37.5 Billion is based on media reports which expect avg. proceeds of INR 12-14K Million from sale of 25.5 million shares as the IPO has not been priced yet by the bankers.  I pay homage to the old saying of "when in doubt- take averages" and use an average of this range to come up with the market value of equity. Post the high growth period, the cost of capital declines to median cost of capital of 11.2% for Indian companies.

From operating value to equity value

Using a 10 year explicit forecast period, I project out the free cash flows for first 5 years of high growth, transition period from year 6-10 and stable growth period post 10. For the terminal value, growth is capped at the current risk free rate i.e. 4.6%, ROIC of ~ 19% and cost of capital of ~ 11%. The value of operating assets is INR 26.5 Billion. Subtracting out debt and adding back cash and equivalents leads to a value of equity of INR 24.2 Billion. Taking out the value of options and dividing by the shares outstanding gives me a value per share of  INR 300 which is 37% lower than the expected IPO price as per media reports of INR 478 per share. The pricing number might be refined once the book building process is over but based on my narrative there is a clear gap between price and value.

Factoring in the uncertainty

To capture the the risk in my key value driver assumptions, I looked at various combinations of revenue growth in the high growth phase and target operating margin in year 10 which solve for the current value per share. Note that the base case assumes ~ 34% growth at expected margins of ~ 28% for value of INR 300 per share. Is the speculated price of INR 478 possible? Of course! But to deliver those expectations, Sula will need to generate annualised growth of 40%+ in first five years and target margins of 28%+ in Year 10 and beyond. In my opinion, this would be hard to achieve as there will be roadblocks in terms of existing consumer preferences towards spirit and beer and limits to cost efficiencies.

To further capture the volatility in my key assumptions, I did a Monte Carlo simulation by assigning distributions to overall market size (lognormal), market share (triangular) and operating margin in year 10 (uniform). This helps me in incorporating the wide values around these key variables rather than just point estimates. After 500K simulations, the median share price of INR 247 which is below my base case value of INR 300. Based on my assumptions, the expected IPO price is close to 95th percentile of the distribution. There are possibilities to achieve this price but the pathways remain slim at best. 

Final thoughts

The Sula IPO is an exception for the Indian markets rather than the norm: with a bunch of young money losing tech/fintech start-ups going public recently, this is a company which has a couple of decades of history behind it and a successful (profitable) track record of scaling the wine business. The next phase of publicly listing in the markets will be a challenging one- the company isn't tapping the market for capital yet but will be under the performance lens every quarter. It will also be interesting to see the price band of the IPO which should be out in the next few weeks and might warrant an update to my market value of equity. The rationale of buying into the Sula story is the strong brand recall and allure of the potential Indian market and parallels to growth in China. However, the expected IPO price based on media reports is still too rich even after factoring in the optimism in the story and the numbers. I am intrigued to see how these variables play out on the street. In the meantime, I'll sign out of this valuation for now (with a glass of whisky by my side).

Sula Vineyards IPO valuation model

 

Note: The content on this blog reflects the personal views of the author and should not be considered as an investment advice or recommendation. 

Bumble Valuation: Swipe left to invest?

After a hiatus of 5 years, I finally decided to restart my blog by valuing Bumble, a key player in the sprawling online dating space. The company has been around 2014 but went public in Feb 2021 and raised $2.2 Billion with investor expectations propelling the stock price to almost 2x of the IPO asking price. However, shareholder returns have witnessed a steep decline over the last year shaped by reality of business fundamentals along with macro headwinds. With the 2021 financials and 2022 10-Q filing out a few days back, I put my valuation hat on and drive the intrinsic valuation journey of the company by linking the business narrative and numbers and hopefully mitigating my bias in the process.

Company background

Bumble started in 2014 as an alternative to the widely popular Tinder app which revolutionized the dating app scene by bringing the quintessential "swipe feature". Interestingly, the company's CEO worked for Tinder due to differences and collaborated with founder of Badoo, another dating app, to launch the company) The company's value proposition is simple: given the unpleasant experiences and unwanted advances faced by females on dating apps, only female users can initiate conversations in heterosexual matches. This was a deliberate attempt to distinguish from Tinder, which over the years has gained the notorious distinction of being the "hook-up app". Studies have also backed up Bumble's focus on female user experience: a 2019 survey showed women across most age groups are far more likely to be at the receiving end of offensive statements and unsolicited pictures.

While the female centric focus resonated with users, the paradigm shift in lifestyle and consumer behaviour tailwinds further accelerated adoption rates across online dating industry over the last decade. With technology getting more intertwined with our lives along with higher penetration of smartphone and internet access, there has been a significant shift with couples ditching traditional ways of meeting- 2 out 5 couples met through online platforms.

Shareholder returns and operating performance

To get a quick performance overview, I start with looking at the shareholder returns post listing. Stock price has plummeted over the last year with Bumble losing almost 70% of it's IPO price and underperforming the broader market whereas it's main rival Match group has declined by almost 33%. Market expectations have become more measured as the resurgence of COVID-19 and lockdowns have kept users at home along with more spotlight on paying users and conversion rate. There has been a spike in the stock price post Q1 F22 results with the company exceeding wall street expectations on addition of new paying users.

Bumble and sister app Badoo essentially operate on a subscription ("freemium") model: the service is free to use but users have to pay for premium features and in-app purchases. Subscription ranges from 7 days to 180 days and in-app purchases allow both subscribers and non-subscribers to leverage on specific features to boost matches.  Apart from the dating profile, there is also the BFF feature for platonic connections and Bizz for professional networking. Badoo follows a similar approach and is more popular across Europe and Latin America. 

Revenue growth trajectory has been strong with an increase of more than 2x over last 4 years. However, the path to profitability has been volatile, after capitalising R&D costs and adjusting for non-operating items. The key operating metric here is paying subscribers average revenue per paying users (ARPPU). The stock price has spiked post Q1 2022 results with market rewarding the higher than anticipated total paying users of 3.0 Mn. Note that while Bumble has a better user monetisation and conversion compared to Match, they lag on profitability with high operating costs tied to selling and advertising through digital channels. Also, while the number of Badoo subscribers are higher than Bumble, the value of a bumble user is more than double with ARPU of $30 vs $13 for Badoo. While this drags the overall monetization, another key factor would be the split of users across geographies and change over time as pricing variations come into play. For e.g.  a Bumble user in the US pays $19.99 per month whereas in India it's less than $10 per month. Unfortunately, this information is not disclosed by the company across filings but the geography split gives a directional sense of the delta in ARPPU for Bumble vs Badoo- a typical lifetime premium access for Bumble costs $249 vs $60 for Badoo which operates majorly in Europe and Latin America. 

Industry diagnostic: Into the datingverse

To get some perspective on the potential market opportunity for Bumble, I looked (google searched) at the size of the global dating industry. The size of the online dating industry in 2020 was estimated to be $5.3Bn with North America accounting for 40% of the global dating market. 

Note that the global market is expected to grow faster than North America over the next few years benefitting from the increase in digital penetration. The market is highly competitive with dating apps galore based on regions, demographics and sexual orientation. The largest player in the industry is Match Group. With a mind boggling portfolio of 45 apps (incl. websites) and serving wide spectrum of users, they capture almost 50% of the global market share with revenues of $2.9 Billion (7 out of 10 top apps are owned by Match). The standouts apps and direct competitors to Bumble are Tinder and Hinge. Tinder has been the leader in dating apps and the first mover advantage of inventing the "swipe culture" has yielded significant gains with annualized growth of 42% over last 5 years . Hinge was acquired in 2017 and it's value proposition of meaningful relationship and "Designed to be deleted" tagline has gained popularity with revenues surging 2x over last 3 years.

Based on my understanding of Bumble's business and the industry/competitive landscape, my overarching narrative for the company is summarised in the following themes:

+ Competitive advantage: Fading faster than expected? While Bumble had steadfastly positioned women making the first move as their key differentiating factor vs competitors, there are signs that this might not be the only core strategy endgame with the tacit introduction of Bumble compliments (5 compliments where a user irrespective of gender can make the "first move" to compliment on your profile along with swipe). With 2 out of 3 users on the platform identifying themselves as male and increasing competition from Match, the strategic direction might include "men making the first move" implicitly.

+ Paying users: Macro headwinds to add growth pressure Bumble has maintained an impressive user conversion rate to paying users. However, with increasing stress globally spending due to higher inflation and interest rates, discretionary companies like Bumble will be highly sensitive to cutback in overall consumer spending along with increase in cost of capital. Interestingly, Bumble claims it's potential market size might be as large as streaming services. Although (which is outlandish to say the least), the stagnant or declining user growth across both industries might be the actual overlap in the future.

+ BFF: Platonic relationships might be the key after all Another driver of growth apart from the dating user base could be the BFF feature. Embedded in the broader dating app, the Bumble BFF  provides opportunity to create ang engage communities across different cohorts for networking etc. This might create another additional growth opportunities and enhance user monetisation. But is it proprietary and what stops Match and rest of the competitors to launch something similar?

+ The Badoo factor: Strategic fit or returns laggard While Badoo accounts for ~ 40% of total paying users (1.2M) with a large footprint across Europe and Latin America, it's average revenue per paying user is less than half of Bumble and is a drag on returns. Moreover, the recent quarterly filing indicates a loss of 106K subscribers with a substantial portion attributed to the war in Ukraine. With the acquisition of Fruitz (a dating app popular with millennials in Europe), the strategic narrative for Badoo remains questionable. Currently, it seems like the higher Bumble revenue growth is subsidising Badoo users but this might make the profitability pathway more treacherous going forward

+ Low switching costs: No App to rule the all? One of the perils in the dating app industry is to cultivate a loyal user base. While Bumble and Hinge have been successful to some extent, the fact of the matter is that people use multiple apps at the same time and whichever works first wins. Also, there is a niche of apps which cater to different demographics and preferences. I did a simple test to check this out: downloaded 3 apps, kept my distance for potential matches less than 1 km and started swiping left and right. Unsurprisingly, I was bumping into similar people across these apps. While this test is based on N=1 and is largely unscientific, user retention will be a hard thing in the dating app industry with no one size fits all approach.

The Bumble Narrative

"Bumble is an online dating company which will continue to differentiate itself through it's female centric strategy. It will consolidate its position as one of  the largest but not dominant players in the dating app space globally and generate higher margins through higher paying user conversion. The company will continue to reinvest in technology and risk of failure remains low. However, growth momentum will be challenged by high competition, macroeconomic pressures and changing consumer preferences"    

Crunching the numbers

+ Revenue growth- To estimate the revenue growth for Bumble, I start with the market size estimates of the dating app market. Currently, Bumble has a 13% market share based on the market size of $6 Bn in 2021 Match's share of 50% in 2021. I give Bumble a market share of 20% in year 5 for Bumble i.e. revenues of $2.0 Billion based on expected market size of $9.8 Bn. This leads to annualised growth rate of 26% (vs 29% historical) for the high growth phase and 3% growth rate in perpetuity after year 10. How high is this assumption? If I assume Match's market share to remain constant at around 50%, the annualised growth for them would be 13% per annum based on a higher start base of $3.0 Bn. Therefore, while I am comfortable giving Bumble a higher growth rate during the high growth phase, I am implicitly assuming that they will continue to play second fiddle to Match and it's portfolio of apps.

+ Operating margins-  Currently, the adjusted operating margin excl. one-off items and capitalised for R&D is at 8% (even though the non-GAAP margin is supposedly in high 20's by adding back stock based comp). For the end-state, I assume a pre-tax operating margin of 28.5% in year 10 which is in-line with the average industry margin and also corresponds to the largest player in the market i.e. Match. Essentially, this implicitly assumes Bumble's to continue to sustain/increase payer conversion over time. The profitability trajectory follows a linear increase towards the target margin over the 10 year forecast period.  

+ Reinvestment- The proxy for reinvestment would be capital turnover i.e. for every dollar of capital how much does the company generate in sales. Bumble's capital efficiency is high as they operate on a low asset base and most of the balance sheet is tied up in goodwill. Currently, the sales to capital ratio is 3.4x which I assume as constant over the first 5 years and gradually transitions to 2.0x based on the nature of the business and capital productivity. Post year 10, the reinvestment is driven by an implicit perpetuity ROIC assumption of 22% in line with industry average.

Cost of Capital

With rising interest rates and tougher macro environment, the cost of capital for Bumble is ~ 9.6%. Note that the company has considerable debt on the books as well which has a below investment grade rating and bulk of the debt is due after 5 years. While this is a red flag, I have assumed that the company will be able to meet it's obligations and incorporated no chance of failure. The cost of capital transitions to ~ 9% in year 10 and beyond which is the median cost of capital for US firms.

From operating value to equity value

Using a 10 year explicit forecast period, I project out the cash flows with the first first 5 years of high growth, transition period from year 6-10 and stable growth period post 10. For the terminal value, growth is capped at the current risk free rate i.e. 2.7%, industry average ROIC of ~ 22% and cost of capital of ~ 9%. The value of operating assets is $6.5 Billion. Subtracting out debt, minority interest and adding back cash and equivalents leads to a value of equity of $5.4 Billion. Taking out the value of options and dividing by the shares outstanding gives me a value per share of  $28 which is ~ 27% lower than the current share price of $38.

Factoring in the uncertainty

To capture the volatility in my key assumptions, I did a Monte Carlo simulation by assigning distributions to overall market size (lognormal), market share (triangular) and operating margin in year 10 (uniform). This helps me in incorporating the wide values around these key variables rather than just point estimates. After 1 Million simulations, the median share price of $26 is in line with my base case value of $27. Based on my assumptions, the current market price is already around 85th percentile of the distribution. Would I buy the stock at this price? I don't think so- maybe when it is below the median price of $27 or there is a significant change in the narrative. Based on my current narrative and link to numbers, the stock is overvalued by ~ 27%.

Final thoughts

Based on my story for Bumble and the bridge to numbers, the current intrinsic value is low versus the prevailing market price. I think the real test for the company will be over the next few months- with global inflationary pressures and impending drop in global consumer discretionary spending, will the company be able to maintain it's growth trajectory and accelerate path towards profitability? The impact of these macro shifts might influence and possibly pivot my narrative for the dating app industry and Bumble as an investment. The next steps would be to look out for new information in the quarterly earnings and watch out for any company narrative shifts/breaks. Till then, I'll sit back and swipe left on this investment.

Bumble valuation model link

Note: The content on this blog reflects the personal views of the author and should not be considered as an investment advice or recommendation.